First posted on:
Jeffrey Frankel's blog, 30 August 2018.
US economic statistics are currently good. But the next recession could be bad.
This American expansion has been long-lived. If it continues another year it will equal the record 10-year expansion in the 1990s. Unemployment is low: 3.9% in July, as low as in 2000, during the Clinton Administration. GDP growth has been relatively strong: the BEA recently estimated 2nd-quarter 2018 growth at 4.2%, the highest quarter since 5.1% and 4.9% in 2014, during the Obama Administration.
But sooner or later there will be a new recession. There always is. When it comes, it could be more severe than the typical downturn.
The next recession
What could set off a recession in the coming years? Here is one possibility. Because the US stock market is high – as indicated, for example, by a historically high cyclically adjusted price earnings (CAPE) ratio – and because global corporate debt is also high, a negative shock could send securities markets tumbling.
What sort of shock? A return of inflation is one good candidate. Another is an escalation of the trade war that Donald Trump has started.
Possible shocks could also originate in the rest of the world. The crisis in Turkey could spread to other emerging markets. The euro crisis is not truly over, even though Greece’s bailout ended on 20 August with its creditors declaring over-optimistically that the country is back on a sustainable debt path. Italy is in particular danger. China — which Americans view as a manufacturing juggernaut that threatens to surpass it — is vulnerable, in light of its slowing growth and high levels of debt.
Why do I worry that the next recession, whenever it comes, could be severe? Because US government policy is currently pro-cyclical, rather than counter-cyclical.
Admittedly it is hard to get counter-cyclical timing exactly right. But that is no excuse for adopting pro-cyclical policy. The current government is acting pro-cyclically in three areas: (1) fiscal policy; (2) macroprudential policy; and even (3) monetary policy.
Pro-cyclical fiscal policy
The US is now undergoing the most radically pro-cyclical fiscal expansion since the late 1960s, and perhaps since WWII. Usually during economic upswings, the budget deficit falls, at least as a share of GDP. Not this time. The respected Congressional Budget Office projects that despite good growth and low unemployment, the budget deficit will soon exceed $1 trillion.
Expansionary fiscal policy is blowing up the deficit on both the tax side and the spending side. Most notable is the tax bill passed by the Republicans in December 2017, featuring big cuts in the corporate income tax. A reduction in the corporate tax rate was appropriate; but true tax reform should have been revenue-neutral. Also spending has been increasing rapidly this year. Once again, as in the administrations of Ronald Reagan and George W. Bush, despite their small-government rhetoric, ‘fiscal conservatives’ are fiscal profligates in practice.
When the next recession comes, the US will lack ‘fiscal space’ to respond, having already used up its ammunition.
Such destabilising fiscal policy is traditional in developing countries, exacerbating their booms and busts. The historical pattern is well-documented, though some emerging market countries achievedcounter-cyclical fiscal policy after learning from the mistakes of the 1970s-1990s.
(Another reason, besides cyclical timing, why this is an especially bad time to push up the budget deficit: the retirement of the baby boom generation means that big deficits are coming in social security and Medicare.)
Pro-cyclical regulatory policy
A second reason, beyond fiscal policy, why a future crisis may be severe is pro-cyclical financial regulation: relaxing financial regulation at the height of a financial boom. This is the wrong way to do it. Pro-cyclical regulation exacerbates the swings.
The White House and Congress have been de-regulating too much, at the wrong point in the cycle. They have now gutted Obama’s fiduciary rule, which would have required professional financial advisers (in return for their fees) to put their clients’ interests first when advising them on assets invested through retirement plans. They have halted the good work of the Consumer Financial Protection Bureau, which was protecting households who take out pay-day loans, student loans, and car loans. Sensible regulation of housing finance has been rolled back, for example, risk-retention rules to require that mortgage-originators ‘keep skin in the game’ and requirements that borrowers should be able to make a substantial down-payment before they take on debt that they may not be able to repay.
Congress and the White House have been working to ‘do a number’ on the Dodd-Frank reform of July 2010. Its key features helped to strengthen the financial system: the creation of the CFPB, higher capital requirements on banks, SIFI designation, and enhanced transparency for derivatives. Undermining or rescinding these regulations increases the risk of an eventual recurrence of the 2007-2008 financial crisis.
Like most major legislation, Dodd-Frank could usefully be modified after a few years of experience. Banks’ paperwork burden and other compliance costs were indeed excessive, especially in the case of small banks. The original threshold for ‘too big to fail’ stress-tests, at $50 billion in assets, was too low. But the $250 billion threshold is probably too high. Furthermore, non-banks should not be exempted from annual stress tests. Now is the right point in the cycle to raise banks’ capital requirements as called for under Dodd-Frank; the cushion will minimise the risk of a future banking crisis.
Other countries do macroprudential policy better. Europeans have applied the counter-cyclical capital buffer on their banks. Some Asian countries raise bank reserve requirements and tighten homeowners’ loan-to-value ceilings in a boom, and loosen them when there is a financial downturn, rather than the other way around.
Pro-cyclical monetary policy
Third comes monetary policy. Although the Federal Reserve has been doing a good job, its independence has been under assault from politicians. If the assault were successful, it would impair the counter-cyclicality of monetary policy.
In past recessions, the Fed has responded by short-term cutting interest rates around 500 basis points, helping to moderate those recessions. But it won’t be able to do it next time, if interest rates at the peak are only 200 basis points, their current level. As Martin Feldstein wrote on 26 July in a Wall Street Journal op-ed: “raising the rate when the economy is strong will give the Fed room to respond in the next economic downturn with a significant reduction.” That is counter-cyclical monetary policy.
Most Fed critics think differently. In 2010 they attacked the Fed for easy money (quantitative easing), even though unemployment was still above 9%. Now President Trump says he is “not thrilled” (19 July) about the Fed raising interest rates, even though unemployment is below 4%. Fed critics act as if they want pro-cyclical monetary policy.
Déjà vu
We have been here before. The tenth anniversary of the global financial crisis is upon us (September, if one dates it from the Lehman Brothers failure). In the years 2003-2007, the government pursued fiscal expansion and financial de-regulation. It was possible to predict that when the next recession came, the government would feel constrained by the national debt from enacting sufficiently big tax cuts or spending increases to fully deal with it. History may repeat itself yet again.
Authors' note: This post is based on “The Next Economic Crisis,” remarks on a panel at the 2nd annual retreat of the American Enterprise Institute in Jackson Hole, Wyoming, August 13. A shorter version appeared at Project Syndicate. Comments can be posted there or at the Econbrowser site.
