How Congress can help fight the next recession
There will be another recession. Exactly when it will happen is difficult to say. It could develop within the next year, or not until years from now. But a recession at some point in the future is inevitable.
The bigger question isn't about when it happens, but whether policymakers be able to limit its damage.
That depends on several things. And one of them does regard when it happens.
If the recession comes sooner rather than later, it's likely that interest rates will still be low, which will limit the Federal Reserve's ability to cut rates and stimulate the economy. The Fed can still use unconventional policy measures such as quantitative easing to give the economy a boost, but unconventional policy isn't as powerful as slicing interest rates, and such policies' impact wouldn't be large enough to overcome a moderate or severe downturn.
If the downturn comes further into the future and the Fed has raised interest rates in the interim, it will then be able to lower them again and offset a moderate downturn. But if that downturn is severe and prolonged, as in the Great Recession, the Fed won't have the power to turn the economy around on its own.
In that case, fiscal policy -- changes in government spending and taxes -- will be needed. Unlike monetary policy, fiscal policy becomes even more powerful in deep recessions, so it's an effective tool when monetary policy loses its impact.
Unfortunately, while the Great Recession demonstrated the need for fiscal policy in deep downturns, it also made clear that the country can't rely on Congress to implement the appropriate countercyclical policy response. Although fiscal policymakers did pass a stimulus package at the beginning of the recession, it wasn't big enough or sustained enough to provide the help the economy really needed.
In fact, instead of bolstering its efforts with additional fiscal policy measures as the recession deepened and dragged on, Congress did exactly the opposite: It worked against the recovery by turning to austerity measures that cut rather than increased government spending. We would be much better off today if Congress had been able to set politics aside and do what's best for the economy.
The failure of fiscal policy has another cost that's often overlooked. It shackles the Fed's ability to fight the next recession, especially if it comes sooner rather than later.
Currently, the Fed is struggling with when to raise interest rates for a second time in this "normalization" cycle. Some indications show it may increase its target interest rate in June, but it's not clear that the economy has recovered sufficiently to support another rate increase yet. And even if the Fed does move to raise rates, the increase will be relatively small, and further hikes may not come for quite awhile.
However, if the economy were stronger, as it would be if Congress had used the fiscal policy measures at its disposal, the Fed could increase rates sooner and faster without endangering the economy. And the faster the Fed can raise rates, the better equipped it will be when the next recession hits.
Although Congress failed to do what was needed during the last recession, it's not too late to help the economy and, at the same time, make it easier for the Fed to battle the next one. Recession or not, the case now for a particular type of fiscal policy -- infrastructure spending -- is overwhelming. As the following graph from a recent talk by Larry Summers at the Brookings Institution shows, total government investment in the economy has fallen considerably in recent years, and federal investment is negative.
Renewing America's commitment to improving its infrastructure -- which has provided proven economic benefits in the past -- would help to create jobs, increase GDP growth above its currently stubborn low rate and help ensure against the possibility that low growth will continue. In addition, with interest rates as low as they are now, the cost of borrowing the money needed to make infrastructure investments is extraordinarily low, and the longer we wait to make the necessary investment the more costly it will be.
During the period from 1982-2007, known as the Great Moderation, fluctuations in output and employment were relatively mild, and the Fed was able to stabilize the economy without the need for assistance from fiscal policymakers. The country became used to relying on the Fed, and fiscal policy was all but forgotten.
But in a severe recession, fiscal policy must be part of the response, and Americans ought to be able to expect economic needs to trump political gamesmanship. In any case, we should certainly expect Congress to meet the country's infrastructure needs, especially when it helps fight a current or future recession.