U.S. LACKS AMMO FOR NEXT ECONOMIC CRISIS / THE WALL STREET JOURNAL

U.S. Lacks Ammo for Next Economic Crisis

Policy makers worry fiscal and monetary tools to battle a recession are in short supply

By Jon Hilsenrath and Nick Timiraos

           

 

Federal Reserve Chairwoman Janet Yellen, speaking at a Senate hearing last month, has described low interest rates as insurance against another economic downturn. Photo: Ron Sachs/CNP/Zuma Press

 

As the U.S. economic expansion ages and clouds gather overseas, policy makers worry about recession. Their concern isn’t that a downturn is imminent but whether they will have firepower to fight back when one does arrive.

Money has been Washington’s primary weapon in the decades since British economist John Maynard Keynes proposed aggressive government spending to battle the Great Depression. The U.S. generally injects cash into the economy through interest-rate cuts, tax cuts or ramped-up federal spending.

Those tools could be hard to employ when the next dip comes: Interest rates are near zero, and fiscal stimulus plans could be hampered by high levels of government debt and the prospect of growing budget deficits to cover entitlement spending on retired baby boomers.

Few economists believe the U.S. is near recession. The economy seems to have regained its footing after a first-quarter stumble, and Federal Reserve officials are considering whether to raise short-term interest rates for the first time in nearly a decade to ensure the economy doesn’t overheat.

Even so, looming threats are a reminder that the slow-growing global economy is just a shock away from peril. Japan’s economy contracted in the second quarter and Europe recorded lackluster growth. China’s slowdown, meanwhile, appears more severe than global policy makers initially realized and a currency devaluation there might spur trade frictions.

With the U.S. expansion entering its seventh year, policy makers are planning how to respond to the next downturn, which history shows is inevitable. The current expansion is now 16 months longer than the average since World War II, and none has lasted longer than a decade.

“The world economy is like an ocean liner without lifeboats,” economists at HSBC Bank HSBC 0.28 % wrote in a recent research note.

In the next downturn, former Fed Chairman Ben Bernanke said in an interview, the tools of government will be “more limited than usual, but they’re not zero by any means.”

The Fed, for example, could experiment with negative interest rates. A recession also could force Congress and the White House to bridge Washington’s partisan divide to strike a deal that pairs short-run stimulus with long-run plans to reduce the deficit.

‘Live question’

“This is a very live question,” said Douglas Elmendorf, the recently departed director of the Congressional Budget Office. “Policy makers are thinking about their backup, backup plans.”

The Fed’s strategy of keeping interest rates low well into an expansion is intended to help avoid a relapse into recession. Fed Chairwoman Janet Yellen has described low rates as insurance against another downturn. That is another reason officials intend to move slowly once they begin nudging up rates.

Worries stretch to the White House. “Federal fiscal policy will be a more important tool in addressing future business cycles because monetary policy may be more frequently constrained,” Jason Furman, the chairman of the White House Council of Economic Advisers, said in an interview. “That’s a big change in the way the economics profession sees the world.”

The U.S. over the past quarter century regularly turned to the Fed to provide stimulus when the economy stumbled.

In the most recent recession, short-term interest rates were pushed to near zero, then the central bank embarked on massive—and controversial—bond-buying programs to drive down long-term interest rates. The Fed also promised to keep short-term interest rates low for an extended period.

The tactics were meant to make it easier for households to pay off debts, encourage new borrowing and promote risk-taking; officials hoped that would push investment and consumer spending higher.
The next downturn could further expand Fed bondholdings, but with the central bank’s balance sheet already exceeding $4 trillion, there are limits to how much more the Fed can buy.

Mr. Bernanke said he was struck by how central banks in Europe recently pushed short-term interest rates into negative territory, essentially charging banks for depositing cash rather than lending it to businesses and households. The Swiss National Bank, SNBN 2.22 % for example, charges commercial banks 0.75% interest for money they park, an incentive to lend it elsewhere.

Economic theory suggests negative rates prompt businesses and households to hoard cash—essentially, stuff it in a mattress. “It does look like rates can go more negative than conventional wisdom has held,” Mr. Bernanke said.

Others, including Sen. Bob Corker (R.,Tenn.), see only the Fed’s limits. “They have, like, zero juice left,” he said.

Many economists believe relief from the next downturn will have to come from fiscal policy makers not the Fed, a daunting prospect given the philosophical divide between the two parties.

Republicans doubt federal spending expands the economy, and they seek to shrink rather than grow government. Democrats, meanwhile, say government austerity hobbles the economy, especially in a downturn.

 

 

At issue is how much the U.S. can afford to borrow and spend to goose the economy out of the next recession. The experience of the past recession has set off sharp disagreement among economists.

Federal debt has grown to 74% of national output, from 39% in 2008. To restrain short-term budget deficits, Congress and the White House agreed earlier this decade on a mix of spending cuts and tax increases. In all, total state, local and federal government spending, adjusted for inflation, shrank 3.3% since the recovery began in 2009, compared with an average increase of 23.5% over comparable periods in past postwar expansions.

