The Weak Recovery and the Coming Deep Recession

It looks like the next recession will be deep and difficult to escape.

| Fri Mar. 17, 2006 4:00 AM EST

Article created by the The Century Foundation.

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.

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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 prescribe 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.

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