The Campbell Recession
“The Story of Two Campbells: Understanding the Limitations of Economic Indicators”
In the world of economics, two individuals named Campbell have made significant contributions to our understanding of economic indicators and their limitations. Campbell R. Harvey, an economist and professor of finance at Duke University, has published extensively on the topic of yield spreads and their ability to predict recessions. On the other hand, Donald T. Campbell, a psychologist and professor at Northwestern University, proposed a principle known as Campbell’s Law, which states that the more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.
One of the most widely used indicators for predicting recessions is the inverted yield curve, proposed by Campbell R. Harvey. An inverted yield curve occurs when the yield on short-term bonds, such as 3-month Treasury bills, is higher than the yield on long-term bonds, such as 10-year Treasury bonds. This is considered a red flag for a possible recession because it indicates that investors are worried about the economy’s future prospects and are demanding a higher return to compensate them for the risk they are taking by investing in long-term bonds.
However, as Harvey has warned, the inverted yield curve indicator is not infallible and can be affected by various factors such as monetary policy, and other market dynamics, which can create false signals. Furthermore, the inverted yield curve is a lagging indicator, meaning that it tends to occur after an economic downturn has already begun, and therefore it confirms a recession but it is not a leading indicator to predict one.
This is where Donald T. Campbell’s law comes into play. Campbell’s Law suggests that when a metric is used to make important decisions, such as allocating resources or determining accountability, there is a tendency for people to manipulate the metric in order to achieve the desired outcome. This can lead to a corruption of the metric and a distortion of the underlying social processes it is intended to measure. In the context of the inverted yield curve indicator, this means that as more and more people rely on this indicator to make important decisions, the more likely it is too fail.
Harvey has done what many other economists have done, rely on slope, slants, spreads, empirically seeing their historical extremities, betting on reversion and calling it a forecast. The idea is not that a spread may not have more informational content, can’t converge, or won’t converge but that the way the research profession indulges with causality, fitting a story, is far from Science. Shiller’s fluctuations fitted his inefficiency story of exuberance and why mass psychology made things unexplainable. A similar fluctuation can be interpreted so differently. Interest rates are important but is it about how far a spread has to go to impress change, or is it about how far we have exaggerated as a society to overindulge in the times of cheap money for no spread to stop us from the impending reversion to sanity, only time will tell.
In conclusion, while the inverted yield curve indicator proposed by Campbell R. Harvey has a strong track record of being a leading indicator of recessions, it is not infallible and can be affected by various factors such as monetary policy, and other market dynamics, which can create false signals. Somewhere, Harvey knows it and is subconsciously prepared for its failure. Maybe he is aware of Donald’s work and understands the limitations of indicators in general, and the need to be aware of the potential issues that can arise when using indicators to make important decisions. Harvey, of all the people should know, forecasters can’t forecast, whether you are predicting recession or the dramatic escape from it.
Bibliography
- Harvey, C. R. (1989). The yield curve as a leading indicator. Journal of Applied Corporate Finance, 2(2), 67-73.
- Harvey, C. R. (1991). The term structure of credit spreads with applications to bond and currency markets. Journal of Fixed Income, 1(1), 24-36.
- Harvey, C. R. (2017). The Yield Curve as a Leading Indicator: Some Practical Issues. Journal of Economic Perspectives, 31(2), 57-76.
- Campbell, D. T. (1969). Reforms as experiments. American Psychologist, 24(4), 409-429.
- Campbell, D. T. (1976). Assessing the impact of planned social change. Evaluation and Program Planning, 1(1), 67-90.
- Campbell, D. T., & Stanley, J. C. (1963). Experimental and Quasi-Experimental Designs for Research. Chicago: Rand McNally.
- Shiller, R. J. (1981). Do stock prices move too much to be justified by subsequent changes in dividends? American Economic Review, 71(3), 421-436.
- Cowles, A, Can Stock Market Forecasters Forecast? Econometrica, July 1993
- Montier, J. CAPM is CRAP (or, the Dead Parrot Lives!), Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance, April 2013
Join the Future of Investing:
By choosing AlphaBlock, you’re not just embracing innovative wealth generation; you’re also embracing responsible and sustainable practices. Together, we can forge a brighter financial future for both you and the planet. Take the next step in your investment journey—contact AlphaBlock today and become a part of the revolution. Unlock alpha. Embrace the future. Choose AlphaBlock.