Monday, June 3, 2019

The sources of the next recession

 - by New Deal democrat

While we are waiting for the ISM May manufacturing survey and construction spending data to be released later this morning, both of which will give us important clues to Friday’s jobs report, let me write down some thoughts on the nerdy question I ruminated about this weekend: what is the most likely source of the next recession?

I should start by noting that I remain on “recession watch” for later this year, as in, a substantially heightened risk, due to enough of the long leading indicators turning negative by the end of last year. But my base case remains that there will be a slowdown without an actual recession, because those indicators haven’t gone down *enough* and some, like real M1 and some housing metrics, have already rebounded.

But I read a tweet over the weekend from a political source I respect, who essentially said, “housing’s fine, there will be no recession, end of story,” and, well, I was annoyed.

That’s because housing isn’t always the source of a recession, and occasionally, as in 2000-01, it doesn’t turn down very much at all. In fact, housing has turned down since the beginning of last year about as much as it turned down in 2000 - which didn’t prevent the 2001 recession, did it?

So what are other sources of recessions? Here’s my take:

1. Fiscal policies. Government imposes an ill-advised austerity. This was the main source of the deep 1938 recession, as the FDR Administration ended New Deal stimulus and pulled back on the reins. It’s pretty clear that austerity put a number of European countries back in recession earlier this decade. 

2. Interest rate policy. Big enough hikes in interest rates. This was the main source of the 1981-82 recession. Paul Volker’s Fed raised interest rates from 9% to 19% (!) in the year from July 1980 to July 1981. Lot’s of ordinarily leading indicators gave very little warning of the oncoming recession because of the speed and ferocity with which the Fed acted.

3. A price spike in a basic, non-substitutable commodity - like oil. This was the main source of the 1974 and 1979 recessions. In each case OPEC doubled the price of oil overnight, and in 1974 embargoed shipments to the US due to its support for Israel in the Yom Kippur war. The effect on both production and consumption of other goods and services was so immediate that many usually leading indicators didn’t even peak until after the recession began.

4. A producer-led recession, due to a hit to profits or the sustainability of production. This was the main source of the 2001 recession. When the dotcom bubble burst, lots of early internet and general tech companies went bust. Needless to say, production and employment both went down. Fortunately, in the wider economy producers weren’t leveraged very much, so the downturn was shallow.

So let’s turn back to our current situation. Do any of the four problems above exist?

Although the Fed has hiked rates by 2% or so over the last few years, and while yes that is a drag on the economy, in the grand scheme of things this isn’t very big. With inflation running at only 2% at the moment the Fed, if it chose, could lower rates without sacrificing either of its two mandates of price stability and full employment.  Also, there’s been no commodity spike — far from it, commodities are down over 10% in the past year (very much suggesting a slowdown in the *international* economy), and particularly no spike in the price of oil. Nor does it appear such a price spike is on the immediate horizon.

But Donald Trump’s tariffs and trade wars do fit into the first concern of fiscal policy. Even if one assumes the tariffs are a valid means to an appropriate end, they do come with a cost. That cost is paid by importers, and is shared between suppliers in the US, and their consumers. Suppliers, of course, will try to pass on the costs to consumers, but it is likely that there will be at least some decline in demand as a result, so suppliers are likely to bear at least some of the cost. I saw a note the other day that it is estimated that tariffs will add about $860 in costs to the average US household. That’s a little bit higher than a big hike in gas prices! 

And because producers must pay the import tariffs, and probably will not be able to pass on all of the cost, the remainder of the costs will come out of their profits. 

So sources of recession #1 and #4 are very much in play. But because the person in the US solely responsible for this - Donald Trump - is so impulsive and likes to deliberately create chaos, it is almost impossible to know ahead of time whether the impact will be enough to cause an actual economic downturn. 

On the other hand, since corporate profitability is very much at issue, using 2001 as our touchstone, paying extra-close attention to the producer side of the ledger via corporate revenues, profits, delinquencies and defaults, and credit and loan provision to companies looks like an excellent place to focus our attention. 

UPDATE: Two other comments. First, I don’t mean to imply that any of the recessions I discuss above were mono-causal. For example, it’s pretty clear that the spike in gas prices to $4.25/gallon in the first half of 2008 played an important role in the first half of that recession.

Second, I didn’t list over-leverage as a potential cause of a recession. Rather, leverage is what allows a bubble to exist. It does not *caue* a bubble to burst. Rather, once the downturn starts, the chaotic unwinding of leverage amplifies the downturn and causes it to spread via counterparty risk.