Saturday, August 6, 2011

The New Recession – What To Do?

It now appears that the United States will enter, or possibly has already entered, another recession. Growth in the first quarter was reported to be a measly 0.4 %, and more and more numbers keep pointing in the same direction: The double-dip is here. The manufacturers index was down to recession levels and (partly as a consequence of that), the stock market has been falling for 8 out of the 9 last days.

However, this recession is different than the first one. Why? Because this time, the US government does not have the options it had the last time around.

When the financial crisis struck in September 2008, the US government debt – while high – was still at a manageable level. There was room for borrowing, and at low rates too. Also, the Federal Reserve interest rate was still significantly above 0 %, so there was room for quantitative easing in the form of lower interest rates and more printing of money. All that printing of money, all the stimulus and the bailouts, may not have made for a stable recovery – but it certainly helped somewhat temporarily. Most of all, what helped was not the spending in itself, it was the fact that the financial markets still trusted the US government. When Barack Obama told investors that he was going to fix the economy, they believed him (like a majority of Americans did too, at the time). He had many tools at his disposal, and this kept investors in the stock market calm for the entire year of 2009. Dow Jones was up more than 40 %. Obama’s approval was still in the skys, the Tea Party was still just an extreme group of lunatics who’d never influence an election, and “Glee” was the best sitcom ever. In 2010, this changed quickly. Sure, Glee was still holding up, and the stock market did go up in ’10 as well, but the leadership qualities of Barack Obama was being questioned more and more. His approval ratings dived, and the Tea Party became a force to be reckoned with. What also happened was the Eurozone crisis; suddenly it was discovered that the Greek government had cooked the books, and their financial situation was even worst than reported. Several European countries are today on their way to default, and if only one of them does default, that’s most likely the end of the Eurozone, and 17 countries will be left standing with a currency not worth the paper it’s printed on. This possibility has continued to be a major drag on the global economy.

The people no longer trusted Barack Obama, they no longer believed him (if they ever had) when he talked about “recovery summers”. Consumer confidence remained low, and even though the government was spending like never before, the overall economy refused to lift. Sure, the stock market was alright, but unemployment levels were higher than anyone had estimated (after all, the justification for the stimulus in the first place was that it would stop unemployment from reaching double digits). The reason the stock market did recover was because it is based on expectations about dividends; as long as investors think that companies will use whatever profits they have to pay out dividends, and as long as they think dividends will continue to grow every year, they’ll invest in the stock market. In a market like this one, when firms are too uncertain about the future to hire, of course they’ll focus on paying dividends and keeping their stock prices up. The second requirement is more tricky; since a stock price is based both on the current dividend and how much investors believe the dividend will grow in the future, if investors happen to believe that the economy is going off a cliff and that therefore, dividends will decrease in the long term (though they may be high now), then stock prices are going to drop.

That summarizes that is happening now; investors no longer believe the US will get out of the crisis any time soon. They are counting on another recession, and this time, there is nothing the government can do about it.

That’s what’s so terrifying about double-dip recessions; you just have to ride them out. The US is already running a deficit of more than a trillion dollars, so increasing government spending to prop up demand is hardly an option. And the Federal Reserve interest rate is already at 0.5 %, so lowering it even further to stimulate the economy (which was done in 2007-08) won’t work.

The interesting thing is that as the US enters a recession, tax revenue is bound to fall. This will increase the deficit (because who really thinks Obama will cut spending in a recession, no matter how bad the deficit gets). And this means the US will hit the new debt ceiling faster than previously thought. As of right now, you’re supposed to hit it early in 2013, but with a fall in revenue, it could easily happen in… november 2012.

How much do you want to bet that a debt ceiling debate is the last thing Barack Obama wants in 2012? Another interesting question is; what happens if Obama is voted away in November, and the debt ceiling is reached in December? Will he respect the president-elect and sign a deal that will most likely mean deep cuts in exchange for a small increase in the debt ceiling? Or will he view this as a possibility to fire a liberal parting shot, and veto any deal that doesn’t include at least 50 % tax hikes? And will the outgoing, lame-duck congress, which (the way the economy is going) will be full with moderate republicans who have lost their primaries and are going home anyway, really have the courage and will to stand up to Obama? Time will tell.

