If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts.
Running the economy hot has produced some good numbers in
the short run, but warning signs are beginning to accumulate. Although there is
no natural life-span for a business cycle, this one has already been the
longest on record, measured the previous peak of December 2007. It is only
prudent to give some thought to our preparedness for the next recession — or
our lack of it.
Let’s start with the monetary side. The Fed’s primary tool
for fighting recessions is to cut its key interest rate, the federal funds
rate, in order to encourage lending and maintain liquidity of the banking
system. However, for that tool to work well, the rate has to be high enough
before the downturn starts to make room for significant cuts.
The following chart, in which gray bars show recessions,
allows us to compare the present situation with business cycles of the past.
For example, in late 2000, as the dot-com boom began to wind down, the fed
funds rate stood at 6.5 percent. Over the next year, the Fed cut the rate by
four and a half points, helping to keep the 2001 recession short and shallow.
That still left room to cut another point over the next two years, speeding the
recovery.
By the summer of 2007, when it was becoming hard to ignore
the growing weakness of the housing sector, the fed funds rate had risen to
5.25 percent. Between July 2007 and December 2008, the Fed cut it as close to
zero as was technically possible. This time, even a 5-percentage-point rate cut
was not enough to avoid a serious slump.
In both 2001 and 2007, the Fed was able to begin cutting the
fed funds rate based on early indications of trouble, and still have room for
maneuver. Today’s situation is not as favorable. If a strong expansion
continues through 2019, the rate may rise a bit higher than its current 2.4
percent, but if a recession were to come sooner, the Fed would have far less
countercyclical ammunition than it did at the two previous cyclical peaks.
Let’s turn now to fiscal policy. As the next chart shows,
the federal deficit normally moves toward surplus as the business cycle
approaches its peak. When a recession begins, or seems about to begin, having
the deficit under control creates “fiscal space” that makes it easier to use
tax cuts and spending increases to moderate the downturn and boost the
subsequent recovery.
This time, however, the budget began moving toward deficit
already in 2016. The turning point came with a package of spending increases and tax cuts, designed to
keep the government running through the 2016 elections, that was passed in
December 2015. That was followed by an even larger tax cut, not matched by
spending cuts, at the end of 2017. Although final numbers for 2018 are not yet
available, the deficit for 2018 (shown by the extension of the line at the far
right) is estimated to have been 3.9 percent of GDP. That makes the downturn
earlier and the pre-recession deficit larger than in any other business cycle
since World War II.
Under these conditions If a recession were to come any time
soon, the deficit will quickly eclipse the 10 percent mark that it approached
at the bottom of the Great Recession. Even if we accept the technical
feasibility of large-scale stimulus under those conditions, it would take a
Congress with a lot more political courage than the one we have now to pass a
robust countercyclical package of tax cuts and spending increases under those
conditions.
The bottom line: DeLong is right. We are not ready for the
next recession.
Previously posted at Medium.com
