The U.S. Government Was Unprepared for the Coming Recession. Then the Economy Caught Coronavirus. Benjamin Way Follow Apr 2 · 10 min read

The U.S. fiscal and monetary tools were already exhausted throughout the lackluster recovery from the Great Recession. We now face a crisis beyond our capacity to counteract.

Even before the Coronavirus epidemic, the United States government was deeply unprepared for the next recession. Although it is far too soon to say how extensive the damage from COVID-19 and the response to it will be, one thing is certain: our government does not have any savings left to cushion our fall.

Governments are generally understood to have a few different levers they can pull to heat up or cool down the economy (in this article, I have conflated these with Gross Domestic Product [GDP]). These are broken up into two categories: monetary policy and fiscal policy. Monetary policy is handled by the Federal Reserve; fiscal policy is handled by the Federal government.

Let’s start with fiscal policy, taxing and spending.

Fiscal policy basically works like this: the amount the government spends in a year is added to GDP, whereas the amount that it taxes is subtracted from GDP. Thus, governments can increase GDP by lowering taxes or increasing spending, and they decrease GDP by raising taxes or lowering spending.

Note that unfunded spending in the present will be subtracted from GDP in the future, whereas unspent taxation will be added to GDP in the future. Thus, a responsible government would increase taxes and cut spending to accumulate savings during expansionary years, and pump those saved taxes into spending and tax refunds during recessionary years. This would help balance out market cycles and give us leeway to weather unexpected shocks.

Let’s see how we’ve been doing by comparing the stock market against our deficits since 1980.

A quick examination shows a clear pattern. Although our government does typically increase net taxation during economic expansions, it does not do so enough to offset the deficits maintained during the years of lower GDP. Although Clinton came close to achieving sustainability, he is unfortunately unique over recent history in this B+ level success.

Much more topical for our purposes, take a good look at 2016. A very dangerous thing happened: the Obama administration decreased net taxation in 2016 instead of increasing it. Stocks had hit a minor correction, and that was the justification given. However, it is a bit suspect to initiate costly expansionary fiscal policy when stocks are at almost record high levels if it happens to be an election year, and federal finances are already in terrible condition.

Whether or not the Democratic majority had nudged federal finances to nudge the election, they lost, of course, and the Trump administration and Republican majority decided to continue that “precedent” and increase deficits each year even as stock prices continued breaking records.

Remember, the Obama 2009 deficit was the largest in history, by more than triple. Well, not anymore. Behold, the glory of Donald Trump’s 2 trillion dollar unfunded stimulus package. It’s March, so it’s too soon to count how much we spent by December, but this is the current, if-nothing-else-goes-wrong estimate for the year’s end:

Not even going to comment further on this, except, “Ahhh!!!”

There’s more. Consider the following graph of Tax:GDP ratios across time.

As you can see, the U.S. reliably follows the strategy of slashing taxes during recessions and gradually restoring them throughout expansions. There was a minor hiccup there in 2016 as I mentioned, followed by a recession-level tax cut called the Jobs and Tax Cut Act of 2017, whose effects were felt in 2018, ahead of Election Day. If there had been doubts about Democratic attempts to manipulate the election with the economy, those same doubts do not apply at all to a scheme of this magnitude; it was obvious electioneering by Donald Trump, and the price to pay is the depth of the coming recession. As a direct result of that decision, we are starting this recession with much less room to cut taxes than we had during the Great Recession.

Alright, now let us move on to consider public debt, which is the closest thing we have to talking about federal savings. A responsible government would have savings, but ours contents itself to have some unused credit lines. Once again, we are looking at a much worse situation than we were looking at just prior to the Great Recession. Consider this chart of pubic debt as a proportion of GDP from 1900–2016.

That all-time-high is World War II, when the entire nation was mobilized for an existential war. The point where public debt began rising again after that coincides with the end of the USSR and “containment” and the rise of Ronald Reagan and modern “conservatism” based on global domination and “American Interests” abroad rather than fiscal responsibility at home.

The trough where that trend was reversed occurred under Bill Clinton, as fiscal conservatives found themselves with a conservative-leaning Democrat as the closest approximation of their priorities, after being abandoned by the hawks of the Republican party. Many of these, such as myself in ‘08, were very disappointed when Obama did not display the same fiscal responsibility as Clinton, although this is not an entirely fair comparison, because he took office during a recession, not an expansion, and followed all of the “right” theoretical steps according to the same model as Clinton, except that Clinton cut military spending whereas Obama increased it — again, constrained by external factors. The fault for 2009, according to this theory, lies mainly with Bush Jr., whose voluntary wars and tax cuts did not capitalize on the expansion to restore a surplus for Obama to work with, and indeed baked spending increases into Obama’s tenure. Even with the most damning evaluation of Bush and Obama’s combined 16 years, however, they just do not hold a candle to Trump and Powell’s single terms.

Finger-pointing aside, we are now under a mountain of debt without any easy way out of it. Unlike WWII, there will be no signing of a Treaty that instantly restores fiscal health. We built this mountain not out of defensive necessity, but out of superfluous wars of aggression and inflated living standards. To climb down, we will need deflated living standards and to abandon our hard-won puppet governments abroad to vengeful civil war and conquest by other rising empires. It is not going to be fun, and it is not going to be pretty.