So what is Obama going to do? He can’t get another stimulus package through congress, and it probably wouldn’t help anyway. Monetary stimulus is also off the table. You’ll just have to ride this one out. And how can Obama campaign on that? Most likely, he’ll use the “Truman strategy” and blame the “do-nothing” congress. He’ll point out that the economy went out of recession under his watch in 2009, and didn’t fall back into recession until the Republicans took over in 2010 – kind of the same argument I heard some Republicans make during the crisis in 2008, that the Democrats had been in charge for the past two years and therefore they were responsible. That wasn’t true back then (both parties were responsible) and it wouldn’t be true this time either (although this time, 90 % of the blame falls on the Democrats). As a president, you simply can’t swear yourself free from blame even if you lost congress.

Will it work? Most likely not. Most Americans didn’t like the stimulus package (that’s how we won congress, remember), so to “blame” congress for not passing another one is probably not the sales argument Obama needs. The case could be made that if the economy crashes badly enough, people will turn around and ask congress to do anything. While that possibility does exist, don’t you think people would rather have tax cuts than another stimulus package? A Republican candidate campaigning on tax cuts to solve the recession could easily win people’s trust and votes, since every other option has been tried and failed.

The problem with tax cuts however is that, at least in the short run, they do increase the deficit. Like a co-blogger pointed out the other day, tax cuts can increase revenue and tax hikes can decrease revenue, however that’s not normally the case and it nearly always happen in the medium-to-long term. That is, a tax cut can increase economic activity and therefore tax revenue over the course of 5-10 years, but the immediate, short-term effect will still be a loss of revenue.

Notice that I’m not saying tax cuts will actually solve the recession, only that politically, it could attract voters. The problem in the US is not so much the tax levels in themselves, which are (with the exception of the corporate tax) quite low in an international comparison. The problem is the deficit spending that is crowding out private investment, together with a complicated tax code, regulations and uncertainty.

The one thing the government can do, that won’t cost them anything and that is certain to decrease unemployment, is deregulating the labor market. This would lower the cost of doing business, make America more competitive and decrease government intervention in the private sector. All good things, in other words.

What can we take away from all of this?

Well, first, if the US does enter a second recession, then it is very hard to see a way Obama could win the next election. The GOP would have to nominate Donald Trump (with Meatloaf as his running mate) just to make the election close. Already Obama is struggling against Mitt Romney in the polls, but if things turn out the way I’ve predicted in this post, we may be able to nominate Sarah Palin and still have a shot.

Obama won’t campaign on deregulations in the labor market. Whoever the Republican candidate is, he or she will have a monopoly on this issue. Obama may realize the need (he’s not stupid, after all), but the trade unions are among his biggest donors. Just do the (political) math, and you’ll see why he can’t touch the issue.

It’s too early to talk about what a new recession would mean for the Republican primaries, but in general, if Obama appears to be very vulnerable and voters are angrier than ever, that’s certainly good news for a candidate like Sarah Palin or Michele Bachmann. On the other hand, it could also help someone like Mitt Romney, who has a good reputation when it comes to economic issues (whether he deserves it or not). As long as he doesn’t duck and cover again like he did during the debt ceiling crisis, there’s certainly a chance he could profit from it.

The debt ceiling will have to be raised again. Under which terms we don’t know yet, but even if the US could avoid reaching the debt ceiling before january 2013, there is no way the budget can be balanced overnight and the new (presumably Republican) President will therefore have to raise the debt ceiling at least somewhat. A default is still too costly that we must try to avoid it or postpone it as long as we can. If we can get a Republican president, before long there might actually be a balanced budget. We shouldn’t blow that chance; a default would lead to a global financial crisis, a massive recession and a drop in revenue so big that the budget won’t be balanced in a lifetime. Yes, even if you default, you can still borrow – it’s only that once you have defaulted, you have to pay a so much higher interest rate. And that would be very unfortunate.

The reason, in summary, why a recession following shortly after another recession is so bad, is because all the cards the government has when it tries to fix a recession will have been played already during the last recession. There will be no options left, except for one option (deregulation) that the current administration won’t use for ideological reasons.

Fasten your seatbelts. This is going to be one bumpy ride.

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