US Will Lack Fiscal Space to Respond When Next Recession Comes

The economy is doing well but the US is in a weak position to manage the inevitable shock.

The US economy is doing well. But the next recession – and there is always another recession – could be very bad.

The US Bureau of Economic Analysis estimates that GDP growth in the second quarter of 2018 reached 4.1% – the highest since the 4.9% achieved under President Barack Obama in 2014. Another year of growth will match the record 10-year expansion of the 1990s. Add to that low unemployment and things are looking good.

But this cannot continue forever. Given massive global corporate debt and a soaring US stock market – the cyclically adjusted price-to-earnings ratio is high by historical standards – one possible trigger for a downturn in the coming years is a negative shock that could send securities tumbling.

That shock could be homegrown, coming in the form, say, of renewed inflation or of the continued escalation of the trade war that President Donald Trump has started. The shock could also come from abroad. For example, the financial and currency crisis in Turkey could spread to other emerging markets. The euro crisis is not truly over, despite the completion of Greece’s bailout programme, with Italy, in particular, representing a major source of risk. Even China is vulnerable to slowing growth and high levels of debt.

Whatever the immediate trigger, the consequences for the US are likely to be severe, for a simple reason: the US government continues to pursue procyclical fiscal, macroprudential, and even monetary policies. While it is hard to get countercyclical timing exactly right, that is no excuse for procyclical policy; an approach that puts the US in a weak position to manage the next inevitable shock.

During economic upswings the budget deficit usually falls, at least as a share of GDP. But with the US undertaking its most radically procyclical fiscal expansion since the late 1960s, and perhaps since the second world war, the Congressional Budget Office projects that the federal government’s fast-growing deficit will exceed $1tn (£775bn) this year.

The US deficit is being blown up on both the revenue and expenditure sides. Although a reduction in the corporate tax rate was needed, the tax bill that congressional Republicans enacted last December was nowhere near revenue-neutral, as it should have been. Like the Republican-led governments of Ronald Reagan and George W Bush, the Trump administration claims to favour small government but is actually highly profligate. As a result, when the next recession comes, the US will lack fiscal space to respond.

The Trump administration’s embrace of financial deregulation is also procyclical and intensifies market swings. The Trump administration and the Republican-controlled Congress have gutted Obama’s fiduciary rule, which would have required professional financial advisers to put their clients’ interests first when advising them on assets invested through retirement plans. They have also rolled back sensible regulations of housing finance, including risk-retention rules, which force mortgage originators to keep some “skin in the game” and requirements that borrowers make substantial down payments, which work to ensure ability to pay.

The White House and Congress have also been acting to gut the 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act, which strengthened the financial system in several ways, including by imposing higher capital requirements on banks, identifying “systemically important financial institutions” and requiring more transparency in derivatives. The Consumer Financial Protection Bureau – established by Dodd-Frank to protect borrowers with payday, student, and car loans – is also now being curtailed.

Like most major legislation, Dodd-Frank could be improved. Compliance costs were excessive, especially for small banks, and the original threshold for stress-testing “too big to fail” institutions – $50bn in assets – was too low. But the current US leadership is going too far in the other direction by raising the threshold for stress tests to $250bn and letting non-banks off the hook, which increases the risk of an eventual recurrence of the 2007-08 financial crisis.

Now is the right point in the cycle to raise banks’ capital requirements as called for under Dodd-Frank. The cushion would minimise the risk of a future banking crisis.

Other countries do macroprudential policy better. Europeans have applied the countercyclical capital buffer to their banks. Some Asian countries raise banks’ reserve requirements and homeowners’ loan-to-value ceilings during booms and lower them during financial downturns.

When it comes to monetary policy, the US Federal Reserve has been doing a good job but its independence is increasingly under attack from Republican politicians. If this assault succeeds, countercyclical monetary policy would be impaired.

In the past, the Fed has moderated recessions by cutting short-term interest rates by around 500 basis points. But, with those rates standing at only 2%, such a move is impossible. That is why, as Martin Feldstein recently pointed out, the Fed should be “raising the rate when the economy is strong”, thereby giving “the Fed room to respond in the next economic downturn with a significant reduction”.

Most Fed critics disagree. In 2010, they attacked the Fed for its monetary easing, even though unemployment was still above 9%. Now Trump says he is “not thrilled” about the Fed raising interest rates, even though unemployment is below 4%. This is tantamount to advocating procyclical monetary policy.

As we approach the 10th anniversary of the global financial crisis we should recall how we got there. In 2003-07, the US government pursued fiscal expansion and financial deregulation – an approach that, even at the time, was recognised as likely to constrain the government’s ability to respond to a recession. If the US continues on its current path, no one should be surprised if history repeats itself.