While federal debt is high by historical norms, the budget deficit has narrowed to around 2.4% of national output. That provides the U.S. with a bit of fiscal breathing room. Even with steady economic growth, however, deficits are projected to surpass 3% by the end of the decade, pushing debt higher still, according to the Congressional Budget Office.

“If there’s another recession, there will be pressure to expand the deficit fairly rapidly to a level that is unprecedented in modern time,” said Stephen King, senior economist at HSBC and author of the report on the global economy’s lack of fiscal lifeboats.

No one knows how much U.S. debt can grow without triggering an increase in inflation and interest rates that would hobble investment and growth. “We don’t have that much experience with countries carrying debt like the level the U.S. has right now,” said Mr. Elmendorf, the budget analyst.

Japan has driven government debt to levels nearly twice its annual economic output, yet its experience doesn’t provide clear guidance. The spending hasn’t spurred significant growth; nor has the debt load driven up government borrowing costs, as economic theory suggests it would.

In a controversial 2010 paper, Harvard University economists Kenneth Rogoff and Carmen Reinhart said nations had slower growth after government debt exceeded 90% of national output.

The paper drove debate over government austerity and was later criticized by researchers at the University of Massachusetts for flaws in methodology and analysis. Mr. Rogoff and Ms. Reinhart said the criticism was overblown.

Economists at Moody’s MCO 0.04 % Analytics say U.S. debt could increase another $5.6 trillion without much danger, enough money to shield against a repeat of the 2007-09 financial crisis with similar financial rescue spending.

International Monetary Fund economists warn against undercutting growth by imposing austerity programs when a debt crisis isn’t imminent.

Mr. Elmendorf sees two potential misjudgments for the U.S. over the relationship between growth and debt. The first, he said, would be to assume that higher debt levels eliminate short-term fiscal policy tools in a recession. The second would be to see no need to reduce government debt in the long run.

Even if it were clear that the U.S. could afford to boost spending or cut taxes, partisan disagreements over Mr. Obama’s 2009 stimulus spending stand in the way of a consensus on the benefits of fiscal policy in a downturn.

The $787 billion spending package “was so badly designed it probably gave fiscal policy a bad name,” said Martin Feldstein, a Harvard University professor and former economic adviser to President Ronald Reagan who had earlier supported a large stimulus to address the financial crisis.

“Any objective observer would look at the $1 trillion-plus in stimulus money and say that has not been effective in having the economy grow in a way that is lasting,” said Rep. Tom Price, the Georgia Republican who chairs the House Budget Committee.

The White House disputes the criticism, noting the U.S. economic recovery has been stronger than in developed nations that rejected fiscal stimulus.

And predictions that rising debt levels would lead to higher inflation and soaring interest rates have so far been wrong. Even though debt as a share of GDP is nearly double where it was before the financial crisis struck, interest rates have remained low.

“It feels like we have a lot more fiscal space than you would have thought 10 years ago,” said Mr. Furman, the White House economic adviser.

A related lesson of the recent recovery, Mr. Furman said: If governments borrow for a good reason, such as infrastructure spending to boost employment during downturns, “it doesn’t appear as if the markets would penalize us.”

Mr. Furman has been trying to steer policies at the White House to prepare for the next downturn.

There are signs the next recession will be more difficult to manage, he said, because of sharp cuts to state and local governments, budgets that in previous downturns had acted as a buffer.

Automatic programs

At the federal level, the White House has focused on expanding programs that automatically ramp up when the economy stumbles and fade away during economic recovery.

In this year’s budget proposal, for example, the Obama administration proposed replacing the unemployment benefit system, which in past downturns wasn’t expanded by Congress until well after a recession had begun. The idea is to automatically boost the amount of insurance available to unemployed workers when state unemployment rates reach certain thresholds.

Opponents cite high costs—officials said the overhaul would cost $50 billion over 10 years—and point to research suggesting that expanded unemployment insurance can deter men and women from re-entering the workforce.

Compromise has been elusive. After Republicans won control of the House in 2010, the White House sought, unsuccessfully, a deal to raise revenues and curb long-run growth in spending, in exchange for a short-run stimulus.

The next downturn could return the two sides to the bargaining table. But lawmakers will have less room to maneuver “because the entitlement side hasn’t been addressed,” Mr. Corker said. “We haven’t dealt with even the most basic elements.”

Mr. Feldstein and Robert Rubin, the former Treasury Secretary under President Bill Clinton, are calling for so-called revenue neutral incentive policies, such as tax credits for business investment that offset government costs by raising corporate taxes elsewhere.

The challenge is that these policies “sound simple, but politically, it is really hard,” said Glenn Hubbard, the dean of the Columbia Business School who advised President George W. Bush through the 2001 recession. “We have very little cushion for whoever the next president is and the next congressional leaders if they had to deal, gosh, with anything.”