Indicators for Another Recession and Pre-Emptive Policies

4022 words (16 pages) Essay in Economics

23/09/19 Economics Reference this

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Introduction:

 As the United States has experienced an extended period of economic growth since recovering from the great recession in 2008, many believe that another recession must certainly be on the horizon. As this sentiment grows throughout the nation and calls for preparation become more frequent, this paper sets out to examine whether such fears are justified and to recommend any appropriate action necessary to protect the US economy from drastically negative effects of any nearing recession. In order to achieve this, we will examine various indicators to assess the current and future states of the economy and business cycle. Following this assessment, fiscal and monetary policies will be proposed in response to any findings of concern.

The Current State of the U.S. Economy:

 The current state of the economy is difficult to assess from any single indicator and thus, an examination of various aspects of the US economy is required in order to gain an understanding of where the United States is at this point in time. To gain a more wholistic understanding of the state of the economy, we will focus on the following four areas: (1) the state of consumers; (2) the state of businesses; (3) the state of the labor market; and (4) the state of the housing market.

 The attitude of consumers is a driving force behind the macroeconomy of the United States and consequently must be evaluated. Recent data from the University of Michigan regarding consumer sentiment (Figure 1), indicates that confidence in the economy has been fairly steadily rising since 2009. Consumer sentiment appears to fall prior to recessions, so this increase suggests that consumers have been and are continuing to do well. With consumer sentiment high, consumption is also likely to be rising, especially within the context of Keynesian thought where consumption is driven by consumer animal spirits.

Figure 1:

When examining the personal savings rate and real disposable income, the data is quite consistent with consumer sentiment. The personal savings rate is variable, but has been staying steady recently despite a small drop beginning in February 2018. Real disposable income has grown pretty constantly throughout time, yet, observing it in terms of percent change from a year ago could provide some insight on where the economy is and may be headed (Figure 2). Prior to the 2001 and 2008 recessions there was a decline in real disposable income when measured this way, but it is currently quite steady for a rather volatile measurement. Additionally, the lack of significant change in the personal savings rate could be tied to the steady disposable income. These past trends could indicate that the US is not set for another recession. Overall, with consumer sentiment high, and personal savings and real disposable income remaining steady, the economy appears to be strong from the consumer perspective.

Figure 2:

 Following the examination of consumers, the state of businesses must be analyzed to gain insight into how another portion of the economy is performing. An interesting metric to consider is the total business inventories to sales ratio (Figure 3). Prior to previous recessions there has been a moderately steady decline in the inventories to sales ratio followed by a mid-recession peak, which somewhat resembles the inverse of the business cycle. This mid-recession peak likely indicates inventory accumulation due to fixed prices in the short run and could be driven by a decrease in demand via consumer animal spirits. The accumulation of inventory in the presence of fixed prices provides firms only one option: reduce production and/or lay off workers, which decreases overall output. Despite suggestions of past trends, this ratio simply shows that businesses are not experiencing significant inventory accumulation, which is a good thing. As is displayed in Figure 3, the inventories to sales ratio is on the decline as of 2016.

Figure 3:

An additional indicator of the state of businesses is capacity utilization, which measures the rate that potential output levels are being met in the US (Figure 4). No economy will ever realistically reach full capacity, but the United States has managed to hold capacity utilization above 70% for the most part with the exception of during the 2008 recession. This indicates that while businesses are not achieving their full potential, they are attaining a high percentage of it. Historically, decreases in capacity utilization often lead into recessions. Currently, capacity utilization is at 78.4%, and has been trending upward since 2009 despite a decrease from 2014 to 2016. This positive trend suggests that businesses are operating more efficiently, enabling higher production, and therefore creating more employment opportunity.

Figure 4:

The final metric related to the state of business is the purchase of new durable goods. These purchases have been rising and can be linked back to rising consumer sentiment due to the fact that consumers are unlikely to make big purchases when they perceive the economy to be approaching or experiencing a downturn. Keynesians would suggest this increase will lead to higher output. Altogether, the absence of negative indicators, lack of significant inventory accumulation, rising efficiency, and increasing purchases of durable goods portrays a healthy economy.

