Policy in the next recession

What will economic policy be able to do in the next recession, given that rates are so low and government debt ratios are much higher than they were in 2007? In my view, much more than many fear, though the balance is likely to shift more to fiscal policy and we may see new innovations such as ‘helicopter money’.

I don’t expect a US or world recession in the next 12-18 months. Moreover, it is possible that the upswing could go on for some time, so interest rates could move up quite a bit before the end. Even so, to have the same firepower as last time would require rates to move up over 5%, which seems pretty unlikely. A starting point of 3-4% is possible though, (in the US) if the recession doesn’t come until 2021-22 or later, which would provide at least some ammunition.

Once rates have been reduced to zero we should expect more QE. If there is a recession soon and we start near today’s rates, QE would kick in almost immediately. But if bond yields are already low it is not clear this would provide much stimulus. Corporate bonds and mortgage spreads would likely widen out in a recession, so buying corporate and mortgage bonds would be worthwhile. If the recession proves protracted and other asset prices fall enough then central banks could buy anything, including stocks (as they have in Japan). But I suspect the baton will be picked up on the fiscal side before that happens.

Some people worry that with net debt ratios already around 80% in the US and UK, double 2007 levels, fiscal policy will be constrained. Back in 2009-10 it was argued that high government debt led to lower long-term growth. Government debt above 100% of GDP was viewed with fear and horror which is largely why both the US and UK acted to bring down borrowing rapidly once the recovery was underway. This gave us the ‘fiscal cliff’ in the US and ‘austerity’ in Britain. In a new recession debt ratios will almost certainly go well over the 100% level in the US and UK, just from the operation of automatic stabilisers. Active fiscal stimulus will take it higher.

But now I think the argument has gone the other way. With bond yields so low, people are saying why not borrow? If borrowing is free why not do it? Japan has borrowed its way up to a government net debt to GDP ratio of 153% today, without any panic in the bond market. True, Japan has a high domestic savings rate which makes it easier. But investors around the world buy US bonds so it would likely be no problem for the US. The UK, with a lower savings rate and fewer international buyers might have to be more circumspect.

Of course it would be foolish to borrow heavily right now when the economy is growing, just because rates are low. There is no spare capacity in the US or UK, (or Germany and Japan for that matter), so it just risks ending the cycle early. But in a recession, when borrowing rates will go even lower, why not?

The interesting question will be whether this fiscal spending is financed by issuing bonds or whether there will be pressure to directly monetise it – so-called helicopter money. My guess is that, to begin with at least, there will be bond issuance. If the central banks do QE as well, (which they will) that will keep bond yields low.

So what is the difference between helicopter money and QE? With QE there is an expectation that eventually the extra reserves created will be cancelled when the central bank sells off the bonds. Theory suggests that this expectation blunts the impact. Helicopter money can be done in various ways technically, but the key point is that it is a permanent creation of money. The simplest way is for the Central Bank to literally print bank notes and mail them to people. Another is for the government to borrow directly from the central bank.

My guess is that helicopter money will not be the first resort, rather it will be something adopted if recovery is slow. Incidentally, we should not automatically assume the next recovery will be slow. It was lethargic last time because the banking panic, credit squeeze and subsequent deep recession was such a shock to business, while consumers saw a huge loss of wealth as both housing and stock prices slumped. Also, for the US, the funk in the housing market meant that housing starts did not rebound as is typical and, usually, a strong source of new stimulus. If we have a more normal recession next time, the blow to confidence will be much smaller.

Overall then, I think it is wrong to be too pessimistic about the policy options for the next recession. The central banks don’t have much interest rate firepower but they do have lots of experience with QE and plenty of ideas for how to do helicopter money. And the attitude towards government borrowing has changed in this era of prolonged low bond yields.

It still depends on the politics of course. A Republican President and/or Congress might resist fiscal spending. But the recent deal between Congress and the President opened up the fiscal deficit even with the economy at full employment. So I am pretty sure they will be willing to spend money in a recession. In short the policy options are there and policy makers will be keen to use them. Dont be too worried about getting stuck in stagnation.