Crisis, Rinse, Repeat
Key economic data from the periods following the 1929 stock-market crash and the 2007-2008 financial crisis suggest that the current recovery has been unnecessarily anemic. If policymakers refuse to heed the lessons of the New Deal era, then the next crisis is destined to be as prolonged as the last.
BERKELEY – Later this century, when economic historians compare the “Great Recession” that started in 2007 with the Great Depression that started in 1929, they will arrive at two basic conclusions.
First, they will say the immediate response of the US Federal Reserve and the Department of the Treasury to the crisis in 2007 was first-rate, whereas the response immediately after the stock-market crash of 1929 was fifth-rate, at best. The aftermath of the 2007-2008 financial crash was painful, to be sure; but it did not become a repeat of the Great Depression, in terms of falling output and employment.
On the other hand, future historians will also say that the longer-term US response after 2007-2008 was third-rate or worse, whereas the response from President Franklin Roosevelt, Congress, and the Fed in the years following the Depression was second- or even first-rate. The forceful policies of the New Deal-era laid the foundations for the rapid and equitable growth of the long postwar boom.
Now, consider some key economic data points. US per capita national income peaked in 2006, just before the Great Recession, and was still 5% below that point in 2009. Within three years, however, it had returned to its 2007 peak; and, if we are lucky, it will end up being 8% above its 2007 peak this year.
By contrast, four years after US per capita national income peaked in 1929, it was still down 28%, and would not return to its 1929 peak for a full decade. In other words, there can be no comparison to the Great Depression, at least in terms of decreased per capita national income.
But nor can there be any comparison to the Great Recession in terms of weak productivity growth. Within 11 years of the peak of the pre-Depression business cycle in 1929, output per worker was up 11% and still growing rapidly. By contrast, output per worker this year is only 8% higher than its pre-Great Recession peak, and that figure continues to rise slowly.
So, within 11 years of the start of the Depression, Roosevelt and his team had gotten US per capita national income back to its previous peak while pushing output per worker 11% higher. Moreover, they did that having started from a position in 1933 that was incomparably worse than what US policymakers faced in late 2009. When historians look back at the two periods, they will have to conclude that the relative performance after the Great Recession was nothing short of appalling.
In assigning blame for this dismal track record, Democrats point to the fact that Republicans turned off the spigot of fiscal stimulus in 2010, and then refused to turn it back on. Republicans, for their part, have offered a range of incomprehensible and incoherent explanations for the anemic growth recorded since the financial crisis.
Some Republicans, naturally, blame Obama and his signature legislative accomplishments like the 2010 Affordable Care Act (Obamacare) and the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Others blame the unemployed, those who have dropped out of the labor market altogether, or those who want to work but supposedly have nothing of value to contribute – the so-called “zero marginal product workers.”
There is much more truth to the argument offered by the Democrats, even if Obama and his team also deserve a fair share of the blame for pursuing inappropriate fiscal austerity in the early stages of the recovery. At any rate, austerity is not the whole story. And when thinking about what comes next, the most worrisome aspect of the post-2007 response is that those who implemented it, and those who succeeded them, still do not recognize it as a failure.
For example, Fed policymakers, with a few honorable exceptions, still insist that they did the best they could, considering the fiscal headwinds at the time. Likewise, Obama administration policymakers still pat themselves on the back for preventing a second Great Depression, and say they did the best they could, given recalcitrant Republican congressional majorities after the 2010 midterm elections.
At the same time, right-leaning economists still busy themselves arguing that the Obama administration’s fiscal policies and then-Fed Chair Ben Bernanke’s monetary policies were dangerously inflationary. If we are to believe them, we should consider ourselves lucky to have escaped the fate of Greece or Zimbabwe.
But as Christina D. Romer and David H. Romer of the University of California, Berkeley, have shown, countries throughout the post-war period that lacked the monetary or fiscal space to deal with a financial crisis often suffered from output shortfalls of 10% or more even a decade after the fact.
It has now been 11 years since the start of the last crisis, and it is only a matter of time before we experience another one – as has been the rule for modern capitalist economies since at least 1825. When that happens, will we have the monetary- and fiscal-policy space to address it in such a way as to prevent long-term output shortfalls? The current political environment does not inspire much hope.
Whatever Happened to Saving for a Rainy Day?
The US will be paying for its current fiscal excesses with the promise of future payments. But inefficient economic stimulus now will not give future generations the productive resources needed to make good on it.