 Next, we must consider the state of the labor market in order to continue expanding our view of the US economy. In order to do this, we will focus on three specific indicators: continuing jobless claims, the civilian unemployment rate, and the labor force participation rate. Continuing jobless claims measures unemployed persons currently receiving unemployment benefits and has drastically declined since the end of the 2008 recession. This expresses the continued ability of the unemployed to find jobs even after the economy has recovered from the recession, which is undoubtedly a positive sign regarding the state of the labor market. In addition to the benefit to previously unemployed people, this helps cut back government expenditure, which can be used elsewhere to further sure up the economy. The second indicator is the civilian unemployment rate, which despite being backward-looking, can provide some valuable insight into the labor market. The current unemployment rate in the United States is 3.7%, revealing a flourishing labor market. Unfortunately, earlier recessions have been preceded by very low unemployment rates compared to prior years, which may stir up some concern with the current unemployment rate at its lowest point in over twenty years. However, it is also important to note a positive implication of such low unemployment; a diminished output gap. This means that the difference between the economy’s real and potential output is small, which is associated with an expanding economy. The final measure regarding the state of the labor market is the labor force participation rate (Figure 5). This expresses the ratio of the population that is employed to the total population considered old and able enough to work. The United States has seen a decline in the labor force participation rate since 2001, which may seem condemning, however this is beginning to level off and various potential explanations exist. One such explanation could be changes in cultural and demographic factors that occur as younger generations begin to comprise more of the labor force. These changes could manifest themselves in the form of younger generations prioritizing caring for loved ones over work or being more easily discouraged about employment opportunity by something like a chronic health condition, both of which could result in a decline in the participation rate. In terms of the labor market, the only indication of possible concern is historically low unemployment prior to downturns. Despite this, low unemployment shrinking the output gap, leveling off of previously decreasing labor force participation rates, and falling continuing jobless claims are all promising signs.

Figure 5:

 Finally, it is necessary to gauge the state of the US housing market. One way to do this is to examine housing starts (Figure 6), which measure how many residential building projects are being started each month. With the exception of 2001, housing starts have decreased fairly significantly prior to recessions, indicating less demand for new construction and therefore contractors, laborers, and material supplies, which may eventually produce unemployment. As demonstrated by the data, housing starts are often slow to recover from recessionary periods and have peaked around 2,000 units prior to declining into such periods. Also, housing starts appear to be somewhat cyclical, similar to the business cycle. These trends offer an encouraging outlook on the state of the housing market as starts have been increasing since the end of the 2008 recession and are only around 1,200 units.

 Figure 6:

Another way to analyze the state of the housing market is to examine the trends of mortgage rates and new single-family home sales. Recently, mortgage rates have increased slightly, likely causing the slight decrease of new home sales we have seen. Since purchasing a home requires borrowing money, and the cost of borrowing affects purchasing decisions, logically there is an inverse relationship between mortgage rates and home sales. Higher mortgage rates decrease demand for homes since borrowing is more expensive, which may negatively impact the housing market. Considering that the Fed has been raising interest rates and that housing starts are growing, this is not too concerning, but it should be monitored. Despite higher mortgage rates and a small reduction in new home sales, the state of the housing market appears stable.

The Future State:

 The aforementioned indicators paint a fairly promising picture of the current state of the economy, yet we constantly find ourselves concerned with the future. While it is impossible to precisely predict the future state of the economy, there are methods that may provide some insight as to the direction of the US economy in years to come.

One way of doing this is through comparing real output to real potential output in order to evaluate the US economy’s performance and attempt to predict where it is headed. Figure 7 displays real GDP and real potential GDP, however in order to maintain consistent units, a discontinued data series was used for real GDP.

Figure 7:

Previously, real GDP has either been extremely close to or exceeded its potential recently when the recession struck. Towards the end of the 2008 recession, real GDP began the approach towards its potential and has lessened the disparity with time, which corresponds to growth in the business cycle. Notice that historical trends display extended periods of near equal real and potential output before recessions, and additionally that US real output has only recently begun to close in on potential output after a lengthy recovery from the 2008 recession. Though the relatively consistent intervals of time separating downturns seem to denote an approaching recession, past trends of the output gap exhibit an economy continuing to expand. A second way to assess the future state of the US economy is to examine the FRED leading index (Figure 8) This index amasses information from leading indicators of the economy and provides insight as to where the economy could be headed. The index shows a slightly negative trend originating around 2014, and compared to previous patterns, this is somewhat distressing. Although there are more volatile portions of the index where it has briefly dropped significantly and recovered quickly, previous steadily negative tendencies, similar to that beginning in 2014, have led into recessions.

Figure 8:

 Although there are seemingly conflicting representations of the future, other than the associations of trends in the leading index, unemployment rate, and new home sales with downturns, there is not much evidence for an oncoming recession. The outlook of the majority of indicators is promising, making it apparent that at the very least the US economy is currently strong. Despite the lack of cause for immediate panic, a recession will inevitably occur, and policymakers should use the current economic strength to prepare.

