For the past two weeks we have been looking at economic cycles and typical policy responses. But the characteristics of cycles have evolved over time, as have the responses to countercyclical intervention. This suggests a good news-bad news scenario: lower economic volatility, but reduced impact of government responses.
The good news: business cycles have been lengthening and the frequency of recession has declined.
From 1870 to 1910, the U.S. economy was in recession 50 percent of the time. Meanwhile, the intensity of the booms and busts was greater as well.
The Federal Reserve System was created in 1913 to stabilize the supply of money, the first significant effort at countercyclical policy. However, the economy still found itself in recession 25% of the time between 1910 and 1980, with an average annual rate of growth in Gross Domestic Product (GDP) of 4.3%.
Since 1980, recessions have been shorter and expansions less robust. The United States has been in recession only 8% of that time, but GDP has grown at just a 2.1% annual rate. The current expansion is now the longest in history as well as the shallowest.
What factors have influenced these changes? Getting off the gold standard for one. Until 1971, the U.S. and much of the world relied on gold to back their currencies. This dependence of the money supply on a physical commodity intensified swings and limited the effectiveness of monetary policy. During the "stagflation" of 1970 (stagnation and inflation together), President Nixon finally pulled the plug on gold in favor of fiat money backed by the full faith and credit of the U.S. government. This was a huge and necessary step.
Fiscal responses (changes in taxes and spending) expanded in the 1960s with certain permanent assistance programs like food stamps and unemployment insurance that placed a floor under incomes. Meanwhile, recessions kill jobs and dent tax revenues just as government spending accelerates to fund greater safety net outlays. These legislated permanent polices act as countercyclical "automatic stabilizers," providing stimulus during downturns.
Discretionary (temporary) fiscal policy has also expanded, with virtually every U.S. president and Congress taking some action to enact targeted deficit-financed fiscal stimulus in an effort to boost employment during downturns. The fact that the deficits never prove to be temporary is fodder for another day.
Monetary policy has advanced as well. Over the past 40 years, systemic structural inflation has been tamed and the Fed has maintained vigilance in reacting to any nascent inflationary signals and maintained stable prices.
The U.S. economy also has evolved over 50 years. Manufacturing now comprises less than half as much of the economy as it did in 1970, reducing our dependency on highly volatile commodities and shifting to less unstable services. The United States today consumes half as much energy and two thirds less steel per dollar of per capita GDP compared with 1970, essentially outsourcing much of our internal volatility to trading partners.
The bad news: there are few arrows left in the quiver. The Fed pushed the limits of monetary policy after 2008 and never fully normalized. And with a more global economy awash with cash and interest rates at historic lows, the central bank has few remaining weapons to fight the next battle.
And don't look to fiscal policy. Rather than saving for a rainy day, legislators have spent like drunken sailors throughout this expansion and have now racked up almost $23 trillion in debt, depleting the powder magazine.
Economic theory has actually been quite successful given the foregoing historical overview and the relative stability we enjoy today. But next time, there may be few tools left.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga