Ready or Not for the Next Recession?
Policymakers normally respond to recessions by cutting interest rates, reducing taxes, and boosting transfers to the unemployed and other casualties of the downturn. But, for a combination of economic and political reasons, the US, in particular, is singularly ill-prepared to respond normally.
COPENHAGEN – A sunny day is the best time to check whether the roof is watertight. For economic policymakers, the proverbial sunny day has arrived: with experts forecasting strong growth, now is the best time to check whether we are prepared for the next recession.
The answer, for the United States in particular, is a resounding no. Policymakers normally respond to recessions by cutting interest rates, reducing taxes, and boosting transfers to the unemployed and other casualties of the downturn. But the US is singularly ill-prepared, for a combination of economic and political reasons, to respond normally.
Most obviously, the US Federal Reserve’s target for the federal funds rate is still only 1.25%-1.5%. If no recession is imminent, the Fed may succeed in raising rates three times by the end of the year, to around 2%. But that would still leave little room for monetary easing in response to recessionary trends before the policy rate hits zero again.
In the last three recessions, the Fed’s cumulative interest-rate cuts have been close to five full percentage points. This time, because slow recovery has permitted only gradual normalization of interest rates, and because there appears to have been a tendency for interest rates to trend downward more generally, the Fed lacks room to react.
In principle, the Fed could launch another round of quantitative easing. In addition, at least one of US President Donald Trump’s nominees to the Federal Reserve Board has mooted the idea of negative interest rates. That said, this Fed board, with its three Trump appointees, is likely to be less activist and innovative than its predecessor. And criticism by the US Congress of any further expansion of the Fed’s balance sheet would be certain and intense.
Fiscal policy is the obvious alternative, but Congress has cut taxes at the worst possible time, leaving no room for stimulus when it is needed. Adding $1.5 trillion more to the federal debt will create an understandable reluctance to respond to a downturn with further tax cuts. As my Berkeley colleagues Christina and David Romer have shown, fiscal policy is less effective in countering recessions, and less likely to be used, when a country has already incurred a high public debt.
Instead of stimulating the economy in the next downturn, the Republicans in Congress are likely to respond perversely. As revenues fall and the deficit widens even faster, they will insist on spending cuts to return the debt trajectory to its previous path.
Congressional Republicans will most likely start with the Supplemental Nutrition Assistance Program, which provides food to low-income households. SNAP is already in their sights. They will then proceed to cut Medicare, Medicaid, and Social Security. The burden of these spending cuts will fall on hand-to-mouth consumers, who will reduce their own spending dollar for dollar, denting aggregate demand.
For their part, state governments, forced by new limits on the deductibility of state and local taxes to pare their budgets, are likely to move further in the direction of limiting the duration of unemployment benefits and the extent of their own food and nutrition assistance.
Nor will global conditions favor the US. Foreign central banks, from Europe to Japan, have similarly scant room to cut interest rates. Even after a government in Germany is finally formed, policymakers there will continue to display their characteristic reluctance to use fiscal policy. And if Germany doesn’t use its fiscal space, there will be little room for its eurozone partners to do so.
More than that, scope for the kind of international cooperation that helped to halt the 2008-2009 contraction has been destroyed by Trump’s “America First” agenda, which paints one-time allies as enemies. Other countries will work with the US government to counter the next recession only if they trust its judgment and intentions. And trust in the US may be the quantity in shortest supply.
In 2008-2009, the Fed extended dollar swap lines to foreign central banks, but came under congressional fire for “giving away” Americans’ hard-earned money. Then, at the London G20 summit in early 2009, President Barack Obama’s administration made a commitment to coordinate its fiscal stimulus with that of other governments. Today, almost a decade later, it is hard to imagine the Trump administration even showing up at an analogous meeting.
The length of an economic expansion is not a reliable predictor of when the next downturn will come. And the depth and shape of that recession will depend on the event triggering it, which is similarly uncertain. The one thing we know for sure, though, is that expansions don’t last forever. A storm will surely come, and when it does, we will be poorly prepared for the deluge.
Giddy Markets and Grim Politics
Economists have endless debates about whether culture or institutions lie at the root of economic performance. But there is every reason to be concerned that the recent wave of populism is a threat to both.
CAMBRIDGE – Economic growth worldwide picked up in 2017, and the best guess is that the global economy will perform strongly in 2018 as well. At the same time, a rising tide of populism and authoritarianism poses a risk to the stable democratic institutions that underlie long-term growth. And yet headlines seeming to portend political instability and chaos have not prevented stock markets from soaring. What gives?
