When the NBER’s Business
Cycle Dating Committee draws the boundaries on the current recession, it’s
unlikely to stand out as an especially long one. In fact, by the time the
committee publishes the official start date, it could be past its end date.
Why?
Because it’s front-loaded. Spending has dropped so sharply in
such a large portion of the economy that many types of activity have nowhere to
go but up. And once activity starts increasing, even from nothing, that’s expansion, not recession.
But the eventual business-cycle dates tell us little about our
current situation. We could hit bottom in 2020 but then expand so weakly that
we don’t restore vitality for several years. So let’s consider how the economy
might unfold over a fixed horizon—say, three years from 2020 to 2022—rather
than fixating on business-cycle dates.
First, I’ll look at the reasons why our situation is really, really bad, and then I’ll consider why it might not be that bad, after all. I’ll benchmark my calculations against the post–World War II period, but especially against the economic destruction from 2008 to 2010.
Why this is the worst economy since the Great Depression
I have six reasons.
Reason #1: This is a
“double-recession.”
Consider that our last ten recessions were shaped mostly by four categories of spending: business equipment, commercial real estate, home building and consumer durables. If you isolate only the ups and downs of those four categories (but throw in changes in inventories to account for milder, inventory recessions), your partial business-cycle history would be almost indistinguishable from the actual history.
Moreover, those four categories typically amount to less
than a quarter of the economy. In 2019, they composed
19.5% of GDP, as shown below:
- Business equipment: 5.8%
- Commercial real estate: 2.9%
- Home building:
3.7% - Consumer durables: 7.1%
So a 19.5% chunk of the economy explains the first part of
the double-recession, and we know it’s currently recessionary because the usual
precursors are back—collapsing business profits, tightening loan standards, widespread
job losses and rising delinquencies. With the usual precursors in place, we can
expect a sharp contraction in all four categories noted above.
But the second part of the double-recession is separate. Consider
the 2019 GDP weights for the additional spending categories below, totaling
11.3%:
- Transportation services: 2.2%
- Recreation services: 2.7%
- Food services and accommodations: 4.8%
- Gasoline and other energy goods: 1.6%
Now we’ve reached the piece that’s completely new—it has no
precedent in past business cycles. Each of the four categories shown above has
contracted far more than ever before. In each case, activity is only a fraction
of what it was just three months ago—probably less than half, and maybe even
less than a quarter. Considering the severity of the contraction, together with
the GDP weights, the destruction in these items alone is enough to establish a
recession, even without the usual fixed investment and consumer durables
categories discussed earlier.
So that’s what I mean by a double-recession. The first part includes
the fixed investment and consumer durables categories (totaling 19.5% of GDP).
The second part includes the additional categories (totaling 11.3% of GDP) that
imploded during the last two months, even as they’re normally only bit players
in the business cycle.
Reason #2: Pandemic-related
business costs could last for years.
Businesses will have to manage through some combination of
the following:
- Migration to more secure but higher cost
suppliers (in response to supply chain fragilities exposed by the pandemic) - Measures to facilitate social distancing,
including larger business premises in some cases - More frequent and thorough cleaning of business
premises - Personal protection equipment for employees and,
in some cases, customers - COVID-19 testing costs
- Potentially greater contributions to employee
health insurance (when insurance companies build COVID-19 into their cost
structures, premiums can only go up) - Potentially greater absenteeism (employees being
told to stay home with even mild illnesses, employees relying on public
transportation facing greater challenges getting to work safely) - Potential work stoppages when employees test
positive - Potential hazard pay
We can only guess how widespread and persistent these costs
will be. But across the whole economy, they’ll surely add to a significant,
positive number. They’re bad news for business profits, inflation and probably both
(more on inflation in a moment).
Reason #3: The Fed
only had two bullets in the interest-rate chamber (the two March rate cuts).
After cutting the fed funds rate in March from 1.6% to just
above zero, the Fed can’t reduce it further without entering the Twilight Zone
of negative rates. (Sure, other countries have tried negative rates, but it’s
still the Twilight Zone.) By comparison, here are the fed funds rate changes during
the last five recessions, from business-cycle peak to business-cycle trough:
–4.8%, –9.8%, –2.0%, –3.2% and –4.1%. So this year’s change of –1.5% is only a
fraction of the interest rate stimulus we normally see in recessions.
Reason #4: Bankruptcies
could be more severe than in any other post-WW2 recession.
I wrote “could be” because we don’t know for sure, but
record bankruptcies seem consistent with three things we do know. First,
business shutdowns within the 11.3% of GDP noted above (the second part of the
double-recession) will surely result in record destruction in that particular portion
of the economy.
Second, activity has already contracted more sharply than at
any time since the 1933 national bank holiday, and in that instance, widespread
business stoppages only lasted a week.