CAMBRIDGE – More than a decade ago, I undertook a study, together with Graciela Kaminsky of George Washington University and Carlos Végh, now the World Bank’s chief economist for Latin America and the Caribbean, examining more than 100 countries’ fiscal policies for much of the postwar era. We concluded that advanced economies’ fiscal policies tended to be either independent of the business cycle (acyclical) or to lean in the opposite direction (countercyclical). Built-in stabilizers, like unemployment insurance, are part of the story, but government outlays also worked to smooth the economic cycle.
The benefit of countercyclical policies is that government debt as a share of GDP falls during good times. That provides fiscal space when recessions materialize, without jeopardizing long-run debt sustainability.
By contrast, in most emerging-market economies, fiscal policy was procyclical: government spending increased when the economy was approaching full employment. This tendency leaves countries poorly positioned to inject stimulus when bad times come again. In fact, it sets the stage for dreaded austerity measures that make bad times worse.
Following its admission to the eurozone, Greece convincingly demonstrated that an advanced economy can be just as procyclical as any emerging market. During a decade of prosperity, with output close to potential most of the time, government spending outpaced growth, and government debt ballooned. Perhaps policymakers presumed that saving for a rainy day is unnecessary if this time is different and perpetual sunshine is the new normal.
Fast-forward to the United States in 2018. Trillion-dollar deficits as far as economists can project are prima facie evidence that the arc of fiscal policy in the US bends in the wrong direction. An aging population should be husbanding resources for the future, not spending on itself now. Of course, democracies have a long history of over-rewarding current voters at the expense of future generations, but the current scale and scope of fiscal largess is mistimed to both the trend and cycle of the US economy. Most analysts believe the US is at or near potential output. Fiscal stimulus at such a time is plainly procyclical.
The previous round of fiscal stimulus dates to the 2009 American Recovery and Reinvestment Act, enacted in response to the Great Recession. The stimulus stretched past the immediate need, the ultimate price tag rose to $840 billion, and the net economic benefit remains debatable. Yet, even with these flaws, the legislation addressed the palpable cyclical reality of an unemployment rate touching 10%. This is what to expect in the exercise of discretionary policy, which is why the unemployment rate moves inversely with the federal budget deficit.
The Reagan tax cuts of the early 1980s came at a time when the unemployment rate was climbing to post-war highs, the economy was in recession, and the Federal Reserve battling inflation and keeping interest rates at or near record highs. The gross public debt at the time, at 31% of GDP, was small potatoes compared to today’s ratio of 105%.
The two main pillars of fiscal policy passed since December contravene the fundamental design principle of countercyclicality. The Tax Cuts and Jobs Act of 2017 and the Bipartisan Budget Act of 2018 are projected to put the deficit above $1 trillion by next year, even as most economists project the unemployment rate to move lower. Most Federal Reserve officials, for example, expect the unemployment rate to be just above 3.5% over the next three years, or almost one percentage point below their assessment of its natural rate.
This forecast of excess demand is an important part of the Fed’s rationale for raising the policy rate and shrinking its balance sheet. The net result of fiscal and monetary policy moving in opposite directions is that the Fed will make the government debt created by this legislation more expensive. The scale is not inconsiderable. The Center for a Responsible Federal Budget forecasts that interest costs will be the fastest-growing component of the budget, eating up 14% by 2028.
True, the federal tax code is in dire need of improvement, and last year’s reform, especially the reduction in the corporate tax rate, should boost output in the longer term. But such a gain is hard to bank on, and there is no plausible way that reform pays for itself. Rather, the preferable strategy would have been to pair costly tax policy changes with revenue-raising and expenditure-cutting initiatives. In fact, this year’s budget deal goes further in the wrong direction, making it likely that the public debt exceeds nominal income within ten years.
My concern about excessive government debt back goes a long way, both in terms of my research agenda and along the timeline of global economic performance. In work with Vincent Reinhart and Kenneth Rogoff examining a sample of advanced economies since the Napoleonic War, we found that periods of high debt were paired with long periods of weak economic growth. And in the current context, any adverse effect of debt on economic growth will intensify ongoing headwinds.
An aging US population implies lower participation in market activity. This, together with slower productivity, implies that rising entitlement spending will take a bigger slice of the income pie. Indeed, the Congressional Budget Office foresees increases in spending relative to GDP of about five percentage points in each of the next two decades.
Some officials argue that foreign investors’ appetite for US government debt – the rest of the world holds almost half of all outstanding Treasury securities, worth more than $6 trillion – insulates America from economic harm. Capital-account surpluses, mirrored in current-account deficits, summed to about $3.3 trillion from 2010 to 2017, compared to an $8 trillion aggregate federal deficit.