First, the good news. Surely the largest single factor in the synchronized global upswing is that the world economy is finally leaving behind the long shadow of the 2008 financial crisis. Part of today’s good fortune is payback for years of weak demand. And the rebound is not over, with business investment finally picking up after a decade of slack, thereby laying a foundation for faster growth and higher productivity gains in the future.
True, economic growth in China is slowing somewhat as authorities belatedly try to contain a credit bubble, but many other emerging markets – notably including India – are set to grow faster this year. Rising stock and housing markets may fuel inequality, but they also drive increased consumer spending.
Investors and policy wonks are also cheered by the resilience of central bank independence in the major economies. US President Donald Trump has not only largely spared the Federal Reserve the not-so-tender mercies of his wee-hour tweets; he has also nominated highly qualified individuals to fill Fed vacancies. Meanwhile, the German right has failed to pull the plug on European Central Bank policies that have helped prop up Italy, Spain, and Portugal, and the ECB remains by far the most respected and influential eurozone institution.
Elsewhere, things are pretty much the same. In the United Kingdom, British Prime Minister Theresa May, early in her tenure, once took a swipe at the Bank of England, but quickly retreated. As Mohamed A. El-Erian has noted, many investors regard central banks as “the only game in town,” and they are willing to overlook a lot of political noise as long as monetary-policy independence is upheld.
But while politics is not, at least for now, impeding global growth nearly as much as one might have thought, the long-run costs of political upheaval could be far more serious. First, post-2008 political divisiveness creates massive long-term policy uncertainty, as countries oscillate between governments of the left and the right.
For example, the recent US tax overhaul has been advertised as a surefire way to boost corporate spending on long-term investment projects. But will it live up to its billing if businesses fear that the legislation, passed by a thin partisan majority, will ultimately be reversed?
Part of the case for trying to secure bipartisan agreement on major long-term policy initiatives is precisely to ensure stability. And policy uncertainty in the United States is nothing compared to the UK, where businesses face the twin disruptions of Brexit and (potentially) a Labour government led by the far-left Jeremy Corbyn.
Harder to assess, but potentially far more insidious, is the erosion of public trust in core institutions in the advanced economies. Although economists have endless debates about whether culture or institutions lie at the root of economic performance, there is every reason to be concerned that the recent wave of populism is a threat to both.
Nowhere is this truer than in the US, where Trump has engaged in unrelenting attacks on institutions ranging from the mainstream media to the Federal Bureau of Investigation, not to mention adopting a rather cavalier attitude toward basic economic facts. At the same time, the left seems eager to portray anyone who substantively disagrees with its proposals as an enemy of the people, helping fuel both economic illiteracy and a hollowing out of the center.
Beyond existential risks, there are near-term risks. One, of course, is a potential sharp growth slowdown in China, which more than any other major economy in the world today seems vulnerable to a significant financial crisis. Perhaps the number one risk to the global economy in 2018, however, is anything that leads to a significant rise in real (inflation-adjusted) interest rates.
Low interest rates and easy monetary policy have papered over a multitude of financial vulnerabilities around the world, from Italian and Japanese government debt to high corporate dollar debt in many emerging markets, and perhaps account for political support for trillion-dollar deficits in the US. Admittedly, markets see little chance of any significant rise in global interest rates in 2018. Even if the Fed raises rates another four times in 2018, other major central banks are unlikely to match it.
But market confidence that interest rates will remain low is hardly a guarantee. A plausible pickup in business investment in the US and northern Europe, combined with a sudden slowdown in Asian economies with surplus savings, could in principle produce an outsize rise in global rates, jeopardizing today’s low borrowing costs, frothy stock markets, and subdued volatility. Then, suddenly, the economy’s seeming disconnect from politics might end, and not necessarily in a happy way.
Preparing for Europe’s Next Recession
In a recent interview, Peter Praet, the ECB's chief economist, explicitly noted that “all central banks” can print money and send checks to each and every citizen. But there are better ways to boost eurozone economic growth than resorting to so-called helicopter drops of money.
PARIS – If you do not understand what is happening to the eurozone economy, you are not alone. One day we are told that growth is definitely passé; the next that recovery is on track; and the third that the European Central Bank is considering sending checks to all citizens to boost output and revive inflation. Rarely has the economic picture been so confusing.
Start with medium-term growth. Since the global financial crisis erupted in 2008, productivity has grown at a snail’s pace. Oddly, the smartphones’ magic computing power does not seem to offset the slowdown in efficiency gains in manufacturing and standard services. For almost a decade, annual productivity growth in the advanced economies has been close to 1%, versus 2% previously.