Third, nonfinancial businesses are loaded up with record
amounts of debt. As of Q4 2019 and relative to GDP, nonfinancial businesses
were more indebted
than ever before on a gross basis (74% of GDP), and they also carried more debt
than in any prior expansion after netting out interest-earning assets and cash
(55% of GDP). In short, nonfinancial businesses could hardly have entered this
crisis with a riskier aggregate balance sheet.
Reason #5: Meet the zombies—next
generation.
Stimulus programs are helping forestall economic
destruction, but they’re also propping up companies that wouldn’t be viable
without cheap financing backed by the Federal Reserve and Treasury Department. Some
of those companies will still go bust, despite public support. Others will
become zombies, dependent on loans that can only be paid back by obtaining more
loans. To those
who
pointed
to the zombie companies of the last decade as one reason for a less-than-vibrant
global expansion, you haven’t seen anything yet.
Reason #6: Inflation
risks are unusually high for a recession.
As noted above, the pandemic has lifted business costs by
adding procedures and complexities that didn’t exist before. Rising business
costs damage profitability, at first, but should eventually have some effect on
inflation. And that’s not all. Inflation is normally a policy choice (either
intentional or inadvertent), and policy makers are more inclined to risk it
than at any time in the last four decades. Notably, current policies include
direct injections of Fed-financed spending power into the Main Street economy.
Moreover, those injections appear to be augmenting rather than just supplanting
spending power supplied by commercial banks. (I’ve shown several times that
past QE programs merely substituted Fed financing for commercial bank
financing, without having a significant effect on the total.)
Note that I’m not using the flawed logic of monetarist economists who predicted rising inflation during the Fed’s earlier QE programs, nor did I join those predictions (just the opposite, as shown here, for example). Also, the inflation outlook is hardly one-directional, since certain items, such as housing costs, are now less likely to inflate than they are to deflate or remain stable.
But the factors discussed above should threaten the benign
inflation of recent decades. After remaining below 3% for the last 24 years, an
increase in core inflation to just 4% would be a major event. And if we get
there, fiscal and monetary policies would become more challenging, to say the
least. After many years of disinflation, policy makers would again be forced to
choose between snuffing out inflation and sustaining growth.
Why this isn’t the worst economy since the Great Depression
I have six reasons, once again, the first three of which
compare 2020 to 2008.
Reason #1: The big-4 “home” risks—home prices, home mortgage debt, home building and home equity extraction—are relatively nonthreatening.
The mid-2000s housing bubble brought unsustainable prices
alongside unsustainable growth in mortgage debt, home building and home equity
extraction. Just before the pandemic, by comparison, house prices and housing
activity appeared sustainable. Here’s a rundown of 2019 data versus “peak”
housing boom data:
- Home prices: Grew 3% in 2019 versus –19% in 2008 (after peaking in mid-2006)
- Home mortgage debt: 49% of GDP in 2019 versus 72% in 2007
- Home building: 3.7% of GDP in 2019 versus 6.6% in 2005
- Home equity extraction: 1% of DPI in 2019 versus 8% in early 2006 (according to Bill McBride’s calculations)
We can link each of the items above to a significant drop in
household spending power or housing activity in the 2008-9 recession and the
years that followed, whereas the data show much lower risks today. Clearly, the
big-4 home risks are unlikely to wreak as much destruction in the current
recession as the destruction caused by the housing bubble.
Reason #2:
Sterilization? What’s that?
In 2008, the FOMC fretted for months before dropping long-established
central banking orthodoxies. But such lengthy deliberations have long since
gone out of style. The committee now crams money without hesitation into every
financial-sector crevice that appears to be leaking. The new policy “normal”
invites both moral hazard and zombification of wide swathes of the economy, as
noted above. But the immediate upside is significant—the Fed’s interventions
short-circuited the financial crisis that appeared to be unfolding in March.
Reason #3: Banks have
more capital than they did in 2008.
We’ve all heard the story about the better capitalized banking
system, and it’s true. But higher capital ratios won’t stop banks from slowing
or even shuttering their lending operations. (They’ve
already
done
that.)
So the capital cushion is larger, and that’s nice to have, but it won’t save
the economy. The main benefit is that measures to bail out the banks won’t need
to be as large as they would otherwise be.
Reason #4: Some areas
of the economy are seeing stellar demand.
I noted above that spending has evaporated like never before
in portions of the economy that total 11.3% of GDP. Now consider three other
types of spending:
- Food and beverages purchased for off-premises
consumption (4.8% of GDP) - Other consumer nondurables (5.6% of GDP)
- Health care (11.5% of GDP)
Solid spending in these areas, which total 22% of GDP,
doesn’t negate the destruction in the transportation, recreation, restaurant,
hotel and energy sectors. But it’s important to recognize that some of the
spending lost through health fears and business shutdowns is being redirected,
not extinguished. It’s flowing strongly into other parts of the economy. And the
jobs market demonstrates that point—many recently jobless workers are finding
new positions at Amazon, Instacart, CVS or one of a smattering of other
companies whose outlook has brightened. So the double-recession I noted above
might net out to more like a recession-and-a-half.
