As the economic expansion extends past the length when most tip into recession, influential economists are increasingly questioning whether the U.S. government would be able to respond to another downturn.
Some have expressed fears that Congress, the White House and the Federal Reserve would be limited in counteracting another downturn.
The concern is that with federal debt at 76 percent of the economy and rising, spending programs or tax cuts wouldn’t be an option. Meanwhile, with short-term interest rates not far above zero, the Federal Reserve wouldn’t have the option to cut interest rates.
In other words, the U.S. government is not prepared for the next recession, which, if history is any guide, is overdue. The current expansion has lasted 87 months, well past the postwar average of 58.
The Committee for a Responsible Federal Budget, a nonprofit group that favors measures to keep the debt down, concluded in a paper published last week that, because of the rising debt, the U.S. “has significantly reduced borrowing capacity for the next major war, recession or other national crisis.”
Typically, government spending would ramp up because of programs that automatically kick in during bad times, such as unemployment benefits for laid-off workers and food stamps. At the same time, tax revenue would fall because of lower earnings. The result would be higher deficits, pushing the accumulated federal debt higher.
But another recession the size of the one that accompanied the 2008 financial crisis would push the federal debt to unprecedented territory, the group warned.
The Obama administration has argued that it won’t leave its successor hamstrung by debt. When announcing Obama’s final budget request in February, Office of Management and Budget Director Shaun Donovan told reporters that the government had the “fiscal room” for anti-recession spending, although the debt has risen to 76 percent of the economy.
“If anything, the last seven years have taught us around the world that there probably was more fiscal room in a lot of countries to begin with than people might have imagined seven years ago, and we have even more today than we had then,” Donovan said.
Frank Warnock, a professor at the University of Virginia’s Darden School of Business who has researched the federal debt, agreed with that assessment, citing the enormous demand for government bonds. With Ireland able to borrow up to five years at negative rates — meaning the government is effectively paid to borrow — it’s likely that the U.S. could deficit-finance spending easily. How much more debt the Treasury could take on is not known. “There is some constraint, I guess, but we don’t know where it is,” Warnock said.
Some research has suggested that debt above 80 percent or 90 percent of gross domestic product might cause trouble, by slowing economic growth or creating an adverse feedback loop in which the debt rises and becomes more burdensome.
More recently, however, International Monetary Fund research has suggested that the U.S. isn’t close to a level that necessitates debt reduction. Moody’s Analytics estimates that the U.S. could more than double its current debt without incurring grave risk.
In normal times, the Fed might be able to smooth out the business cycle by adjusting short-term interest rates, which are thought to affect overall spending. In past recessions, the central bank has responded by cutting rates by an average of 5.5 percentage points.
The problem is, however, that the Fed has little room to cut rates. The Fed is targeting short-term interest rates between 0.25 percent and 0.5 percent and sees them rising to about 2.4 percent by 2018.
With rates that low, the Fed might not have the ability to stimulate the economy through rate cuts even if it made it to 2018 without a downturn.
That concern was one of the major questions mulled at the Fed’s conference at Jackson Hole, Wyo., last month. Federal Reserve Chairwoman Janet Yellen discussed possible steps the Fed could take beyond rate cuts to counteract a recession. She concluded that “that monetary policy will, under most conditions, be able to respond effectively.”
Yet her pronouncement did not convince Larry Summers, the Harvard professor who was thought to be President Obama’s preferred selection to head the Fed in 2013. Summers warned that Yellen’s optimism one day might be viewed the same way that Ben Bernanke’s statements downplaying the subprime crisis were, and he concluded in an op-ed that “the Fed’s complacency about its current toolbox is unwarranted.”
Summers argued that the tools that Yellen expressed confidence in, namely “forward guidance” to promise lower rates for longer and quantitative easing, were not as effective during the current recovery as the Fed seems to think.
The Fed’s lack of tools has led some observers to speculate that the central bank might try even more unconventional methods if it is faced with another crisis, such as targeting higher inflation or implementing negative rates, as has been tried in Japan and Switzerland. Yellen noted those possibilities in her speech, although she conspicuously left out consideration of negative interest rates.
But it’s an open question just how reassuring those possibilities are. “If we had a recession shock right now, I think [the Fed] has some tools, but you would wonder if it would be enough,” said Joseph Gagnon, an economist at the Peterson Institute for International Economics who previously worked at the Fed’s Board of Governors. Gagnon pointed to the steps that the central banks of Japan and Switzerland have taken, including implementing negative rates. While those tools have provided some benefits, they have not yielded the results that their governments would have hoped for.
David Beckworth, a monetary economist at the Mercatus Center at George Mason University, said central banks that have lowered rates to zero and still have to fight off recession are “groping in the dark, trying to figure things out.”
Should another major recession hit and force the Fed or other central banks to experiment with new tools, “my guess is they’ll try helicopter drops,” Beckworth said, referring to the idea of financing public spending with permanent expansions of the money supply. It’s an idea that Yellen has given some credence. She has also suggested openness to the concept of having the Fed buy not just government bonds but also stocks or other assets.
The best option, however, would be to avoid a recession in the first place. “The good news is it seems extremely unlikely there would be a severe recession right now,” Gagnon said.