This may be a temporary lull or a statistical illusion. But with no evidence that it will end, policymakers have downgraded their forecasts. Since 2010, the US Congressional Budget Office has lowered its outlook for productivity growth in the decade to 2020 from 25% to 16%; so has the United Kingdom’s Office for Budget Responsibility, reducing its forecast from 22% to 14% productivity growth. Everyone is adjusting to leaner times.
The surest way to buck this trend is to invest in education, promote innovation, and foster efficiency. In Europe, especially, a broad array of reforms could contribute to bridging a growing efficiency gap with the US. The ECB can exhort or incentivize, but it is governments that must act.
Turn now to current growth. In 2015, eurozone output barely exceeded its 2008 level, a dismal performance for which sluggish productivity growth cannot be blamed. Despite considerable slack in the economy, growth in 2015 was a disappointing 1.5%, and the ECB expects just 1.4% growth this year. This is far better than the contraction that occurred from 2011 to 2013, but one would expect a growth surge in an economy benefiting from a favorable exchange rate, record-low interest rates and the plunge in oil prices.
Austerity is not the culprit. Whereas premature consolidation of public budgets was largely responsible for causing a double-dip recession five years ago, fiscal policy has been broadly neutral since 2015.
Part of the explanation is the slowdown of the emerging economies. But such external factors also apply to the UK and Sweden, yet their growth rates are 2-3%. The truth is that the eurozone lacks internal momentum. Despite income growth, households are reluctant to consume and build; and, despite a surge in profits, companies are not inclined to take risks and invest.
One reason for wariness is that the future looks bleak. This is why reforms that strengthen the economy in the medium term can help in the short term, too. Another reason is that the past weighs too heavily on the present: because inflation is so low, accumulated debt does not go away and agents are forced to save to pay it down. Finally, unemployment in parts of the eurozone remains too high for households to regain confidence, while the fiscal stance is not distributed across countries in a way that maximizes growth prospects. This enduring malaise sustains below-target inflation, which in turn keeps real interest rates too high.
With the economy more fragile than it should be, the ECB has crossed one Rubicon after another in order to spark inflation. Despite renewed efforts, however, the battle remains undecided.
A third question must therefore be asked: What could the eurozone do if confronted with a severe deterioration in the global environment – for example, a precipitous interest-rate hike in the United States or an outright recession in China?
In such a case, private demand would contract; and, with heavily indebted governments keen to avoid being caught off guard by a surge in risk aversion, public demand would not come to the rescue. The memory of the 2011 sovereign-debt crisis remains fresh, and many officials would refrain from using fiscal policy to prop up the economy. At the same time, the ECB would have reached the limit of quantitative easing.
But to let a new recession happen after a short and feeble recovery would be regarded by citizens as a major policy failure, which would further weaken support for the euro.
Against this background, the ECB is openly pondering the right response. In a recent interview, Peter Praet, its chief economist, explicitly noted that “all central banks” can print money and send checks to each and every citizen – a last-resort option known as “helicopter money.” Because households would spend part of the windfall, a helicopter drop would boost both domestic demand and the price level.
Helicopter money raises both legal and technical difficulties. More fundamentally, orthodox economists claim that it would be a quasi-fiscal operation for which the central bank has no explicit mandate. Its advocates reply that the ECB does have a mandate to keep inflation close to 2%, and that it should consider all options – even highly unconventional ones – to achieve that target.
It is true that a helicopter drop would be functionally equivalent to a direct government transfer to households, financed by central banks’ permanent issuance of money. So helicopter money, while consistent with the ECB’s price stability mandate, would indeed blur the distinction between monetary and fiscal policies.
Could an explicitly fiscal option be embraced instead? Assuming individual governments would not want to spend, the eurozone as an entity could borrow to finance growth-enhancing policies. A sort of beefed-up Juncker plan (the European Commission president’s scheme to invest €315 billion over three years), based on preselected projects to be activated when the time is right, would provide a significant hedge against the risk of recession.
Such projects could be investments that would help limit global warming, or investments to equip the labor force for the digital economy. Borrowing would be carried out jointly and should be backed by a dedicated source, either a tax or a defined GDP-based contribution that would enable the eurozone to pay down its debt.
The political difficulties inherent in such a scheme would no doubt make agreement difficult. It is not clear whether eurozone-wide borrowing would be easier to contemplate than an ECB-engineered quasi-fiscal transfer. What is clear is that the eurozone should evaluate these options, because either one might well be needed sooner or later.
