The downside of avoiding a recession

Welcome back. Over the past few years, the global economy has been hit by a series of shocks, from wars and rising protectionism to huge spikes in interest rates. The fear of recession is rife everywhere.

But history provides perspective. Barring pandemics, there has been no synchronized global contraction since the 2008 financial crisis. In fact, recent decades are known for their long, uninterrupted expansion of economic growth.

In this edition, I explore why that flexibility may be less reassuring than it seems.

“Recessions have become rarer over time,” says Jim Reed, global head of macro research at Deutsche Bank. “The US has only seen four recessions since 1982. But there were nine recessions in the last 40 years, and 10 recessions in the 40 years before that. We’ve seen a similar pattern in Europe.”

Most simultaneous recessions since the 1970s have coincided with recessions in the US, given its strong global trade and financial ties.

Based on data from the National Bureau of Economic Research dating back to the 1850s, the U.S. economy was in recession for 58 months over the past five decades, compared with 143 months in recession during the same period before that.

The past five cycles of US economic expansion – including the current one, which began after COVID-19 lockdowns – have averaged more than eight years, close to triple the average length of prior cycles.

On the surface this is a good thing. Recession leads to unemployment, business closures, investment losses, social chaos and mental stress. But are there any downsides to long-term economic expansion?

Part of the answer lies in assessing why the recession has subsided.

The transition from weather-prone agriculture to manufacturing and then to services and innovative industries has made advanced economies more complex and less sensitive to volatile supply and demand cycles.

Another factor is globalization, which enabled the West to move into higher value-added sectors and move away from more cyclical material production. Efficient global supply chains reduced the risk of shortages and supported low prices, which meant central bankers did not have to tighten policy as frequently or rapidly.

The rise of China and India has also served as a motor for global growth.

Policy has also played a big role. In both advanced and emerging economies, policymakers have become more adept at smoothing the macroeconomic cycle and enhancing economic resilience.

“Since the 1960s, countercyclical fiscal policy has been used more actively. Before then, many governments adhered to balanced-budget orthodoxy, sometimes even in major recessions such as the Great Depression,” says Deutsche Ried. “Since 1971, fiat money has also provided authorities with greater flexibility to manage the business cycle.”

But it is not completely benign. Large fiscal deficits as a share of GDP were once a transitory feature in the rich world in periods of war – they now persist even in peacetime.

Higher government expenditure is linked to some inevitable growing demands of the state like demography, health and defence. But, as I examined in the August 17 edition, it also reflects democratic dynamics, including higher political will to provide economic aid and greater public expectations for it.

In particular, recent crisis response – from the pandemic and regional US bank collapse in 2023 to European energy price shocks – has normalized emergency fiscal and monetary support (such as quantitative easing and low rates).

It is no coincidence that the longest economic cycles and bull markets have occurred in recent decades, when deficits and bloated central bank balance sheets have been most persistent.

What is the result?

First, with debt-to-GDP ratios and borrowing costs already high in advanced economies, scope for further support is limited, says Deborah Lucas, a professor of finance at the Massachusetts Institute of Technology.

She says, “The risk is that future large shocks could be more disruptive and prolonged as governments are no longer able to tap debt markets cheaply to pursue aggressive countercyclical policy.”

As the debt burden increases, the risk of a fall in the bond markets also increases.

Next, there are threats to financial stability. A prolonged expansionary period favors risk-off, overconfidence and a build-up of debt in the markets.

A May 2024 paper John Cochrane and Amit Seru, senior fellows at the Hoover Institution, argue that expectations of central bank support if conditions worsen also drive up stock prices, fueling leverage and, in turn, increasing the risk of self-reinforcing monetary policy intervention and taxpayer-funded bailouts.

Animal husbandry incentives also shouldn’t be underestimated, Lucas says. “If financial managers exit the market early and prices continue to rise, clients will go elsewhere. But those who suffer big losses during a crash can at least say that everyone was wrong.”

At the moment, analysts are pointing to several signs of overreach. These include the rise of crypto treasury companies, circular funding among tech companies, meme stocks, and the growing role of debt in data center build-outs. There are also concerns about mispricing in less transparent private equity and debt markets.

Most prominently, the AI ​​mania has led to inflated equity market pricing and high concentration.

“It seems to me like what happened before the 2007-8 crisis: a lot of knowledgeable people are quietly talking about overvaluation, while still maintaining large exposures and privately praying for a soft landing,” says MIT’s Lucas.

Ultimately, the longer markets rise, the further they may eventually fall, and the bigger any consequences could be. Deutsche research shows that when the S&P 500 has sold off by more than 10 percent, it has coincided with a recession.

Another potential threat is that of creative destruction and productivity.

Long-term growth and economic support can keep capital and workers locked in less productive parts of the economy. In this way, the recession could be “purified,” says Ufuk Aksigit, an economics professor at the University of Chicago.

“This works best when credit continues to flow to high-potential firms, and bankruptcies and restructurings of less productive firms occur rapidly,” he says. “It also helps if policy helps workers move through retraining and job searching rather than blocking specific firms.”

In practice this does not happen during all recessions, and some, such as the GFC, may hinder redistribution, notes Axiom.

The growing prevalence of zombie firms and concerns over zombie PE funds underline fears about misallocated resources.

In turn, as I noted in the June 15 edition of this newspaper, measures of business dynamism in advanced economies, including rates of firm entry and exit and job reallocation, have weakened over the past few decades.

There are several drivers for this, including strategic consolidation by incumbents. But benign economic conditions and access to multiple credit lifelines, including private markets, also play a role in propping up weaker firms and slowing growth.

Recession is not a necessary condition for correcting these shortcomings. Fiscal discipline, market reforms and prudent supply-side policy can help.

Nor is the recession over. Emerging financial risks and rising government borrowing could still sow the seeds of the next crisis.

But just as recessions do not guarantee “cleanliness”, long expansions are not always a sign of dynamism. Recession is sad. Avoiding them is also costly.

food for thought

How has the age of online dating affected marriage and divorce rates? this study Analyzes.

Free Lunch on Sunday Edited by Harvey Nripia