Reason #5: Furloughs,
not layoffs.
Of the newly jobless workers who don’t find jobs elsewhere,
many remain on their employers’ payrolls, retaining certain benefits but not
working or receiving wages. One survey shows
that 78% of employees who lost their wages due to the coronavirus expect to return
to their former jobs. That might prove more hopeful than realistic, but it’s a less
bearish recession story than the more typical story of companies slashing labor
unconditionally.
Reason #6: Helicopter
money!
Now for the elephant in the room. Fiscal policy makers are
intent on providing “what
it takes” to overcome the crisis. For that, they’re tapping into the Fed’s
unlimited capacity to finance government spending with newly created money.
They’re tapping it like never before. To highlight just two data points:
- Roughly half
of unemployment claimants will have more income than they had while working
(through July, at least), thanks to an extra $600 weekly of CARES Act benefits
on top of their normal state benefits. - Millions of working Americans will also make
more than they would have without COVID-19, thanks to CARES Act stimulus
payments.
It shouldn’t be surprising that the survey linked above shows
people feeling better about their finances than they did a month ago, despite
weekly unemployment claims averaging over five million between the two survey
dates.
So helicopter money gives us yet another surreal and
unprecedented development to ponder. In the short-term, it’s certain to blunt
the pandemic’s economic impact. In the long-term, we’ll face consequences, but
I won’t delve into that in this article. I’ll only suggest tuning out pundits
who claim
that “advanced” nations with their own currencies can drop helicopter money
without repercussions. In fact, the advanced nations of today reached their
advanced status long ago after enduring tumultuous periods of fiscal profligacy,
learning from those experiences, and then maintaining relatively sound finances
thereafter. And if they didn’t learn from experience? Well, that’s one of the
biggest reasons that many countries fail to advance.
(My book supports
that argument with an examination of every recorded instance of governments
accumulating a higher debt-to-GDP ratio than America’s debt-to-GDP as of 2018. For
anyone interested in the general idea without the historical detail, I
published an excerpt here.)
Conclusions
The eventual COVID-19 wreckage pivots on many unknowns, and
future policies are among them. But the biggest unanswered question—at least
when it comes to the economy—is this:
For
how much longer will the pandemic prevent vulnerable businesses from operating
profitably (or operating at all)?
Optimistically, new COVID-19 cases will descend downward until they hit bottom in a few months, allowing businesses to restore profitability. That’s the scenario the President’s task force includes in its slideshows—it shows virtually no new cases by July. And the more political voices on the task force have reinforced that message, playing up the idea that we’ll be back to normal by this summer. If their prediction proves accurate, the economy should perform better in 2020–22 than it did in 2008–10, for these reasons:
- With a COVID-19 resolution in the summer, the
housing market would be in far better shape than it was in 2008. - The financial sector would recover relatively
quickly—banks would still be cautious but not as cautious as they were during
and after the Global Financial Crisis. - Many depressed businesses would bounce back at
least partially and rehire furloughed employees. - Some businesses boosted by the pandemic would
continue to thrive. - Exiting the recession, household spending power
would be unusually strong, thanks to the recession’s short duration as well as generous
government handouts.
So
that’s the outcome we’re hoping to see, but it has an obvious weakness. That
is, it presumes the coronavirus remains dormant after the economy restarts. A
different theory says the virus revives whenever it finds an opening. Evidently,
that’s a common feature. Epidemics tend to attack in waves. Until vaccines
become available, the challenge in snuffing out this epidemic is that it only
takes a handful of infected people going about their normal lives to reseed it.
In other words, a future resurgence of COVID-19 seems the
most likely outcome. It’s the scenario many experts warn us to expect, and not
just any experts but the ones who’ve been most accurate to date.
Where does that leave the economy?
The worst case combines a historically deep recession with a disappointing recovery that feels more like continued recession. If future COVID-19 waves prove as dangerous as the first wave, the recession could be an early 1980s–style double-dip. But other possibilities are less severe. For example, medical discoveries could make the virus less risky, restoring confidence in normal business activities. (Note that Dr. Fauci was citing “quite good news” on remdesivir trials as I write this.)
So the possibilities run from one extreme to the other. We need to be ready for anything, unfortunately, from a mid-2020 rebound to a prolonged crisis more severe than any since the Great Depression.
Tags: bank capital ratios, bankruptcies, business cycle, central banking, COVID-19, debt-to-GDP ratios, fed funds rate, federal reserve, fiscal stimulus, FOMC, furloughs, GDP, Great Depression, helicopter money, home building, home equity extraction, inflation, mortgage debt, NBER, pandemic, recessions, spending power, unemployment, zombie companies
