We Don’t Have to Have a Recession
The news is filled with stories of when to expect the next recession. Most say that it will not be this year, but almost certainly sometime in the next two or three years. The underlying assumption is that the current expansion, which will surpass our nation’s longest expansion of the 1990s this summer, has to end soon.
But there is not a “natural” economic reason for this expansion to end. A look back shows recessions occurring from time to time. In recent decades they have been less frequent and have been much milder and shorter than historically, other than the 2008 Great Recession. The onset of a recession can generally be traced to some combination of fiscal and monetary mistakes. The one recent exception was the 2000-’01 recession resulting from the large overvaluations built up during the 1990s.
Forecasting the next recession is not a mechanical “business cycle” process but involves trying to figure out when the next major policy mistake will be made. Without such a mistake, the expansion could continue uninterrupted into the foreseeable future.
The counter argument is that if fiscal and monetary authorities are given enough time, they will mess up. There is some truth to this. The tin ear response of Federal Reserve Chair Jerome Powell to market and economic conditions in December last year is a reminder of how such monetary mistakes can arise. But bond and stock markets reacted strongly, the Fed retreated quickly, and a potential mistake was avoided.
Economy Less Susceptible to Downturns
The good news is that the economy has become less susceptible to downturns and policymakers have become more adroit at setting the stage for growth and low inflation.
It used to be that the severity of a recession was driven by how much inventory had to be drawn down. Inventories build up as sales slow, while production continues. The steeper the sales drop-off, the greater the inventory buildup, and the deeper and longer the recession, as firms cut back on production. But in recent years, industry has widely adopted just-in-time inventory management and thus are able to respond much more quickly to changes in demand. And advances in technology have made this process even more responsive.
One of the great surprises in recent years is how tame inflation has remained as the economy strengthens. The U.S. is experiencing a full-employment unemployment rate of 3.6%, accompanied by GDP and wage growth exceeding 3%. Historically such conditions have produced surging inflation. But that has not happened this time around.
It still remains to be seen if this is a temporary phenomenon or if inflation will heat up in the near future. We have been waiting for this uptick for some time, with no increase in sight. The longer tame inflation continues, the more likely it is that the Phillips Curve, which posits an inverse relationship between unemployment and inflation, becomes a theory of the past.
Technology Impacts Inflation Measures
Technology has a positive impact on inflation. As technology is woven into every aspect of our lives, it becomes increasingly difficult to get an accurate picture of inflation. This is because it is necessary to measure both price increases and quality improvements in order to come up with an accurate representation of inflation.
Take your smartphone, for example. Over the last few years, the price of a smartphone has risen slightly. If this increase is not adjusted for quality improvements, then inflation in smartphone prices is reported. But the phone of today has considerably more features and is much more powerful than it was just a few years ago.
How do we adjust the calculated price increase for these quality improvements? This is difficult to do and, as a result, the Bureau of Economic Analysis within the Commerce Department often makes little or no adjustment for such improvements. Multiply this by the millions of technology improvements throughout the economy, and you can see why some think the reported U.S. inflation rate is overstated by 1% to 2%, something that even Alan Greenspan recently thought was the case. It is possible that we are currently experiencing full employment with no inflation to speak of occurring.
Policy Mistakes Do Harm
The 2008 recession is a disturbing reminder of the horrible impact of policy errors. First, the government, with good intentions, pulled the credit control rods out of the mortgage market. This led to the origination of millions of subprime mortgages, toxic assets that were distributed throughout the U.S. and the world.
When housing prices began collapsing throughout the U.S., our financial system began to teeter. In September 2008, Fed Chair Ben Bernanke piled on by allowing Lehman Brothers to go bankrupt. Within hours we witnessed one of the worst monetary mistakes of all time: the collapse of the federal funds market, which is the basis for all short-term financial transactions. The U.S. payments system shut down!
The combination of a seriously misguided federal policy and a compounding horrible Fed mistake sent the economy into the worst tailspin in decades. Our hope is that policymakers have learned important lessons from the Great Recession.
Policy decisions that can harm are not limited to the Fed. The current imposition of tariffs has not gone far enough to raise alarm bells, but if we mistakenly cascade into a full-blown trade war, this would be a policy mistake that could drive the U.S. into recession.
Can the Next Mistake Be Predicted?
With improvements in inventory management and the positive impact of technology on inflation and the business cycle, recessions have become less likely and milder if they do occur. While policymakers have become more adroit at setting the stage for growth and low inflation, there is still a risk that some policy mistake could lead to a recession. Which policy, which mistake? Hard to predict. But if the mistakes are avoided, the current expansion could continue unabated.