Preparing for the Next Recession: Better response is required towards Fiscal Policy

Executive Summary

There is a real possibility that the U.S. economy could slip into a recession sometime in the upcoming months. Current economic indicators point to an economy that is humming along nicely, and the unemployment rate is at an all-time low. This is the longest economic recovery on record, but it will not last forever, recession will occur. We have not eliminated the business cycle.

Here are the factors shaking the grounds of a solid economy, and causing probable concerns of a looming recession. Firstly, President Trumps unprecedented move towards the execution of the trade war with China and other countries has increased uncertainty among businesses. Secondly, corporate investment is also softening, despite the big tax cut, assured by Mr. Trump to boost it. Coupled with central banks inability to stimulate growth. Lastly, an expected inward pressure by other countries could make the governments less effective at responding to an economic downturn.

During the Great Recession which started in late 2007, household wealth and jobs evaporated across the country, and in many parts of the world. The U.S. government responded with a mix of monetary policy and fiscal stimulus that stopped and reversed the decline. Furthermore, the fed placed less emphasis on fiscal policy.

The Recovery Act legislation was passed after we had been in recession for a year. If we don’t prepare for the recession, we may be hit with the same problem again. Recession will come and will be in the middle of the election season, unable to do anything about it, because we will have to wait for the next president to pass the bill. We need to avoid such scenarios at all cost.

We need a wide variety of policies, as recessions plays out differently among various demographic and geographic areas. For instance, some states never really recovered from the 2001 recession, therefore we need a set of polices for people living in places slow to recover or who may have never experienced a recession before.

Automatic stabilizers are a starting point and not the end point. More emphasis must be placed on the design of automatic stabilizers. Automatic stabilizers should reach people of all geographic and demographic areas in times of hardship. Decision makers must place increased effort in the functioning of automatic stabilizers.

More thoughtful and pragmatic approaches is required towards how we will respond towards the recession should it happen again. For instance, a fix in administrative complexities related to how cheques are processed is required. We want to think through these things ahead of time.

Pulling forward the prescribed policy recommendations policy makers should take action now and not wait for a recession. Understanding that one size does not fit all we need a wide variety of policies to target various geographic and demographic settings.

Introduction

There is a real possibility that the U.S. economy could slip into recession sometime in the upcoming months. Current economic indicators point to an economy that is humming along nicely, and the unemployment rate is at an all-time low. However, we are on the verge of this being the longest economic recovery on record Figure 1 [1]illustrates the current economic expansion being the longest in U.S. history.

This economic recovery will not last forever, and that recessions will happen. We have not eliminated the business cycle. Notably, when recessions happen it can be devastating for workers and families, and for the people that are hurt by the loss of unemployment. So, we need to start thinking in advance.

In good times fewer people are unemployed, because they are paying the unemployment taxes, meaning we are spending less and taxing more. On the contrary, when we run in to a recession more people are unemployed and are collecting unemployment insurance, hence the government is spending more money.

Recent changes in longer-term interest rates started to take a plunge in July, indicating a shift in slower growth. Other contributing factors include interest rate cuts from the Federal Reserve, an elevated risk that the economy can slip in to an outright contraction.

During the great recession Federal Reserve faced constraints when the rates dropped to a zero. Unfortunately, tools used in the past were not perfect substitutes to cutting interest rates. So far, we have had seven recessions since 1970 the Fed cut interest rates by at least 5 percentage points. Currently, the fed fund rate is 2.25 %. According to economist, the fed will not cut interest rates 5 percentage points next time we have a recession.

Figure 1

Source: Data from the National Bureau of Economic Research (NBER 2019) Note: The orange bar indicates projected future duration of the current expansion through June 2019 and the vertical line marks the change in economic expansion

Here are the contributing factors shaking the grounds of a solid economy and causing probable concerns of a looming recession. Firstly, President Trumps unprecedented move towards the execution of the trade war with China and other countries has increased uncertainty among businesses. Secondly, corporate investment is also softening, despite the big tax cut, assured by Mr. Trump to boost it. Coupled with central banks inability to stimulate growth. Lastly, an expected inward pressure by other countries could make the governments less effective at responding to an economic downturn.

Reminisce of the past recession are all related to false beliefs about market happenings. In 2001, market held the belief that a technology boom would continue to fuel the economy, unfortunately this belief was short lived, resulting in information technology bubble bust.

In 2007, market belief was positively reassuring that the housing market would never face a meltdown, again this belief was soon proven to be inaccurate. This time the belief holds that the economy will continue to grow more stable and interconnected over time and that trade, currency, and diplomatic relationships can be depended upon for continuous economic growth.

During the great recession fiscal policy was overlooked, meaning less emphasis was placed on fiscal policy, because we had to wait for the new administration to pass the bill. Furthermore, we lacked the political capital, and focus because so many other casualties were taking place in the back end.

This paper briefly discusses the role of fiscal policy and why we should get it right in times of recession, and why we should start acting now and not wait for a recession for the fiscal policy tools to work.

