Monetary and fiscal space will be very limited in the next US downturn

Editor’s note: This post was first published on Patreon on 27 June 2018.

The United States governments spends money by keystroke. And though it is forced by law to sell bonds when its accounts at the Fed run low, this artificial constraint is easy to overcome. Quantitative easing alone — where the Fed buys US Treasuries via money it creates with keystrokes — tells you that. There is no limit to the number of dollars the US government can create.

Yet, when I look at where things are headed in the next downturn, I see very little policy space. Let me tell you why below.

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Limited monetary space

The monetary side of this is easiest to explain. Rates have eased by an average of 6% over the past five business cycles. As I explained in March:

  • In July 1981, federal funds went from 19% to 12 3/8% in that cycle (6 5/8%)
  • In April 1982, federal funds went from 15% to 8 1/2% in that cycle (6 1/2%)
  • federal funds went from 9.75% in May 1989 to 3% in November 1982 (6 3/4%)
  • From November 2000, federal funds went from 6.50% to 1% in July 2003 (5 1/2%)
  • federal funds went from 5.50% in July 2007 to 0% by the end of 2008 (5 1/2%)

And remember, in the last recession, even after 5.5% of cuts the Fed felt compelled to add more stimulus in the form of quantitative easing. So clearly, the Fed wanted to cut more, if it could have done. The zero lower bound was a problem for the Fed.

The Fed won’t have anywhere close to this this much ammunition in the next downturn. If the Fed has half as much room to cut rates, it would feel fortunate. As a result, the yield curve will not steepen enough to help banks rebuild their balance sheets. And, therefore, credit supply will be restricted even if the recession is much less severe than the Great Financial Crisis.

Limited political space for fiscal expansion

So given the lack of monetary space, we will depend on fiscal policy to do the heavy lifting. And as I said at the outset, the US government has an unlimited ability to credit bank accounts, with inflation as its only real check.

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But the political constraints are a different story. Republicans may deride Nancy Pelosi as a socialist but the reality is quite a bit different. Marshall Auerback pointed out to me in conversation earlier today that Pelosi celebrated deficit hawk Pete Peterson when he passed away, wants to re-introduce “paygo”, and thinks Medicare for All is a terrible idea. In short, she is much more fiscally conservative than many believe.

Moreover, last night, I was talking to a Fed watcher who has spoken to Janet Yellen since she left the Fed. And his comments suggested she thinks Trump’s deficits are irresponsible and ill-timed. Comments by Fed officials suggest this view of the Trump deficits is widespread at the Fed, even amongst doves.

The Democrats are the party of fiscal responsibility

Finally, look at this comment regarding the views of Bernie Sanders supporter Alexandria Ocasio-Cortez, who will likely head to Capitol Hill as a NY Congresswoman in November.

Sorry to be the wet blanket, guys. When asked by @WillieGeist today about whether tax hikes would pay for @Ocasio2018‘s agenda (universal medidcare, free post-HS ed, forgive student loans, etc). Her reply was confident, articulate incoherence.

— Noah Rothman (@NoahCRothman) June 27, 2018

That’s exactly where Nancy Pelosi is on those issues. So, effectively, the mainstream Democratic position is anti-fiscal expansion, anti-loan forgiveness, anti-universal Medicare. The Democrats believe in fiscal responsibility and are unwilling to expand deficits more than they have expanded already.

Don’t expect a robust fiscal response to the next downturn

So when the Fed cuts to zero, there won’t be a bevy of fiscal measures coming — irrespective of how government funds itself. On the fiscal front, the political obstacles are too high to overcome, especially given the existing deficit levels created by Trump’s tax cuts.

The Sanders position on using fiscal policy to increase the social safety net of the US middle class through deficit spending has been met with contempt by the Democratic Party. Hillary Clinton disavowed these ideas in 2016. Nancy Pelosi has gone one further, promising to bring back Paygo if the Democrats win the House of Representatives. Unless the Democratic Party shifts leftward, you can forget about large fiscal stimulus anytime soon.

Trump did get his tax cuts through a Republican Congress in 2017. But now there is little appetite for more deficit spending in the Republican Party. Were we to fall into recession, nothing I see in the Republican Party shows any likelihood of stimulus.

Remember, recessions increase deficits by reducing tax intake and increasing expenditures because of fiscal stabilizers. We could have double digit percentage deficits without any stimulus.

The risk, of course, is that, even if the next recession is a garden variety one, the downturn will be significantly exacerbated by a lack of policy space. This will impact the real economy negatively, but it will also be negative for risk assets. Long-dated Treasuries will benefit, another reason to be sceptical of the long anticipated bond bear market.

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