The Washington PostDemocracy Dies in Darkness

Just how likely is a recession? Ask the charts.

It’s a race between a potential slowdown and the arrival of better economic leadership.

(Jared Bernstein)
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If articles warning of a recession are a harbinger of an actual downturn, we’re in trouble. You can’t open a paper or click on a website without seeing warnings about a forthcoming downturn. As the first figure in this figure-laden post shows, Google searches for the r-word are spiking, much as they did the last time the economy tanked. And, yet, the unemployment rate remains near a 50-year low, and job growth, though slower, keeps chugging along.

To help make sense of the moment, here are pictures of some of the key variables. Some are flashing — if not red, at least orange. Others look pretty good, considering all the worrisome chatter. Economists can’t tell you when the next downturn will hit, but if you forced me to take a stand, I’d guess that consumers and balance sheets are solid enough to stave off a recession for at least the next few months. After that, we’ll see.

The inverted yield curve: This is one of the more indirect recession indicators, but because of its solid track record, it cannot be ignored. Typically, longer-term bonds provide a higher yield (i.e., interest rate) than shorter-term bonds, as lenders want to be compensated more for tying up their money for longer periods. But there are times when fear of the economic future leads investors to pile into longer-term bonds, which can cause their yield to fall below that of shorter-term bonds. As the figure shows, such inversions have a good track record of predicting recessions at some undisclosed point in the future, usually between eight months and two years.

Trade related indicators: All the articles worrying about recession cite President Trump’s trade war for contributing to the threat. I agree, for the reasons shown in the following figures: Global trade volumes are down, and that’s taking a toll on our manufacturing sector. There are a few historical cases where falling manufacturing output has not accompanied recessions -- but just a few. American businesses have explicitly said that uncertainty induced by the trade war is dampening their investment plans (a sub-point here is that the corporate tax cuts have yet to boost business investment).

Balance sheets: Your grandfather’s recession probably involved the just-discussed factory sector. Some “demand-shock” occurred, a bunch of folks got furloughed, the shock ended and the workers got called back. Your recession typically involves finance, as in a credit bubble bursting, which has at least two recessionary impacts: It does lasting damage to the balance sheets of households, banks and businesses, and it whacks people’s wealth, leading them to spend less.

Despite that fact that there’s a lot of debt on the balance sheets of these sectors, because interest rates have been low, and incomes and business profits have been rising, balance sheets look better than you think (I’ll get to government debt in a moment; it’s a real problem in this context). The figure below shows a broad measure of income minus spending for households and businesses. Like consumer spending, it’s in a good place, which should which should reduce the chance of a very near-term downturn. But it also can go south pretty quickly.

The mighty American consumer: We Americans like to shop, and consumer spending is a much larger share of our GDP (68 percent) than that of, say, China (40 percent) or Europe (54 percent). And this is the best thing going for the current economy, as strong job growth and at least moderate real earnings growth is fueling solid consumer spending. The figure shows total real earnings (paychecks times the number of jobs) plotted against spending. It’s a pretty tight fit, especially lately, and it sits in a pretty good place. But — and this is an important caveat — note how this data quickly heads south in downturns. Unlike the yield curve, which looks ahead (and doesn’t like what it sees), this indicator looks good for now but can’t tell us much about later.

Federal debt: Though it’s not often cited in recession-warning pieces, this figure is the one that keeps me up at night. Whenever it hits, we’re going into the next downturn with a federal debt/GDP ratio that’s twice the historical average. That creates the risk that politicians won’t do enough with discretionary fiscal policy — new spending on programs such as unemployment insurance or extra food and housing support — to offset the next recession. To be clear, there’s no good economic reason for them not to do so. Austerity policy — avoiding temporary, countercyclical spending to offset a recession — can basically be described as over-worrying about debt at exactly the wrong time.

The Federal Reserve’s interest-rate policy will also be constrained in the next recession. If the economy starts to slide, the Fed will cut the benchmark rate to provide monetary stimulus. In fact, it has already taken out an “insurance cut” against further slowing. But because interest rates have been so low, it will be starting their recessionary cuts from a low level. In other words, the Fed is facing limited monetary space, because it’s unwilling to cut past 0 percent (Japan and some European central banks have gone in for negative interest rates; our Fed has shown negative interest in going there).

We are not helpless in the face of these head winds. Trump started the trade war; he could end it. This would be a significant, anti-recessionary move. There is a lot that Congress and the administration could do to get ready for the next recession, most importantly improving the responsiveness of key anti-recession tools, as described here. To do so is especially important given the Fed’s limited monetary space and threat of policymakers conflating actual fiscal space, which is ample, with “perceived” fiscal space, which some will argue is highly constrained.

But don’t hold your breath on either of these. I can’t tell you when the next recession is coming. But I can, I fear, give you strong odds that Trump will continue to wage the trade war, and Congress will remain largely dysfunctional, unwilling to work together to plan ahead.

In other words, what we’re looking at here is a race between a potentially waning expansion and the arrival of better economic leadership.