Policy:

Perhaps the greatest concerns for the future stability of the economy are the current political climate and statuses of the federal debt and deficit. The broadening disparity in political views in combination with an unpredictable president makes approving and applying policy difficult in the US today. For example, although President Trump’s engagement in trade disputes seeks to provide advantages to local producers, this carries potential to harm the US economy as higher prices may inhibit consumption. Also, the ongoing rise of the federal deficit and debt is unsettling. Responding to recessions with fiscal policies of government expenditure and tax cuts is a fundamental way to stimulate the economy, and to do this, deficit spending is regularly needed. The worrying trend is the continuing growth in the deficit despite the current economic expansion. Furthermore, the following monetary and fiscal policy recommendations are made keeping in mind the mounting political tension in the United States and its potential to limit some options for undertaking these issues.

Monetary Policy:

 The Fed should not be too heavily influenced by partisan politics and ought to be able to stabilize and prepare the economy for any potential recession without significant impediment. To do this, the Fed must continue to reduce the money supply and raise the currently low interest rate. Interest rates are a vital element of the economy due to their inverse relationship with investment, making them an important tool for the Fed to alter the economy. In recession, investment is low, so the Fed increases the money supply by buying bonds and lowers interest rates to encourage borrowing. This surge in borrowing ramps up output and eventually pulls the economy out of downturns. Following this logic, it was necessary for interest rates to be essentially zero for the US to recover from the 2008 recession, however it is now important to continue to raise them. One might ask how the Fed makes decisions regarding the rate or even what they would do if interest rates were too low when a recession hit. The Taylor Rule provides the Fed some guidance on the ideal interest rate; however, the Fed rarely sets the rate exactly where the Taylor Rule recommends but often follows the general direction indicated. An example of this arises from the most recent recession when the Taylor Rule prescribed a negative interest rate. While this was implemented by other countries and could theoretically work, the US deemed it unrealistic and kept interest rates near zero for quite some time. Bearing this in mind, it is unlikely that the Fed would decide to implement a negative interest rate if a recession hit in the near future and rates were too low to be dropped substantially. This makes continuing to gradually increase rates ideal. An increase in rates would begin to cool off the expanding economy and allow the Fed to drop them if, as the leading index suggests, a recession is coming.

 There may be some questions raised about the reasoning behind this policy based on Keynesian theory, classical theory, the Fischer equation, and the Phillips curve. According to Keynes, high interest rates could cause harm through decreased investment and consequently suppressed output. Classical theorists backing the idea that output is determined by capital and labor may also judge this policy to be impractical, believing that the outcome of an increase in interest rates will not alter long run output. Using the Fischer equation, higher nominal interest rates produce lower inflation, which is good for an economy with extreme inflation, but at the moment US inflation is at a reasonable level. Opponents may connect this fall in inflation to the Phillips curve, and suggest that lower inflation leads to unemployment. From these relationships, it is logical to question whether potentially impeding growth with such a policy is the correct decision. While there is theoretical backing to this opposition and some points may hold true in the long run, it is important to note that this is a short run policy action aimed to prepare the economy for future setbacks. Additionally, the main aspects of the economy to be negatively impacted are currently strong as inflation is hovering around 2.7%, unemployment is exceptionally low at 3.7%, and real GDP is approaching potential. So long as the Fed continues raise rates gradually, the economy will tolerate the downside associated with this policy. Ultimately, with some data indicating a nearing downturn, action is required to ensure the economy is not inhibited for an extended time if one were to occur.

Fiscal Policy:

 In order to recommend fiscal policy, it is essential to evaluate the state and trends of the federal debt and deficit. Since deficits occur when spending exceeds revenues brought in by taxes, the growing trend of the US federal deficit is worrisome for an economy in expansion, and therefore must be met with policy action. The federal deficit grows during times of recession, and justly so, as the government attempts to stimulate the economy through tax cuts and government expenditure. While it is not necessarily a bad thing for an economy to operate in a deficit, an increasing deficit during times of expansion could indicate unnecessary economic stimulus or increasing costs of government programs.

Furthermore, the size of US debt has grown since around 1970 and is currently over $20 trillion. While the existence of federal debt is not too troublesome, excessive debt accumulation could be detrimental. A large federal debt could limit the government’s ability to borrow as it may been seen as a risky investment and carry a lofty interest rate. Consulting debt as a percentage of GDP provides some reassurance since US debt has started to level off around 105% of GDP, meaning that it would take 105% of one year’s GDP to pay off. While this may appear alarming, it is not cause for immediate concern due to the United States continuing ability to borrow when necessary.

