What the Next Recession Will Look Like
Some optimists are touting the hypothesis that the weakness of the economic expansion since the last cyclical trough (June 2009) means that the next recession will be mild.
In fact, such a tendency has never been observed in the 140 years of US business cycle history examined famously by University of Chicago Professor Victor Zarnowitz. The only reliable rule which he found was that “the worse the downturn the stronger the subsequent upturn” — a rule that has famously broken down under the onslaught of the Great Monetary Experiment in the present cycle.
So how can we best decipher the future of this cycle including its peak and subsequent trough? In broad terms the best guide is King Solomon “there is nothing new under the sun” on the one hand and the Austrian school and behavioral finance theorists on the other. The latter warn in combination against pseudo-scientific hypothesis making and the perils of making judgment on the basis of those small sample sizes available from the laboratory of history.
Three Reasons We're Told not to Worry
To be fair, the optimists on the shallowness of the next recession are not citing a past historical episode to back their case. Rather they make three claims: (1), because investment spending has been so anemic, its scope to fall is correspondingly limited; (2), the likely tumble in asset prices will not this time cripple the US banking system which is now unusually resilient; and (3), the new tools which the central bankers have tried out during the experiment so far can now be sharpened and adapted to better combat the next recession when it hits. All these claims are unfortunately bogus and they fail to acknowledge a potential recessionary shock from the side of the consumer.
Weak Business Spending, Declining Consumption, Popping Bubbles
The weakness likely has much to do with the uncertainty generated by the monetary experiment. Business decision-makers and their shareholders in thinking about the future can see that the Fed (and central banks abroad) have generated a dangerous asset price inflation disease which will likely end up badly. This will include much evidence of mal-investment, a crash across many asset markets, and a big pull back in consumption as households realize the mistakes of their past credulity.
Given so much fear about the end-destination of the monetary experiment, the road to raising shareholder equity is often not via undertaking long-term investment projects. Rather, companies are paying out cash to shareholders and leveraging up to do so. This tendency to eschew long-run commitments is also attributable to awareness that present equity values contain much froth which may well have vanished by the time the business owners (including executives with share-options) would hope to cash out.
Yes, the areas of mal-investment during the economic expansion do emit boom-like signals. The speculative stories and the high leverage found there are characteristics of the Hunt for Yield as induced by the income famine conditions prevalent under the Great Monetary Experiment. The eventual plunge of investment in these areas can be large overall in macro-terms even though overall business capital spending across the economy as a whole is sub-normal. We have seen that already for the energy boom and bust in the US. The same may be true further ahead for all the suspect areas of mal-investment, whether commercial real estate construction, Silicon Valley, apartment construction, and any activity related to the biggest bubble of all — private equity.
Why We Should be Skeptical of Claims that There is “No Potential US Banking Crisis”
The widespread collapse in speculative temperatures which would mark the late stage of asset price inflation disease would cause — in the US and globally — a huge loss across a wide range of financial institutions whose purpose is to provide income for retirement. The reckless reaching for yield as these institutions have pretended to meet their commitments under income famine conditions would come home to roost as high-yield debts and dividend-rich equities fell sharply in price and the liquidity of even the investment grade corporate bond market seized up.
The alarmed clients of these institutions would pull back their present spending in alarm that their rosy expectations regarding future income had blown apart. This may already be happening pre-emptively as indicated by the “surprise” weakening of US retail sales during July and August.
The dimensions of the overall seizing up of credit markets would be tremendous even though US banks may continue in relative safety at least in the early stages. Near-zero or negative interest rates has caused the normal credit alarm system to hibernate. Delinquency or non-performance occurs in silence with no evidence of non-payment. But alarm mal-function will not prevent the dud nature of bad credits to finally emerge or sudden fear of these to cause a shudder in market prices.
Italian government bonds, whose 10-year yield is now (mid-September) barely 1.30 and significantly below T-bond yields could be the canary in the mine. A sovereign debt crisis and banking crisis in Europe worse than that in 2010–12 is a mainstream scenario for the end-phase of this global asset price inflation disease. Indeed, Europe could be the tinderbox where a US stock market crash led initial recession shifts into full slump mode with feedback loops to the vaunted safety of US banks.
But Surely the Federal Reserve Would Pre-Emptively Exercise a Mega-Yellen Put?
The advocates of the Great Monetary Experiment would have us believe that the central bankers could put a floor under the next recession and at least provide the basis for a new weak but long economic expansion as the present one. The bad news for the experimenters (and their political chiefs) is that next time the Federal Reserve may not be able to lift asset prices by turning on the music of “nowhere else to go” and stimulating a “Hunt for Yield.” The experience of loss may have tamed the hunters and emptied the audiences, with no one believing the central bank narratives about the wonders of their tool box and the potential to fix long-term interest rates.
The good news for economic prosperity and freedom is that the failure of the grand experimenters next time to ignite asset price inflation early on in any incipient economic upturn might lead to their dismissal (if not effected earlier!).
Why let them continue to nurture the monetary virus which at some point will reach escape velocity and start to re-infect global markets, thus producing anemic economic outcomes? Would it not be better to install a sound monetary order? That is the main hope for curing the global curse of the Federal Reserve and its grand experiment. But its fruition depends crucially on the next US president reacting to the recession and its likely severity by firing the present Fed chief, choosing wisely her replacement, and joining with Congress to legislate a framework for monetary stability.
Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International.