The Weak Recovery and the Coming Deep Recession

To quote Yogi Berra, “It’s tough to make predictions, especially about the future.” Many (including myself) expected that the bursting of the stock market and Internet bubbles in 2001 would cause a deep recession owing to large excesses of borrowing and spending by both the household and corporate sectors. Now we know that the recession of 2001 was fairly mild and of short duration, though the economic recovery has also been the weakest since World War II.

After having been wrong once, it’s either brave or foolish to make a second prediction that the next recession will be deep and difficult to escape. But the facts point to it being just that—despite the optimism of the Federal Reserve. This is because the economic factors that helped escape the last recession have been largely exhausted, and will not be available to fight the next recession.

The main reasons why the last recession was so relatively mild are the federal budget and interest rates. In fiscal year 2000 the federal government ran a budget surplus of $236 billion dollars, but within three years this had reversed to a deficit of $378 billion. The overall budgetary U-turn was therefore $614 billion dollars, equal to about six percent of economic output (gross domestic product). This turn provided an enormous injection of spending that helped prevent a deeper recession and jump start recovery.

The role of government spending in damping the recession and driving the recovery is evident in the employment statistics. From March 2001 (the beginning of the recession) to January 2006 government employment rose by 4.5 percent (one million jobs) to 21.9 million jobs. Over the same period, private-sector employment rose by just one percent. Government, which accounts for just 16 percent of total employment, created half of all new jobs in the four years after the recession ended. The private sector, which accounts for 84 percent of total employment, created the other half. Moreover, part of the increase in private-sector jobs involves government contract and defense-related work, so that the government’s overall job contribution was even larger. In effect, increased government employment has masked persistent private-sector weakness.

This fiscal stimulus was accompanied by an extraordinary extended period of monetary ease that kept interest rates at historical lows. In 2000, the year before the recession, the Federal Reserve’s target interest rate (the Federal funds rate) averaged 6.24 percent. When the recession began, the Fed cut this interest rate aggressively, lowering it to 1.67 percent in 2002 and 1.13 percent in 2003. Moreover, the Fed then held interest rates at historical lows three years after economic recovery had officially begun, so that the Federal funds rate was only 1.35 percent in 2004. Only since late 2004 has the Fed reversed itself and started systematically raising short-term interest rates.

There are three significant features about this monetary easing. First, it contributed importantly to warding off the recession and generating recovery. Second, the weakness of the private-sector recovery, despite the extraordinary scale of the fiscal and monetary stimulus, points to the underlying fragility of the private-sector economy. Third, the monetary easing has promoted massive consumer indebtedness and a housing price bubble, a combination that poses grave future threats.

The Fed’s lowering of interest rates to forty-year record lows served to spur the recovery. It inspired a mortgage re-financing boom, providing immediate relief to households who were able to spend their mortgage interest savings. Lower interest rates also made houses more affordable, triggering a house price bubble that contributed significantly to escaping the recession. Higher house prices increased homeowner equity, and many owners used this increased equity as collateral to borrow against.

Their borrowing then financed consumption, which significantly explains the consumer-spending boom. Higher house prices have also allowed some existing homeowners to cash out, and some have spent part of their windfall. Meanwhile, homebuyers have financed house purchases with loans, which has increased the money supply. Lastly, rising house home prices have also created enormous profit margins for builders, providing an incentive to build new homes and spurring a construction industry boom.

The problem now is that these special conditions are largely spent. The projected federal budget deficit for fiscal year 2006 is $423 billion, approximately 3.3 percent of national output. With the budget already in deficit, this leaves less room for the type of U-turn that occurred in the last recession.

With regard to interest rates, the federal funds rate now stands at 4.5 percent—so there is room to lower it. However, lowering it is likely to have far smaller effects than last time. Why?

Homeowners have already significantly refinanced so that the stock of high interest rate mortgages available for refinancing has been depleted. Consumers are borrowed to the hilt, leaving less access for further borrowing. House prices are already at all-time highs by every measure—so lower interest rates are unlikely to spur another price boom, with all its expansionary effects. Instead, house prices could actually start falling as new supply continues to come on to the market, and this effect could be amplified by recession-induced job losses that trigger mortgage defaults by workers losing their jobs. Taken together, these factors point to future interest rate reductions likely being akin to pushing on a string.

Adverse domestic economic conditions will also be echoed globally. The 2001 recession was business investment-led, with little consequence for China and East Asia. This is because those economies export consumer goods and the American consumer kept spending. However, a consumption spending-led recession will quickly spill over into East Asia, triggering job losses and a decline in investment spending in those economies. Consequently, a U.S. recession will quickly ricochet around the globe.

