Yesterday, some colleagues and I gave a talk on the urgency of being ready for the next downturn before it hits. Here’s the PowerPt (as a PDF) and below is an annotated version. To be clear from the outset, you will not learn from this presentation when the next recession will be upon us because no one knows (as you’ll see, the presentation features some headwind and tailwind slides). What we do know is that there are some important and unique attributes re the current expansion that makes planning now for the next downturn especially urgent.
What do I mean, “limited monetary space?” The arrows in the next slide shows how much–how many percentage points–the Fed funds rate has fallen in downturns since the 1970s–more than 5 ppts, on average. Note that cute, little arrow at the end of the series. Especially given the Fed’s recent shift in bias toward “insurance” cuts, it’s a virtual certainty that we’ll enter the next downturn with less monetary space than in the past (this observation assumes the Fed means it when they say they’re not much interested in Euro-style negative rates).
OK, but what about fiscal policy, which was really the focus of this briefing? As the next slide shows, wherever the next downturn is, absent large, unforeseen (and frankly, unimaginable; neither large tax increases nor big spending cuts are happening anytime soon) changes to our fiscal policy, we’ll be going into the next downturn with a debt/GDP ratio that’s at least twice that of the post-1970 average.
Which is why it’s so important to distinguish between “actual” and “perceived” fiscal space.
The second bullet above is especially important. There’s this crazy idea you sometimes hear from policy makers: “in a recession, households have to tighten their belts, and thus the government should do so as well.” That’s totally upside-down. The whole point of countercyclical policy is that because HHs are belt-tightening, the federal government must engage in deficit-financed belt loosening (remember, states have to balance their budgets so the in a downturn, the federal gov’t is the only fiscal game in town).
The next bullet argues that government spending to offset downturns is temporary. Thus, while it can raise the debt level, it doesn’t raise deficits once the economy recovers.
Still, as the next bullet says, at least one prominent paper found that when countries enter downturns with debt/GDP as high as ours will be, the fiscal response has been too tepid. In other words, history suggests that the distinction between actual and perceived fiscal space has not been adequately made or reflected in countercyclical policies.
The next slide gets a little into policies re lessons I learned from being in the Obama admin during the Great Recession. I recently wrote about these ideas here, but my colleagues on the panel for this briefing–Heather Boushey and Indivar Dutta-Gupta–have a lot more to say about them and others in a recent book for the Hamilton Project.
The key point, however, as I argue here, is to make these programs automatic stabilizers, not discretionary ones for Congress to fight over while the recession is whacking people’s living standards.
Finally, I’ve got these figures on headwinds:
Slower real GDP growth, though nothing recessionary, is uniformly in the forecasts. (“Mark’s nervous” refers to Mark Zandi of Moody’s having the most pessimistic forecast. He and I are writing a joint piece on that, so stay tuned.)
The Treasury yield curve is in inversion territory, and the bond market in general is strongly signalling its expectation of lower growth and significant Fed rate cuts. The stock market, while mostly going sideways for the past year, has popped a bit of late. This too reflects a more dovish Fed, but equity investors are expecting a softer landing than bond investors.
Employment growth has slowed, though it’s still strong enough to fuel solid, non-recessionary consumer spending
However, the Conference Board Consumer Confidence index is trending down…but it’s awfully noisy.
The trade war is whacking global trade volumes which is far from recessionary but is a drag on growth, both here and abroad.
Finally, my personal favorite tailwind indicator (on the right, above): the close tracking between aggregate real earnings and consumer spending. The good news is they’re both clearly in expansion territory. The bad news is that they can both downshift within a few quarters.
So, there you have it. I fear that the likely lack of both monetary space and perceived fiscal space may severely dampen the reaction to the next downturn. Moreover, headwinds exist. Thus, we should fix the roof while the sun is behind a few clouds.
I’m really worried about this, and you should be too. Still, I sleep like a baby. That is, I wake up screaming every two hours.