Wednesday, April 3, 2013

The Next Recession

The Atlantic is out with an interview of David Stockman, a former Director of the OMB during the Reagan Administration, and he's predicting doom and gloom due to a myriad of factors, some decades in the making. Unfortunately, his tone comes off as arrogant, cocky. He's entirely too self-assured and it doesn't work well when you're giving one paragraph responses while being instantly dismissive of people you don't agree with.

But if you go through it, you can find some good pieces to chew on. Here's the most salient point:
No. They're caught up in this Keynesian fog -- The economy is going through a disappointing recovery but if we just keep working at it, everything will work out for the better. The latest OMB and CBO forecasts show no recession through 2023. Well, the latest recession ended in June 2009. Their forecast implies that 14 years are going to go by and there aren't going to be any accidents, hiccups, and dislocations in our economy or in the world. That's nuts. It's never happened in recorded history. We're going to have recessions. There will be a crisis.
This is a pretty sobering point. Although the Democratic Party and the White House in particular are keen to point out any signs of economic progress, the fact of the matter is that we are 4 years out of the recession and we still aren't back to even. Unemployment is still higher. Labor force participation is still lower. Although we're barely over the nominal highs in the Dow and S&P pre-crisis, on an inflation adjusted average, we're still about 10% below the real high.

Household wealth is still vastly lower. Americans are deleveraging but still taking on student loans (which is just about impossible to discharge in bankruptcy). Given the fact that about half of consumer debt reduction has been in the form of write-offs and charges taken by corporations, this hasn't exactly improved the overall debt picture of the average US household.

So we're out of the recession but it doesn't feel like we're out of it. The only question is, what's going to happen during the next recession? Because it's coming and, if you look at historical trends, it's probably knocking on our doorstep. Take a look at this chart:
Source: St. Louis Fed
During a 72 year span from 1940 to 2012, we have been in 12 recessions. That's one recession every 6 years. The last recession ended in June 2009, 4 years ago. Given the fact that it seems like the entire European periphery is near or on the verge of economic collapse, the developed world's mounting debt issues and worsening demographic profile, and a 0% interest rate policy that has existed for about 4.5 years and is planned to continue for another 18 months, it's become increasingly clear that we've stoked an asset bubble somewhere.

Some people say it's happening in agricultural real estate, others say bonds (of all flavors, municipal in particular), and don't forget emerging market equities, the perennial price swings of the commodities trade, and consumer debt. Markets were in free fall in 2008. The next recession is probably not going to be as severe, but a weakened economy suffering another blow is the last thing we need.

The problem is we already used up most of our gunpowder. Public debt increased from 40% of GDP to 70% in 4 short years from 2007 to 2011. The Federal government is not going to be able to borrow at ultra low interest rates (unless the Fed wants to trigger some sort of rampant inflation similar to what we saw in the 70s or even worse) in the next recession.

What we saw during the financial crisis here and in Europe is that the government punted the fundamental issues down the road. Because although the acute crisis was brought up by auxiliary factors, the real issue is that our current fiscal structure cannot support the amount of government we want. At some point we will either need to cleave spending with a battleaxe or raise taxes at levels even California Democrats would balk at, or both, or experience a drastic bout of inflation that will ultimately have the same effects.

The next recession is coming. And it's gonna get ugly.


  1. It all depends on monetary policy.

    If we're still operating with an implicit 2% inflation ceiling then we'll stay near the zlb and be japan during the 90's and 2000's.

    IF we move to adjustable inflation targeting (with a price level target) or NGDP level targeting we'll be fine.

    1. And what is that target gonna be? 5%? 10%? It doesn't matter because as soon as the Federal Reserve starts governing by that principle, people will adjust their inflation expectations. The bond market will have its due.

  2. and really, rampant inflation during a recession?

    you clearly have not thought through this...

    1. Clearly you never studied the 70s.

    2. supply shock + weird things going on with end of nixon price controls.

      this is why AD/AS analysis is so important.