This is not about predicting when the next recession will happen, but rather about its character. The when game is impossible. As Nobel Prize-winning economist Paul Samuelson once quipped, “Economists have correctly predicted nine of the last five recessions.” However, it is possible to anticipate future difficulties and proscribe possible remedies.

First, the Federal Reserve should be very careful about over-shooting with its rate hikes, and at this time it should take an inflation chill pill. Second, the current recovery has been extraordinarily weak, which should finally discredit the notion that tax cuts for the rich drive growth and job creation. Third, the speculative financial market paradigm—which has ruled the policy roost for twenty-five years—is out of gas. It is time for a new paradigm that links growth to rising wages rather than to asset price boom-bust cycles.

13 Responses to “The Weak Recovery and the Coming Deep Recession”

  1. Rich Truxel Says:

    A Regular Guy’s View of the Situation -

    Sorry for all the tongue and cheek, but you just may agree with some of my final conclusions.

    “There are three significant features about this monetary easing.
    First, it contributed importantly to warding off the recession and generating recovery. “
    No - it contributed to high asset prices and high debt / equity ratios. As you pointed out private sector investment has remained low - no one was borrowing to grow, rather to finance ongoing business or buy existing assets. If the money went to new economic assets and activities (growth) there would not have been a bubble.
    “Second, the weakness of the private-sector recovery, despite the extraordinary scale of the fiscal and monetary stimulus, points to the underlying fragility of the private-sector economy. “
    No, - For one thing fiscal and monetary stimulus are always misguided attempts at intervention, they are never a primary driving factor in economic growth. I distinguish between recent attempts to stimulate the economy vs. Keynesian type spending to take advantage of downturns or “bridge” over periods of slow growth. Second, the notion of inherent fragility in free markets is crazy. The question is, why isn’t the private sector growing?

    “Third, the monetary easing has promoted massive consumer indebtedness and a housing price bubble, a combination that poses grave future threats.”
    Yes - as opposed to promoting growth.

    “The role of government spending in damping the recession and driving the recovery is evident in the employment statistics. From March 2001 (the beginning of the recession) to January 2006 government employment rose by 4.5 percent (one million jobs) to 21.9 million jobs.” .”

    And this is the problem. The increasing ratio of government employment is one of the biggest risks to economic prosperity. This is not to say they are not necessary, but government employees do not create or produce anything of value. In fact the increase in g’ment employment should be looked at in terms of a reduction in the labor supply. This is part of the overall problem since the beginning of the decade - the rising role of government in the economy.

    I am just as concerned with the rise of the “non-profit” sector for three reasons. First, in order to qualify as a non profit you must prove that you provide nothing of value to anyone. Second, most non profits blatantly claim to have no direct interest in the issues they address or the parties they claim to represent. Third, setting out to not make a profit is down right un-American.

    Regarding your conclusions:
    First, the Federal Reserve should be very careful about over-shooting with its rate hikes, and at this time it should take an inflation chill pill.

    Hallelujah!! - If we have learned anything since the 1970’s it is that fed policy has little if any relation to consumer prices, that growth does not create inflation, etc. I love Greenspan’s theory that even with extended growth, record easy money, full employment…we can still have low inflation due to “Productivity and efficiency!” Bulletin for Al - growth and full employment drive efficiency, stagnation and low employment drive inefficiency.

    Second, the current recovery has been extraordinarily weak, which should finally discredit the notion that tax cuts for the rich drive growth and job creation.

    Is there a suggestion here? What hurts is that many associate this notion with Reagan’s policies. What he said was that high marginal rates limit income growth - proven beyond doubt by the massive increase in the number of people who would be considered rich by 1980 standards. He also said that high int. rates and high corp. profits tax rates limit growth - regardless of why we grew in the 80’s and 90’s, we have not cut these rates. Note - No dispute the recent cap gains tax cuts and dividend tax cuts are counterproductive. The fact that cap gains are taxed lower than other income adds to the asset price booms, as investors prefer stock price gains rather than current profits and dividends.

    Third, the speculative financial market paradigm—which has ruled the policy roost for twenty-five years—is out of gas. It is time for a new paradigm that links growth to rising wages rather than to asset price boom-bust cycles.
    Exactly - But start with the question of why growth is driving asset prices, and why is growth and high employment not driving wages? Efficient markets would never allow this to happen:
    Suggestions for
    Individuals:
    Why are people putting so much money in financial assets (distorting prices / increasing risk) and at the same time borrowing more money on their homes and credit cards? Let’s see: I have the same amount of money in my 401k with Citibank as I owe on my mortgage with Citibank. Should I pay them off? I would forfeit 50% of my nest-egg and pay much higher taxes in the future with no mortgage deduction. Why not eliminate itemized deductions and tax deferrals and still charge the same tax? I don’t need D.C. to plan my life for me, but I have no choice but to let them. In fact I would be glad to pay more taxes if I could allocate my money efficiently, just not 50% more.