But those macroeconomic outcomes result from policy decisions abroad and the market-clearing movements of financial prices. Officials in important emerging-market economies chose to accumulate Treasury securities, because US yields, albeit low, were higher than in other advanced economies. A confrontational stance on trade, together with greater reliance on government debt, may well extract a higher toll to balance flows of goods and services and of capital. Moreover, the US will be paying for its current excesses with the promise of future payments, and inefficient stimulus now will not give future generations the productive resources needed to make good on it.
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.
The Heightened Risks of a US Downturn
The US economy has experienced nine recessions during the last 50 years. What makes the current situation unusual and more worrying than in the past is the low level of short-term interest rates and the high (and rising) level of federal debt, which will limit policymakers' ability to provide the stimulus needed to counter a recession.
CAMBRIDGE – The United States’ economy is roaring ahead, and above-trend GDP growth looks set to continue in 2018 and 2019. Although the expansion is in its ninth year, there is no sign of an imminent slump.
The greatest risk to the economic expansion is the fragility of the financial sector. A decade of excessively low interest rates has pushed asset prices to extreme heights. The real yield on ten-year Treasury bonds is approximately zero. The price-earnings ratio of the S&P 500 share index is about 70% above its historic average. If these and other asset prices reverted to their historic benchmarks, investors would suffer losses in excess of $10 trillion, leading to declines in consumer spending and business investment.
Economic activity could also slow as a result of international conflict in Korea, heightened trade disputes, or domestic political events in the US.
Downturns are a normal feature of the US economy, which has experienced nine recessions during the last 50 years. What makes the current situation unusual and more worrying than in the past is the low level of short-term interest rates, which limits the ability of the US Federal Reserve to bring monetary policy to bear in countering the next recession.
The Fed traditionally responds to a downturn by sharply reducing the short-term federal funds rate. During the most recent downturn, the Fed lowered the benchmark rate from over 5% in July 2007 to just 0.16% in December 2008, a total reduction of more than five percentage points. At only 1.4% now, the Fed has little scope for a significant rate reduction. At its meeting in December, the Federal Open Market Committee’s median forecast for the federal funds rate at the end of 2019 was still a very low 2.9%.
To stimulate demand in the last downturn, the Fed also practiced what it called “unconventional monetary policy,” promising to keep short rates low for a long time and buying long-term bonds for its own portfolio. This strategy was aimed at keeping long-term interest rates low enough to boost demand for equities and real estate, and thereby increase wealth and spending. It is not clear that this strategy would provide the hoped-for stimulus as long as real interest rates remain low.
The responsibility for stimulating the economy in the next downturn will therefore fall to fiscal policy – changes in taxes and government spending.
A new temporary tax cut would not work. Experience shows that a temporary cut in personal income taxes would provide very little stimulus, because most taxpayers would use the resulting extra net income to pay down debt or increase their savings, rather than spending more.
But the 2017 tax law provides an opportunity for a permanent tax cut by preserving the cuts that are now scheduled to expire in 2025. The Republicans who designed and voted for the 2017 law expected to extend those cuts beyond 2025 in subsequent legislation. An economic downturn in the next few years would be a good time to make the cuts permanent.
The other way to reverse an economic downturn would be to increase government spending. There is now widespread bipartisan support for increased spending on infrastructure of all kinds, just as there was in the 2007 downturn. Although the Obama administration spoke about “shovel ready” projects when promoting its putative stimulus legislation, the reality was that very little of the money was spent on infrastructure, owing to the long delays involved in implementing such projects.
The US Congress and the White House should begin now to develop an inventory of infrastructure projects that could be implemented when the economy slows. If there is no downturn during the next several years, it would still be desirable to start some of those projects.
Another form of spending to stimulate the economy would be increased outlays for defense. Because of the “sequester” rule in the Budget Control Act of 2011, the level of defense outlays is required to decline from 4.3% of GDP in 2012 to just 2.8% of GDP in 2023, the lowest GDP share since World War II. Defense experts agree that this level is far too low for America’s defense needs. An increase in outlays to 4% or more of GDP would be a significant source of increased overall demand and a crucial contribution to national security.
The high level of the national debt – about 77% of GDP now and heading to 97% at the end of the next ten years – would create strong resistance to either tax cuts or increased spending. But a significant economic downturn with limited scope for Fed action would leave Congress with little choice.
The need for a future fiscal stimulus makes it clear that the US needs to start now to develop a strategy for slowing the growth of the national debt. That is the only way to create enough room for the expansionary fiscal policy that the economy eventually will need.