By Frederic Bouchet, Ph.D.
Faculty Member, School of Business, American Military University
The term ‘recession’ appears regularly in the news for a host of valid reasons. The U.S. economy has benefited from one of the longest expansions of the modern era. Trade tensions have brought nervousness to the markets, and the unemployment rate has been at historically low levels for months.
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It is impossible to accurately predict when the economy will slow down and enter a recession or to know how severe this next recession will be. We only know it will eventually happen, since experience tells us is that the cycle of expansion/recession is part of the normal functioning of an economy.
What Is the Next Recession Going to Look Like?
Many of us recall how damaging the last recession was, when the crash of the housing market sent the economy in a tailspin that led a number of firms to bankruptcy. The actions of two successive administrations at the time were controversial, but they were able to shorten the recession and limit its destructive impact. But that came at the cost of high government deficits, though, and the long-term consequences of these deficits are where most of the controversy lies.
The two main policies used in 2008-2010 can also be used to fight the next recession when it comes. The first one is the monetary policy decided by central banks (the Federal Reserve in the U.S.), and the second is the set of fiscal policies enacted by Congress and the President.
Monetary Policies Used by the Federal Reserve
On the monetary side, short-term interest rates were cut from about six and a half percent to almost zero percent. This policy has been used to fight recessions since the 1980s, and rates were often reduced by more than five percent in such times.
However, the Federal Reserve (Fed) has just lowered the target range for the federal funds rate to two to two and a half percent. The least we can say is that interest rates are not likely to increase during the foreseeable future, but the main question is whether or not the Fed will reduce them again before the end of the year.
If we compare the level of interest rates to what it was before the recession of 2008, it is clear that the main tool used in monetary policy over the last few decades will be unavailable if a recession starts. The financial situation is even worse in the rest of the world, since interest rates are barely positive in the European community and in Japan.
Because lowering short-term interest rates was not enough to kick-start the economy in 2008, the Fed tried a policy called quantitative easing. The idea was to purchase large amounts of treasury bonds to lower long-term interest rates.
This concept was a powerful tool since it helped reduce the cost of investment for firms and kept mortgage rates low. It was probably effective 10 years ago, but long-term rates are also fairly low today.
In other words, we are likely to enter the next recession with both short-term and long-term interest rates at historically low levels. Even if the Fed lowers those interest rates all the way to zero, it is unlikely to have much of an impact on the economy.
Fiscal Policies and Their Effect on the Next Recession
With a monetary policy likely to lack enough teeth to significantly fight the next recession, the pressure will be on governments to pick up the slack via fiscal policy. This is what happened in 2008, when massive stimulus packages were financed by the government borrowing from domestic and foreign sources.
The challenge is that the U.S. government now has more debt than ever. It keeps creeping upward; this is the reason Congress needs to increase the debt ceiling on a regular basis.
A quick look at the 2019 budget reveals that 62 percent of the expenses are for mandated benefits such as Social Security, Medicare and Medicaid. Given the increasing number of baby boomers reaching retirement age, these expenses are likely to keep going up.
The interest the government will pay in 2019 on the $21 trillion debt will be $363 billion. It represents eight percent of the total budget and, not surprisingly, is the fastest-growing expense.
To be honest, economists disagree on how much deficit is sustainable. But given the above numbers, it seems unlikely that Congress and the government would be willing or able to finance massive stimulus packages when the economy enters a recession.
As a start, recessions make budget deficits worse. The reduction in economic activity means lower taxes, and the increased unemployment results in increased social expenses such as unemployment benefits and food stamps.
Policymakers will be forced to increase the debt ceiling even without voting for any new expense. We have seen time and again how challenging it can be for Congress and the President to find an agreement, especially when Congress and the President come from different political traditions. Any stimulus package on top of this situation would be very difficult for Congress and the President to agree upon, given the already high debt that is a burden for our country.
Overall, a recession within the next couple of years would be very challenging. On the positive side, it may convince governments to stop running deficits during times of economic growth –– I do not dare hope for budget surpluses –– thus having the resources to intervene when needed. This would be quite a shift from current practices, though.
About the Author
Dr. Frederic Bouchet is an associate professor in the School of Business at American Military University. He holds an M.S. in math and economics from the Paris Institute of Technology for Life, Food and Environmental Sciences (AgroParisTech) as well as an M.S. and a Ph.D. in agricultural and applied economics from Virginia Polytechnic Institute and State University.
Dr. Bouchet was an economic and financial advisor for several private and nonprofit firms, primarily in the food industry sector, during the 18 years he lived in France. While there, he also served as the Chief Operating Officer for a network of European nonprofit organizations. Dr. Bouchet has taught mathematics and economics in the U.S. for the last 13 years.