    Corporations:
    GM just borrowed a ton of money to finance ongoing business. Each month some of my retirement money goes to GM stock. Wouldn’t we all be better off if GM sold more stock instead of bonds? Not when interest is tax deductible and the profit tax is 35%. IF we eliminated interest and depreciation deductions and dropped the tax rate to 8%, tax revenues would rise 40% (from 160 billion to 215 billion according to 2002 irs stats.) This would not only make equity preferable to debt, but make new capital investment more attractive.

  2. Thomas palley Says:

    Thanks, Rich. Lots of interesting thoughts, most of which I agree or half-agree with. I don’t agree with your take on the economic contribution of not-for-profits, and that might be worth a future blog. BTW, this site is neither for profit & nor is it a not-for-profit. So enjoy the services it provides. Best, Tom Palley

  3. Rich Truxel Says:

    Tom,

    Here is another problem that I never here discussed: The access to capital. The point I motioned about individuals not having access to their own capital due to tax laws is one aspect, but think about the barriers to the capital in the capital market.

    Consider:
    Exxon has a market value of over 400 billion, about 4% of the s&p. Between individual and corporate pensions over 600 billion / year goes into markets - mostly mutual funds. This means maybe 25 billion per year of new money buying Exxon stock. Exxon has not sold new stock in years, so where is the money going? - bubbles.
    35% of the stock is owned by 20 large private institutions (as opposed to mutuals and small investors.) These parties have very low turnover and rarely buy or sell. So over the past 5 years we have paid 100 plus billion for stock, they have paid nothing, and they still own 35%
    Now the scary part:
    35% is more than enough to control the boards of D.
    All of the above is true for just about every large company. Talk about a monopoly.
    Public policy seems designed to protect this situation.
    This is an example of my problem with non profits. I will not go into the details but I will list a few things which ensure the status q:
    Securities laws to protect investors.
    Bankruptcy law (restructuring)
    High corp tax rate.
    Import barriers.
    etc., etc.
    All of the above are lauded by NPO’’s. I always wonder where they get their money. With private enterprise you always no whose interest is being served, that of the private party. With NPO’s, those paying the bills and providing the service claim to serve not themselves but others. I don’t trust that. In the end few are motivated by altruism.

  4. Mike Shelton Says:

    Tom, just discovered your website: I really like how you take the time to back your arguments, I’m learning a lot. Thanks!!!

  5. Periodista Miguel Says:

    Very interesting post and comment(s). The government’s contribution to the payroll numbers is fairly impressive — and misleading, since we don’t generally talk about the private sector jobs, just the ‘headline number.’

    I wonder what the trend is? Has the private sector picked up? You do say it’s half of the jobs since the recession ended. I wonder about the past six months? The past three…?

    Also, you make a great point about the military-industrial complex — e.g. Lockheed, Halliburton — where jobs count as private, but are utterly dependent on government spending. Would be great to have more data on that. I know we might try to grab them piecemeal (i.e. check the workforce numbers for big, publicly-trade companies), and that might shine a light, but as they say, the plural of anecdote is not data…

    And so on — I am very curious about government contribution to our supposedly robust job growth…

    I haven’t done it yet, but I will go to the BLS site and see if I can parse any of this (but I am notoriously slow, not to mention lazy, so if anyone has this stuff, I wouldn’t mind having it spoon-fed!!).

    Oh — on a different point. I know we think the government can’t use deficit spending when it’s running a deficit at 3 percent of GDP. But if there *is* a deep recession, what would hold it back? There should would be political incentive to spend, spend, spend. Yes, you’d have to cope with the effect on the dollar and interest rates… Any chance that a global slowdown would level the playing field…?

  6. Periodista Miguel Says:

    Additional question — I am pretty good at thinking of questions, but at the ability of answering, not so much — How much of GDP did the deficit represent during World War II? That was the spending (along with the, um, workforce adjustments) that blew the economy right out of the Depression. I seem to recall seeing somewhere that the budget deficit was at points more than 40 percent of the GDP…

  7. Rich Truxel Says:

    Regarding spending in the Military /industrial complex and the effect on Jobs and growth. Depends whether it is the military or industrial side. I’m not making a policy statement here just looking at the economic impact.

    Military Side: Vietnam in the seventies, Iraq today.
    Industrial side: - buildup for WW2, Mid 1980’s

    If taxes remain the same and we spend the same amount of money:

    Military operations: When we spend money on operations it is a drag on the economy. The money and manpower is mostly spent overseas and does not create economic value.

