Why The Next Us Downturn Could Be A Shocker

By Roger Montgomery, Montgomery Investment Management

Is the next US downturn years away, or just around the corner? Either way, leading US economist, Professor Jeffrey Frankel, says it will be severe. And the reason, he says, is the Trump administration's relentless pursuit of fiscal expansion and financial deregulation.

Right now, adopting a sanguine attitude to the US market is probably not unreasonable. The US economy grew at an annualised rate of 4.1 per cent in the second quarter of 2018 and one more year of growth will see the US economy match the decade-long record expansion phase of the 1990s. Unemployment remains low, as does inflation thanks to advances in technology and the online/e-commerce revolution.

Meanwhile, investors are showing their gratitude, paying up for stocks in the companies responsible for delivering employment growth and low inflation.

But booms never last, and while Australia's more than two-and-a-half decade run without a recession is noteworthy, no country is immune from a downturn.

With that in mind, several notable commentators have asked whether the next recession the US experiences will be severe.

One of those is Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government. He previously served as a member of President Bill Clinton's Council of Economic Advisers and he is a research associate at the US National Bureau of Economic Research, where he is the official US arbiter of recession and recovery.

Frankel is arguably the most qualified person to comment on what to expect from the next US downturn, which admittedly could be many years away or just around the corner.

Regardless, Frankel believes that the consequences of the next US recession are likely to be severe.

Putting aside any comment about what the trigger for a recession might be, Frankel believes that a government committed to pro-cyclical fiscal, macro-prudential, and even monetary policies, places "the authorities…in a weak position to manage the next inevitable shock".

Frankel makes the following observations:

  • Budget deficit expanding to an estimated US$1 trillion during economic expansion.
  • Financial deregulation now underway is pro-cyclical and intensifies market swings.
  • Monetary policy in the past saw the Fed manage recessions by cutting short-term interest rates by between 400 and 500 basis points. Not possible next time around with rates at only two per cent.

In each case, when a recession comes, the US will not have the capacity to respond, such as by cutting rates sufficiently or by expanding government spending and the budget deficit further.

Fiscal Policy

In the past, economic expansion phases have been accompanied by a reduction in government budget deficits at least as a share of GDP. This time around however, the US, under Trump is experimenting with what Frankel describes as the most radically pro-cyclical fiscal expansion since the late 1960s, and perhaps since World War II.

The December 2017 reduction in the corporate tax rate was welcome but Frankel points out it should have been revenue-neutral. And while the Trump administration claims to favour small government, he notes it is actually "highly profligate".

Unsurprisingly, as Frankel notes, when the next recession comes, the US will lack fiscal capacity to spend to rescue the economy.

Financial Deregulation

Trump's preference for financial deregulation is also pro-cyclical and intensifies market swings.

According to Frankel the following changes will exacerbate market booms and busts:

  • Gutting Obama's fiduciary rule, which would have required professional financial advisers to put their clients' interests first when advising them on assets invested through retirement plans.
  • Rolling back "sensible regulation" of housing finance, including risk-retention rules, which force mortgage originators to keep some "skin in the game," and requirements that borrowers make substantial down payments, which work to ensure ability to pay.
  • Gutting the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which strengthened the financial system by imposing higher capital requirements on banks, identifying "systemically important financial institutions," and requiring more transparency in derivatives.
  • Curtailing The Consumer Financial Protection Bureau - established by Dodd-Frank to protect borrowers with payday, student, and car loans.

Frankel points out that now is the right point in the cycle to raise banks' capital requirements as called for under Dodd-Frank. The cushion would minimize the risk of a future banking crisis. He notes that while Europe has applied counter-cyclical capital buffers to their banks and some Asian countries raise banks' reserve requirements and homeowners' loan-to-value ceilings during booms, and lower them during financial downturns, the US, under Trump, is migrating away from these GFC learnings.

Monetary Policy

Frankel compliments the US Federal Reserve, noting it has been doing a good job; but he observes that if attacks on its independence by Republican politicians are successful - a big assumption - counter-cyclical monetary policy would be impaired.

Keep in mind Trump could lose some of his power base at the mid-term elections in November.

Recently, for Project Syndicate, American economist and George F. Baker Professor of Economics at Harvard University, Martin Feldstein pointed out, the Fed should be "raising the rate when the economy is strong," thereby giving "the Fed room to respond in the next economic downturn with a significant reduction."

Today, Trump advocates a pro-cyclical monetary policy stance when he states he's "not thrilled" about the Fed raising interest rates. This is despite the fact that unemployment is below 4 percent. Trump supporters and market bulls, however, credit the online retail revolution and even Amazon itself for keeping US inflation in check.

In concluding his thoughts, Frankel reminds investors that the global financial crisis was the result of the US government pursuing fiscal expansion and financial deregulation between 2003 and 2007 and offers the following warning: "If the US continues on its current path, no one should be surprised if history repeats itself."

 

Roger Montgomery
Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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