The Washington PostDemocracy Dies in Darkness

Tax cuts may leave Washington low on ammo for next recession battle

The National Debt Clock in New York City. REUTERS/Shannon Stapleton

President Trump predicts that the $1.5 trillion Republican tax cut nearing final congressional approval will jolt the U.S. economy into “high gear.”

He may be right. But despite the sunny outlook, the nine-year-old economic expansion, already the third-longest since 1854, will eventually end. And when the inevitable recession arrives, the United States may find it harder to fight than previous downturns — especially if it is severe.

An unexpected recession in the next year or two would catch policymakers still grappling with the aftereffects of the Great Recession and lacking some of their traditional ammunition for combating economic weakness. 

Short-term interest rates, which the Federal Reserve typically cuts to spark a sagging economy, already are near zero, once inflation is taken into account. The government’s ability to goose the economy by cutting taxes or boosting spending also is squeezed by the proposed tax cut, which the nonpartisan Joint Committee on Taxation says will add $1 trillion to the national debt.

“There’re no tools left in the toolbox,” says Daniel Alpert, managing partner at Westwood Capital in New York.

Even before Congress embraced plans to cut corporate and individual income taxes, the federal budget deficit was expected to rise steadily over the next decade, reversing progress made in shrinking the gap since the depths of the financial crisis in 2009. By 2027, those annual shortfalls are projected to drive the national debt to its highest mark, relative to the size of the economy, since 1947, according to the Congressional Budget Office.

Today's $15 trillion debt, equal to about 77 percent of annual output, would rise to more than 91 percent of gross domestic product in 10 years, CBO says.

Just the annual interest on the debt in 2027 is expected to be $818 billion — more than the entire budget that year for Medicaid, which provides health insurance for 68 million Americans. If the Fed responds to the tax cut by raising rates more quickly than anticipated to keep the economy from overheating, those costs would swell further.

With the United States already confronting a mounting tab for the baby boomers’ retirement and health care costs, the tax cut’s addition to the debt has some analysts warning that the nation is testing the limits of its creditworthiness.

“You want to have a sound balance sheet so that when emergencies come along, you’re prepared to fight them,” says Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget. “If and when the next recession arrives, we have tied one of our hands behind our backs.”

The higher debt, aggravated by the tax cut’s effects, might trigger political resistance on the part of “deficit hawks” to fighting the recession by increasing spending as the Obama administration did in 2009 or by cutting taxes as the Bush administration did in 2001.

If that opposition were overcome, an aggressive stimulus program financed by government borrowing could leave the United States in unprecedented budgetary terrain, with a public debt larger than its $19 trillion economy. “If we have an '07 type of financial crisis, we’re in trouble,” says William Gale, a Brookings Institution budget expert.

Still, Fed Chair Janet L. Yellen has said she does not expect a repeat of the recent financial crisis “in our lifetimes,” and most economists say that the U.S. could afford the sort of stimulus measures, such as a temporary payroll tax cut, that have been used to fight typical downturns. Despite soaring deficits, bond market investors remain willing to loan the government money for 30 years at less than 3 percent interest.

“The idea that because of the tax bill we won’t be able to cut taxes or increase spending during a recession is incorrect,” says economist Michael Strain of the American Enterprise Institute.

The landscape was very different in the summer of 2007, as the U.S. began sliding into the Great Recession. Short-term interest rates then hovered above 5 percent, giving the Fed plenty of room to spur growth by cutting borrowing costs. By the end of 2008, then-Fed Chairman Ben Bernanke had cut rates to near zero in a bid to arrest the worst economic meltdown since the 1930s.

Even those actions weren’t enough. The Fed ultimately began buying $4.5 trillion in mortgage-backed debt and U.S. Treasury securities in an unconventional effort to spur growth known as “quantitative easing.”

As layoffs mounted and demand collapsed, Congress sought to fill the hole in the economy with a major stimulus program of government spending and tax cuts. That Obama administration initiative was hotly contested by Republicans, who warned that the debt increase risked mortgaging the economy’s future. But with public debt just one-third of today’s figure, lawmakers ultimately felt free to act.

Today, with the economy growing at an annual rate of 3.3 percent, no one expects a recession any time soon. Next year, growth is expected to continue at 2.5 percent, according to the National Association of Business Economists’ survey of 51 professional forecasters. The Federal Reserve projects the expansion to continue through 2020.

Economists like to say that “expansions don’t die of old age.” But there are reasons to doubt the sanguine forecast, including the fact that recessions historically have taken both Wall Street and Washington by surprise. In the spring of 2007, for example, Bernanke publicly reassured Americans that mounting losses on subprime mortgage securities were unlikely to trigger a recession. Within eight months, events had proven him wrong.

“The consensus has never, ever accurately forecast a recession,” says David Rosenberg, chief economist with Gluskin Sheff. “The consensus tells you about the recession when we’re already two-thirds of the way through it.”

Jim O’Sullivan, chief U.S. economist for High-Frequency Economics, doesn’t expect a recession any time soon. But he puts the chances of one by the 2020 presidential election at greater than 50 percent.

Those anticipating an earlier recession cite plenty of reasons to worry. The conflict over North Korea’s nuclear program could spill into open hostilities. The Federal Reserve has begun raising rates, a process that often slows the economy until it stalls. Goldman Sachs warned last week that both stocks and bonds were at their highest valuations since 1900. And with long-term interest rates only a little higher than short-term rates, the bond market is close to flashing its traditional recession warning known as an “inverted yield curve.”

The Senate-passed version of the massive tax overhaul also includes provisions that may rattle key markets. Realtors have warned that new limits on the mortgage interest and state and local tax deductions will cause home values to fall by 10 percent — with bigger losses in ultraexpensive coastal markets.

“There is a reasonable shot that these two provisions set off another systemic crisis,” says Alpert. “This is something that’s very very serious.”

The last comprehensive tax code rewrite in 1986, which eliminated incentives for commercial real estate, helped spark the savings and loan crisis later that decade, says Alpert, who fears a similar outcome now.

At the Fed, outgoing chair Yellen, who is slated to leave office early next year, already is thinking about the next recession. The Fed is expected next week to raise its benchmark interest rate for a third time this year with an additional three hikes forecast for 2018. Rates are still projected to be below 3 percent at the end of 2019.

One reason Yellen wants to raise rates, though inflation remains subdued, is to create room for the Fed to lower them whenever the next recession arrives. Last month, she said that the likelihood of interest rates returning to zero “is uncomfortably high” even amid an average downturn.

When that happens, the Fed is likely to resume its unconventional asset-buying program even before it has finished selling off all the securities it bought to fight the last recession. That a policy once regarded as a desperate response to an epic financial crash might become a common Fed tool is an indication of the economic management challenge that lies ahead.

“I think we’ll be all right because I don’t think we’ll get a shock that big,” says Joseph Gagnon, a former Federal Reserve economist now at the Peterson Institute for International Economics. “But you’d like to have more room.”