Some have argued that we never actually need to deal with that mountain; that there is no such thing as a credit limit for the United States; that we can borrow infinity money if we feel like it. This is absurd on its face, and is predicated solely on the expectation that past trends will continue under any future circumstances. Unfortunately for those who cling to this ostrich optimism, the Great Recession already hinted at a new trend: Austerity Economics.

When a government borrows money, the creditor expects to be repaid. Just as with personal loans, the bank will consider future income and other existing debt obligations to determine how likely it is that they will be repaid, and then they set an interest rate so that they profit, on average, from loans at that risk level. In recent history, Western governments have largely kept debt:GDP ratios low, so creditors never worried about default. Then, when the Eurozone currency crisis hit in 2010, and their debt:GDP ratios started reaching levels previously only seen in “developing” nations, loans started coming with the same strings attached that “developing” nations had always been forced to contend with.

The U.S. was largely insulated from that crisis, but we did see the first few shots in the coming war fired when Tea Party Republicans repeatedly shut down the federal government over an argument about raising the debt limit without addressing the deficit. They lost that battle, but they will be back in greater numbers and with greater financial backing, as the debt and deficit have both doubled in the meanwhile.

Those financial backers flashed us several warnings variously in 2011, ‘12, ‘13, and ‘14 when they temporarily downgraded U.S. credit ratings one notch, to give the big players time to restructure institutionally with less reliance on the dollar. They have now had that time, and the next set of downgrades may be more severe and permanent. We cannot count on infinite borrowing to get us out of this recession, and we are very likely near our limit for the cheapest tier of loans. Couple this with our already low tax rate, and the federal government is already running out of options for fighting the recession that just began.

On to monetary policy. The Fed has two main tools: it can raise and lower the Fed Funds rate to influence the profitability of lending, and it can buy or sell treasury bonds with member banks, either to liquify banks’ assets and enable more lending, or to increase yields on the savings they hold and rein in lending.

In short, the Fed may choose between high growth in the present and low growth in the future, or low growth in the present and high growth in the future. Thus, a responsible central bank would moderate market cycles by implementing long-term growth policies during boom years and short-term growth policies during bust years. Although they roughly try to approximate this, over the past 40 years, they have had a consistent bias in favor of the short term, which is the opposite of what they should have for sustainability.

Consider the modern history of their more powerful tool, the Fed Funds rate:

The grey bars indicate when recessions occurred. As you can see, the standard response for the Fed is to slash interest rates just before a recession to stimulate lending and thus aggregate supply and aggregate demand, and thus support GDP, and then to raise that rate gradually until the next recession.

Note the reversal of the trend of an increasing Fed Funds rate, once again beginning under Ronald Reagan, during which fiscal responsibility was allowed to decay, and the Fed “wound up the spring” less and less after each recession. This particular graph does not depict it, but the rate has fallen all the way to the floor as of this writing, because the scale of the COVID-19 shock to GDP at a weak point already called for a bigger rate cut than that. Unfortunately, we don’t have any more room to drop it. Those crazy stock market gains that also began under Reagan were like the Biblical seven years of plenty. We did not save up any grain, and now the seven years of famine are upon us. This is the fruit of the Reagonomics Republican abandonment of fiscal responsibility. Let all trees be judged by the fruit that they bear.

The Fed does have one last card to play: “Open Market Operations.”

Cool spin, Brookings Institute. https://www.brookings.edu/blog/up-front/2019/05/17/the-feds-bigger-balance-sheet-in-an-era-of-ample-reserves/

Surprise! This tool is also already starting out this recession in worse shape than last time. The measure of this tool is referred to as the Fed’s “balance sheet.” Now, this is going to sound backward, because the Fed always tries to work opposite of the market, but the Fed’s balance sheet is already loaded up with assets, and that is a problem. They owned about 4 trillion dollars of assets already before announcing a plan to buy 1.5 trillion more.

Understand, the Fed buys up assets at a loss to increase demand for assets, buoying their prices. Thus, if the Fed had a balance sheet in the negatives, like if it had been selling off assets at a profit throughout the bull run instead of buying them to drive it, then it would have lot more room to buy assets right now. Because it has a record high balance sheet at the beginning of implementing expansionary policy, it has to print a lot more money to provide the same price support. Thus, in order to prevent GDP collapse, we would instead suffer massive inflation. The way to escape this choice would have been to be more responsible during the bull run, which is now ended.

How much money will the Fed need to print to maintain a positive balance sheet as their mortgage backed securities (MBS) start defaulting and their treasury bond holdings are eaten by inflation? The number of dollars in circulation has already doubled since the Great Recession began. How much more can that be increased before prices get out of control? We appear to have climbed out on limb where we cannot balance inflation against unemployment without one of them being potentially catastrophic.

I don’t really want to think about what happens if Congress repeals the Dodd-Frank Act or otherwise reduces the reserve ratio for banks (to stimulate the economy, of course!) now that the money supply is doubled and the Fed is running out of other options. The potential for rapid inflation is not insignificant.

In conclusion, the United States has demonstrated a pattern of financial irresponsibility over the past few decades which is culminating finally in a perfect storm of depleted household wealth, reduced real incomes, low employment, over-leveraged incomes, inflated asset values, and simultaneous government fiscal and monetary crises, just as a major global pandemic is beginning.

It is never time to abandon hope, and it is never time to panic, but it is now possibly the last opportunity to prepare for the worst.