Fisher Investments Editorial Staff
Media Hype/Myths, Market Cycles

Are Recession Rescuers Tapped Out?

By, 08/21/2015
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Will the US have the necessary firepower to defend against the next economic crisis? Many have doubts, suggesting policymakers face a “persistent munitions shortage,[i] hamstringing them when the next recession comes. How can the Fed cut interest rates when they’re already near zero? How can they do more quantitative easing (QE) when their balance sheet already has $4.5 trillion? How can Congress pass fiscal stimulus when they’re so gridlocked? How can we even afford it, when debt is at 81% of GDP? Who will rescue us? On the one hand, this says a lot about sentiment: Investors remain preoccupied with fiscal and monetary policy, forgetting business cycles turn naturally and economies can grow organically, without external lifelines—that’s bullish today. But it also makes some pretty big, off-base assumptions about the role and necessity of stimulus when times get tough, needlessly sowing fear.

Fiscal and monetary stimulus can help at a recession’s nadir, when liquidity tightens and demand could use a jump start, but it’s a stretch to say economies need government intervention to return to growth. We reckon the obsession with the Fed and feds comes from the massive wall of fiscal and monetary stimulus enacted in early 2009, which perhaps helped the economic recovery begin faster than it otherwise might have. Chopping interest rates down to zero in December 2008, when interbank lending was all but nonexistent, arguably boosted liquidity and helped credit unfreeze. So did the first round of QE, launched in January 2009, which massively boosted not just bank reserves, but the quantity of money in circulation (unlike successive QE rounds, which largely remained on bank balance sheets). At that time, the financial system had all but stopped, and the Fed helped things get moving again. And Congress’s 2009 American Recovery and Reinvestment Act (ARRA) aimed to create new jobs through fiscal spending. While we can debate how effectively the money was spent, getting money to circulate through a recovering economy is a positive, even if it takes a few spends to find its best use. If demand isn’t coming from the private sector, public spending can help fill the void until households and businesses rediscover their animal spirits.

But all of these, at best, merely accelerated the inevitable recovery. Cycles always turn. Buyers return to financial markets, smelling an opportunity to make a killing when there is blood in the streets. An appetite for risk-taking returns, too—banks feel it and resume lending. Businesses that overcorrected during the downturn, slashing production and inventories, have to raise output to meet even the most modest demand uptick. ARRA, for all its hundreds of billions, didn’t touch vast swaths of the private economy—yet demand returned. A lack of aid doesn’t result in perpetual recession: See the eurozone, which exited recession in Q2 2013. At that point, the ECB had its main deposit rate at zero for a year already, Southern European banks were still deleveraging, and QE was a pipe dream. The 19-member bloc didn’t implement a big fiscal stimulus program to goose growth, either. Indeed, weaker peripheral countries—see Spain and Ireland—actually imposed fiscal contractions. Yet today, they’re now among the eurozone’s top-performing economies. Even Greece resumed growing, without a drop of new public investment. Many called on Germany to put its budget surplus to work and boost public investment to import more from the periphery, but Angela Merkel demurred. Southern Europe grew anyway. Would fiscal stimulus have helped the periphery? Possibly! But these countries clawed their way back without it.

This widespread craving for government help in a crisis also assumes intervention is always and everywhere good. But as 2008 shows, there is a darker side. If the feds get it wrong, they can exacerbate the downturn. For instance, former Treasury Secretary Hank Paulson arguably fed the panic when he tried to sell the Troubled Asset Relief Program (TARP) to Congress by going on national television and saying the US financial system was melting down. Rule number one of crisis management: Don’t panic the people. Shifting TARP’s function probably didn’t help, either. It was originally designed to buy up “toxic assets” (e.g., illiquid mortgage-backed securities) and provide banks with “clean” funds to lend. But the government then used TARP to take direct preferred equity stakes in big US banks—whether they wanted it or not—creating more uncertainty. Then they twisted it again in an effort to boost consumer lending, because—surprise!—the Fed’s alphabet soup of liquidity programs (pre-ZIRP and QE) had failed to unfreeze credit. And who can forget the incomprehensible decisions made by the Fed and Treasury regarding which firms would be rescued and which wouldn’t.

Again, stimulus is all well and good, but when the Fed and Treasury spend months throwing spaghetti at the wall to see what works, it arguably creates more uncertainty than it eases when society sees the fecklessness. For all the benefits some programs ultimately brought, if you can imagine a scenario where the Fed and Treasury stuck to the traditional playbook, foregoing flashy new programs in favor of typical fiscal and monetary stimulus—like, perhaps, if the Fed had dropped the discount rate below the fed-funds rate so banks would have an incentive to tap Fed liquidity—we’d likely be better off. 

But that’s all academic and in the past. Then again, all this speculating about what the government will and won’t be able to do in the next downturn is also academic and unknowable today. Concerns about whether the government will have the necessary “ammo” to attack  the next recession assumes fiscal, monetary and political conditions then will be exactly the same as today. But things change! When the next recession hits—whether it’s in a year, two, three years or beyond—things may look very different. Perhaps Congress won’t be as gridlocked as it is today. Or, even if it seems to be, an actual looming recession could loosen them up. Maybe the budget deficit is lower—or higher! As for federal debt, there is no reason to think a country currently borrowing for 10 years at 2% would have trouble funding fresh investment or handouts. And it’s possible the fed-funds rate would have risen to the point that a rate cut would be perfectly feasible and reasonable. The Fed, as has been well-documented, is on the verge of hiking. We could be well into a tightening cycle by the time the next recession strikes. Recessions don’t just crop up out of nowhere, after all. They usually arise when monetary conditions are contractionary, like when the yield curve is inverted (short rates exceeding long rates). It will probably take several rate hikes to get there, giving the Fed plenty of headroom to cut as needed.

As for the here and now, investing is about planning for probabilities, not possibilities. While it may be fun[ii] to discuss how the government may act under certain hypothetical scenarios, that isn’t actionable for investors. Markets focus most on the next 12-18 months, and within that window, the global expansion and bull market look likely to continue. We’d chalk up fretting about the next crisis as another brick in the wall of worry—a sign investors broadly don’t appreciate the economy’s underlying strength and ability to function without a morphine drip, whether now or in the future.



[i] We aren’t sure what prompted all the weapon-inspired imagery, but we did picture an amusing image of Fed chair Janet Yellen manning a tank.

[ii] For some of us.

 

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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