January 18, 2023 - Podcast

Episode 338 — Predicting US recessions

Researchers at the Indiana University Kelley School of Business and the University of Missouri have devised a new model to predict recessions and economic slowdowns, based on the likelihood of financial misreporting in the economy.

Professors Messod D. Beneish and David B. Farber found that recessions and economic slowdowns are more likely when more firms in the economy misreport their financial performance.

For 2023, Beneish says their model predicts no recession, but it does foresee an economic slowdown. While their recession forecast differs from the consensus forecast of professionals on a recent Wall Street Journal survey, it is in line with forecasts from Goldman Sachs and Morgan Stanley.

Like existing recession prediction models that rely on information from credit markets, capital markets, monetary policy and inflation, Farber says their model uses an estimate of the spread between long and short treasury rates, market returns, and other predictors used by academics and professional forecasters. Unlike existing models, their model improves probabilistic predictions by considering the aggregate probability of financial misreporting in the economy.

The rationale for their finding centers on how the combined probability of financial misreporting measures the amount of misinformation in the economy. Beneish says that this has real economic consequences, as firms base their investment, hiring and production decisions on both their financial information and on that of their competitors.

Firms that misreport often overinvest to hide the fact that they are facing economic headwinds which results in their competitors having a delayed response to the economic decline. When the misreporting is discovered, firms recognize that an economic downturn is occurring and consequently reduce their investment and production activity.

An increasing amount of misreporting in the economy can lower investment by corporations and household consumption, which would account for the economy going into recession.

To assess the prevalence of financial statement manipulation in the economy, Beneish and Farber used a measure widely known as the M-Score, which was created by Beneish in the late 1990s. The M-Score, which measures the likelihood that a company has manipulated its financial statements, remains the most economically viable measure for investors out of seven misreporting measures compared in a study published in October 2022. Notably, the M-Score provided one of the earliest warnings about the Enron accounting scandal. 

Because their model improves the probability about whether the economy will enter a recession or economic slowdown, regulators should find it useful as they consider policy choices based on expected future economic conditions, says Farber.