What was the government’s response to the Great Recession and how does it fit in to the model of discretionary vs. automatic response?

Early on the government started to reduce the interest rate and also send out automatic payments too individuals. The Recovery and Reinvestment Act was instrumental in changing the course of the great recession.

American Recovery and Reinvestment Act (ARRA) was implemented in 2009, right after President Obama was elected. The act was recognized as being the single largest piece of legislation passed in dollar terms, it was seen as a massive stimulus to the economy as it included a wide array of things from tax cuts to aid the states, and Medicaid payment assistance, and infrastructure investments, and ways to shore up automatic stabilizers. Hence, both the discretionary and automatic stabilizers were used.

There was also expansion of welfare program TANF, SNAP, and unemployment insurance, basically we were able to utilize all the tools in the tool box. Additionally, there were also some tax cuts on the payroll side. and continued support provided through unemployment insurance benefits overtime. Unfortunately, only a few attempts were made at job creation.

The timing of the ARRA placement was incorrect. President Obama had been in the office less than a month when this piece of legislation was passed. Admittedly, this piece of legislation was crafted under impromptu circumstances, and it was not passed after we had been in a recession for a year.

Role of Monetary and Fiscal Policy

Monetary policy was instrumental in cutting interest rates. Monetary policy has to do with measures the Federal Reserve takes towards the running of the economy, such as; changing interest that affect the money supply, borrowing and lending rates individuals face in the economy.

Fed was cutting interest rates during the time of great recession. But fed was overlooking the fiscal policy, when it should have been giving more emphasis to fiscal policy. Fiscal policy in this context is defined as policies involving taxes and spending.

Fiscal policy boost during the latest expansion was weak. The fiscal boost emerging from combined fiscal actions are measured either through peak to peak over the entire business cycle, or more relevantly through the first three years of recession recovery. The peak to peak measure involves actions taken during the recession such as the Recovery Act. While the measure from the trough including the three years shows the fiscal stimulus aiding recovery from the recession.

The data from Figure 2 show the fiscal austerity’s drag on the growth soon after the official recession was over. The fiscal stimulus in the first three years of recovery was historically weak following the Great Recession it provided less than a tenth of the spur to spending indicating the 1960’s and early 2000’s recessions, and less than a fifth the fiscal boost provided after the 1980’s and 1990’s recessions.

The fiscal austerity in this context is quite striking given that the fed’s recession tool of lowering short term interest rates was not given much emphasis to aid recovery.

Figure 2

Figure 2 provides a summary measure of the total fiscal boost provided by changes in government consumption and investment spending, transfer payments, and taxes during and after recessions. This figure compares the business cycles of 1960s, 1980s, 1990s, early 2000s, and late 2000s.

Policy Recommendations

We need a wide variety of policies, as recessions plays out differently among various demographic and geographic areas. For instance, some states never really recovered from the 2001 recession, therefore we need a set of polices for people living in places slow to recover or who may have never experienced a recession before.

Automatic stabilizers are a starting point and not the end point. More emphasis must be placed on the design of automatic stabilizers. Automatic stabilizers should reach people of all geographic and demographic areas in times of hardship. Decision makers must place increased effort in the functioning of automatic stabilizers.

More thoughtful and pragmatic approaches is required towards how we will respond to recession should it happen again. For instance, a fix in administrative complexities related to how cheques are processed is required. We want to think through these things ahead of time.

Pass the legislation and think through things ahead of time to avoid bad timings incurred by the previous legislation.

We should not wait for the unemployment rate to reach 7 % to start worrying about recession. Also, if the we unemployment rate is rising rapidly, from 4 to 4.5 % we are in trouble. Note the unemployment rate does not go up that quickly and then stops. The unemployment rate continues to rise. Therefore, we need to monitor the rising rates and apply the tools we already have in variety of different ways. There is no need to create new tools. We need to learn how to apply the same tools in a variety of different ways aiming for them to be more effective should and when the next recession strikes.

Pulling forward the prescribed policy recommendations policy makers should take action now and not wait for the recession to strike. Understanding that one size does not fit all we need a wide variety of policies to target various geographic and demographic settings.

Automatic stabilizers such as SNAP, and TANF is targeted at places with higher unemployment. Notably, families of minority ethnicity tend to be harder hit by unemployment, whatever the unemployment rate is for majority populations is double that for minority populations. This fact has proven to be true for long as unemployment rate has been measured. Therefore, it is incumbent upon us to think hard about our fiscal policy responses when we have face economic down turns.

Conclusion

Pulling forward the prescribed policy recommendations policy makers should take action now and not wait for the recession to strike. Understanding that one size does not fit all we need a wide variety of policies to target various geographic and demographic settings.

Automatic stabilizers such as SNAP, and TANF is targeted at places with higher unemployment. Notably, families of minority ethnicity tend to be harder hit by unemployment, whatever the unemployment rate is for majority populations is double that for minority populations. This fact has proven to be true for long as unemployment rate has been measured. Therefore, it is incumbent upon us to think hard about our fiscal policy responses when we have face economic down turns.