    Industrial side - When the money is going to purchase hardware from manufacturers it adds to growth and employment. We also get a good chunk back in income taxes, and end up with more Assets”

    For what it’s worth the traditional premise has emphasized the importance of tax revenue as a % of GDP, the higher % of gdp taken by taxes, the lower the growth of the economy.

    The % of gdp going to taxes grew from 1960 - the early 80’s as growth slowed and unemployment steadily rose. It began to fall at the same time growth and employment rise (Chicken or the egg?)

    The unwelcome profit:
    “I have spent most of my life as a Democrat. I recently have seen fit to follow another course. I believe that the issues confronting us cross party lines. Now, one side in this campaign has been telling us that the issues of this election are the maintenance of peace and prosperity. The line has been used, “We’ve never had it so good.”
    But I have an uncomfortable feeling that this prosperity isn’t something on which we can base our hopes for the future. No nation in history has ever survived a tax burden that reached a third of its national income. Today, 37 cents out of every dollar earned in this country is the tax collector’s share, ”
    Ronald Reagan - 1964.

  8. Periodista Miguel Says:

    Thanks, Rich… One could argue, of course, that looking back, in economic terms, 1964 actually *was* the best of times… but that’s a different discussion.

    FWIW, I went and looked through the BLS site… Some puzzling things — at least to me.

    It looks like the total job growth since the pre-recession peak (NSA) has been only 86,000. Seasonally adjusted, it is 2.2 million (what’s up with *that* discrepancy?).

    Now, government — all government — has added 1 million (NSA). Seasonally adjusted, BLS says it’s 979,000.

    It appears, however, that private sector growth has been much more than half since the turnaround in 2003. From the bottom of paryolls, the entire economy has added (NSA) 5 million jobs. Of that, just 1.8 million are government jobs. The government share is worse if you use seasonally adjusted figures (313,000 out of 4.99 million).

    What I really can’t figure out is that federal government payrolls seem to have shrunk — whether SA or NSA. That is not what I was expecting, given the war and other military spending, etc., etc.

    Explanations…? Comments…?

  9. Rich Truxel Says:

    1964 - the best of times:

    I couldn’t agree more, the early 60’s and the mid to late 90’s were both great times for the U.S. Economy. From the 60’s through the early 80’s thing became progressively worse, then made a dramatic change of direction. The three recessions up to 82 were progressively deeper and the recoveries shorter - the opposite was true after ‘82.

    40’s - early 60s Strong growth / rising prosperity ended at post dep. peak.
    60’s - early 80’s week growth / falling prosperity ended in worst modern recession.
    80’s - early 00’s strong growth….

    Policy 40′-60’s helpful policy’s, building infrastructure….
    60’s - 80’s harmful policies - fed & tax & reg policies to manage the economy.
    80’s - 00’s - Little effect from policy, (though I agree the Fed caused problems with high rates in the early 90’s and low rates in the late 90’s - should have stayed neutral.)

    What I meant by unwelcome profit (and his sentiments were ridiculed at the time) was his prediction “I have an uncomfortable feeling this prosperity isn’t something on which we can hang our hopes for the future.”

    Over the next 15 years policy continued down the path he opposed and the consequences were as predicted.

    I agree 25 years ago We made a sea change in policy and the direction of the economy. But I think have been reversing course over the past 5 - 10 years and fear the tide has turned toward more regulation and activist fed policy.

  10. Jack Duval Says:

    Thomas,

    Samuelson said it was the stock market (not economists) that had predicted 9 out of the last 5 recessions.

  11. Thomas palley Says:

    Oops. Thanks, Jack.

  12. Jim B. Says:

    What I’ve been trying to figure out is what happens when the recession finally comes, the Fed reverses course, and begins pushing on a string. Helicopters? My unschooled intuition says we could have an abrupt transition to inflation. Isn’t the cure for an oversupply of any commodity a markdown in price? Don’t we have an oversupply paper claims floating around the globe? How will Japan, China, OPEC, et. al. react to the shrinking worth of their $ holdings? Aren’t they aware that they are already worth much less than their face value? What happens to the domestic money supply in the surplus nations when their dollar reserves shrink? Will they have to buy back their gov’t bonds? Can they afford to if their exports are falling?

  13. Sebastian Says:

    Dear Tom,
    You said :
    From March 2001 (the beginning of the recession) to January 2006 government employment rose by 4.5 percent (one million jobs) to 21.9 million jobs. Over the same period, private-sector employment rose by just one percent. Government, which accounts for just 16 percent of total employment, created half of all new jobs in the four years after the recession ended.

    Just one question where did you find these datas ? BEA ? Bureau of labor statistics ? May I have an internet link ?

    Thanks