The appropriate fiscal policy to reduce the federal deficit and therefore debt, is to raise taxes and/or cut government spending. From an efficiency standpoint, cutting government spending is difficult due to the partisan nature of the government and the time required to decide and approve where cuts will be made. Although neither option will be popular or particular speedy, raising taxes provides a somewhat quicker means of implementation and thus has a swifter impact on the economy. For this reason, raising taxes by a moderate margin while the economy is booming would generate the requisite revenue to chip away at the deficit. Additionally, the greater revenue received diminishes further debt accumulation by decreasing the amount of borrowing required for the government to distribute benefits both now and when a recession occurs.

Surprisingly, President Trump recently stimulated the already growing US economy through a tax cut, which unless it is rapidly successful, will likely decrease government revenue and increase the deficit in the near future. Although the recommended increase in taxes may reduce consumption and therefore output according to the Keynesian cross, recent research regarding fiscal multipliers advises that now is the best time to do so. While they can be problematic to measure precisely, these fiscal multipliers essentially assess the extent to which changes in taxes and government spending affect the performance of the economy. This research explored the level of fiscal multipliers on economies of various statuses and found multipliers to be smaller during expansions and in high debt countries (Batini et al, 2014). Having established that the US is both growing and in high debt through the earlier examination of the economy, it is likely that fiscal multipliers are small. Taking these findings into account, the current state of the economy denotes an optimal time to implement a tax raise.

There will undoubtedly be objections to this recommendation, some based on economic theory and others simply objecting to paying higher taxes. Classical economists will not likely be too opposed to this since, in their view, tax hikes and reduced spending lead to greater savings and investment, which is highly valued in the long run. In the Solow model long run, low investment leads to both a lower steady-state level of capital and output, so increasing investment should be seen as beneficial. Those who hold a Ricardian view of debt should also have little opposition to this policy. The Ricardian equivalence suggests that consumers are rational, anticipate higher taxes following a tax cut, and thus do not alter their consumption. If this is to be believed and consumers are in fact prepared, then consumption should theoretically be unchanged. The greatest source of opposition to this policy would arise from the Keynesian perspective, which suggests that an increase in taxes will decrease output therefore harming the economy. This policy, however, should not be overly detrimental to the presently growing economy. Seeing as preparedness is a great remedy for managing a coming recession, these steps would see the deficit and debt reduced, while allowing the automatic stabilizing forces of tax cuts and government spending to be applied when needed with less government borrowing.

While the emphasis of this fiscal policy recommendation has been on a tax increase, cutting government spending is by no means a poor means of reducing the deficit and debt. The primary concern with this type of policy is the time and debate required for officials to agree upon certain government expenditures to cut. For now, the United States government should stick to the prescribed policy of increasing taxes, but to provide options for future deficit reduction, officials should begin to serious discussion of cutting costs associated with programs like social security and the Affordable Care Act. While this is sure to cause an uproar and be difficult to achieve given the divide in the US political system, this type of reduction in spending will eventually be necessary for the long-term success of the economy.

Conclusion:

 The assessment of the current state of the United States presented a healthy and expanding economy. While this is promising, there were a few concerning trends regarding its future direction. As a result of the indicators evaluated, it is recommended that the Fed continue to increase interest rates as they have been. This will allow them the ability to drop rates whenever it becomes necessary to stimulate the economy back into growth. Furthermore, the United States government must begin to make strides in increasing revenue through both increased taxes and government spending cuts. While neither of these actions will please the public, it is in the nation’s best interest for them to be taken. Higher taxes will allow for somewhat quicker increases in government revenue, however it is vital that costly government programs begin to be assessed for their value and viability for generations to come. Cutting programs that will be unsustainable in the future or fail to provide significant benefits will reduce the inherited deficit and debt. While the monetary policy proposed focuses on short term economic sustainability and preparation for the next recession, the fiscal measures suggested will help to provide future economic advancement if taken seriously. Though they may have some prompt negative impacts, these recommendations will help policymakers be prepared to act in the future, which should always be one of their main objectives.

Works Cited:

  • United States – Economic Indicators | 1998-2018 | Data | Chart | Calendar, TRADING ECONOMICS, tradingeconomics.com/united-states/indicators.
  • Batini, Nicoletta, et al. A Simple Method to Compute Fiscal Multipliers. www.imf.org/en/Publications/WP/Issues/2016/12/31/A-Simple-Method-to-Compute-Fiscal-Multipliers-41627.
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