September has been the month of memorials and milestones; ten years since the bankruptcy of Lehman Brothers and, at nearly 3,500 days old, the longest US equity bull market ever. And October marks the longest US interest rate tightening cycle. All of this has focused minds on the cause, timing and nature of the next downturn. While there is no consensus on any of those factors, there is one certainty: the policy toolbox will be half empty.
Desperate for ways to revive the economy and in a political atmosphere of public anger, policymakers will therefore increasingly resort to unorthodox measures, most of which will be interventionist and distort markets beyond recognition. To begin with, the most obvious recession fighter — monetary policy — will fall short. The generally accepted wisdom by Federal Reserve insiders is that a standard recession requires 500 basis points of stimulus, close to the historical average of 476bps in post-war US recessions.
Even the most hawkish Fed watchers do not believe rates will be anywhere near that, with markets currently pricing the Fed Funds rate to peak below 3% in 2019. To make up for the missing firepower, we can assume a quick and aggressive resumption of quantitative easing. But the cumulative effect of all previous rounds in 2009-14 is estimated to have generated only an equivalent of 50 to 75bps in terms of Fed rate fund cuts, so even a heftier round of QE will not fully compensate for low starting rates. And this does not even capture the environment in Europe or Japan, where rates are still close to or below zero.
Next, fiscal policy looks similarly unlikely to pick up the slack. In the US, a spectacularly ill-timed tax reform has led to record deficits. The 2018 US deficit will be more than double the average pre-recession level. Worse, the stock of general government debt already exceeds 100% of GDP, leaving doubts about fiscal capacity to engineer a big countercyclical stimulus. The US is not alone in this conundrum. China was the dominant engineer of global stimulus in 2009 and has rapidly worsening debt metrics. And all other G7 economies, except for Germany, would also start with a significantly higher debt stock and thus would be hampered.
So how will governments respond? The weak post-2008 recovery has empowered populist leaders willing to tinker with unconventional measures. In the next recession, the public appetite for experimental or retrograde policies will be enormous. Consequently, one can expect a degree of interventionism and erosion of institutional separation, all in the name of reviving the economy. First, central banks will be under massive pressure to extend their remit. Despite lacking a democratic mandate, they could be coaxed into expanding their asset buying to more quasi-fiscal realms. In plain English, they could either buy government debt as needed to finance the government or purchase assets directly linked to public expenditure, e.g. public infrastructure bonds (a form of “the People’s QE”).
The long-term absence of credible inflation could weaken resistance to breaking taboos and lead to the transformation of central banking. Second, in search of other tools to lower real interest rates, governments could resort to financial repression. Its exact form would be country-specific, but would typically force regulated asset owners (e.g. banks, insurance companies, pension funds) to purchase specific assets, artificially increasing demand for certain bonds and hence lowering yields. One form of financial repression also concerns restrictions on inward or outward capital flows. Forcing national companies — most simply by changes in taxation — to repatriate more investment would be another means to redress flagging demand. This kind of action would not even require legislation, but could be done by regulatory or executive fiat, or even through the bully pulpit of the press. And given the international environment, this could easily be presented as a national emergency.
Third, beyond financial markets, governments could revisit stronger state involvement in the real economy, such as the directing of lending through state development banks or similar channels. Given the public mood, the nationalisation of industries or breaking up of dominant monopoly-like companies would be relatively low-hanging fruit. And if any of the above did indeed generate higher inflation, at that stage, governments would presumably be open to even more direct price controls for sensitive goods or services. Ten years ago, it was not only Lehman that went under. So did the Washington consensus on how to run market economies. While we have seen the political backlash, the policy backlash has just begun and will only really unfold in the next downturn.
Author: Elliot Hentov, Head of Policy and Research with State Street Global Advisors. To find out more about State Street Global Advisors talk to your financial adviser
First published in the Financial Times on 25 September, 2018
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