Can Economic Policy Solve Economic Problems?
There are plenty of smart policies that can help to address the economic factors that have fueled support for populist politicians over the last year. But, even as economists promote such measures, they must remain humble about the efficacy of their solutions.
CAMBRIDGE – The past year has witnessed several attacks, including a few near misses, on the rules-based global order that has undergirded prosperity in the world’s advanced economies and the rapid growth of many emerging economies. A lively debate has ensued about whether the fundamental cause of such populist attacks is economic or cultural. I suspect the answer is a bit of both, especially because cultural explanations raise the question of why now, whereas economic explanations provide a ready answer: the significant slowdown of income growth.
A tougher question is what can be done about it. The challenge we face consists in the disconnect between the economic aspirations of the discontented and the policy tools we have at our disposal to meet them. And in some cases, the tools themselves may be politically counterproductive.
Still, we must try, because surveys of life satisfaction reveal some disturbing trends. Life satisfaction in the United States, as measured by the General Social Survey, peaked in 1990 and has been largely trending down, even as household incomes have risen (albeit tepidly). Other major economies have also experienced declining levels of self-reported wellbeing, including Italy, where Pew’s measure of life satisfaction peaked in 2002, and France as well.
President Donald Trump won the 2016 election partly by promising to address the drivers of these trends – promises that neither he nor anyone else could keep. He promised to restore manufacturing jobs, even though manufacturing employment is falling worldwide as machines replace humans, propelling record production without commensurate job creation.
Similarly, Trump promised to restore the coal industry, which has also been declining for decades, not only for some of the same technological reasons, but also because of the fall in the price of natural gas and, to a much lesser degree, increased regulation of coal-based energy. More broadly, his promise of substantial job creation, wage gains, and economic growth of 4% or more flew in the face of deep factors, like demographic trends and slow productivity growth worldwide, that are at the root of today’s economic challenges.
The right policy agenda is one that would foster stronger, more inclusive growth. Although the details vary from country to country, they generally include improving education, increasing infrastructure investment, expanding trade, reforming tax systems, and ensuring that workers have an adequate voice in their economic futures.
But I worry that in advanced economies, all of these policies combined would make only a small dent in today’s problems. Developing countries can undergo large swings in growth as a result of major policy and institutional changes – witness China’s transition to a market economy, India’s reforms to end the license raj, or economic liberalization in Latin America. But advanced economies are all growing at very similar rates, and nothing in the last several decades suggests that structural policies can have a major impact on medium- and long-term growth (in certain circumstances, short-run demand policies can make a big difference).
If advanced economies did everything right, their growth rate might increase by, say, 0.3 percentage point. That is certainly worth doing; much of economic policy is about finding ways to add tiny increments to the growth rate. But I find it implausible that our politics will change radically if the median US or French household gets an extra $1,800 after a decade.
Similarly, we should be making a much more robust effort to reduce inequality. In some countries, that means strengthening workers’ bargaining power – higher minimum wages and stronger unions would be a good start – while tackling issues that weaken it, like employer collusion and restraints on employees’ ability to change jobs.
Policies that promote competition and reduce inefficient rents also have an important role to play. This includes more vigorous antitrust enforcement and efforts to reduce entry barriers, for example, by giving people ownership of their personal data. But, again, the plausible impact of such policies would fall well short of overcoming people’s concerns with inequality and slow income growth.
Some other policies are economically sensible, but may be politically counterproductive. For example, while I strongly agree with the widespread view that a robust social safety net is needed to protect the “losers” of globalization and market-based competition, I worry that creating one may be as likely to weaken as to reinforce social cohesion.
In the US, the 2010 Affordable Care Act (“Obamacare”) was the largest expansion of the social safety net in almost 50 years, and it is hard to imagine another as large in the next 50 years. But increased funding for health insurance and the greatly reduced chance of becoming uninsured have not dramatically changed US politics or alleviated concerns about job losses due to trade. If anything, the Affordable Care Act may have increased polarization, given that some of what fuels populism is the resentment felt by those who perceive government benefits as going to others at their expense.
Nonetheless, such economic policies are the right steps to take, and they just might help defuse a little of the anxiety. But we must also be humble about our understanding of which solutions could address our current economic problems, particularly the need to promote higher levels of employment.
In fact, the solution to our political problems, in 2018 and beyond, may lie not in any new policies or materially changed circumstances, but in finding better ways to communicate about the challenges we face, the efforts being made to address them, and the inherent limits that confront all policymakers. There has to be a better answer than just lying to people about what our policies are capable of accomplishing.