The “R-word” has been in the air ever since the Administration’s “Liberation Day” featured crushing tariffs on US imports. That was back in April, and the economy still seems to be motoring along (although with some signs that it’s running out of gas). Where is the recession?
The answer is in an article I wrote in 2019. My manager admired the title, “What to expect when you are expecting a recession.” Read it here.
Admittedly, in 2019 I neglected to mention that a global pandemic might cause a recession. So, not a perfect record. But there is one takeaway from the article that I think is valid today. That is this: Most recessions are caused by a problem in the financial sector. Either tight monetary policy or mispricing of risk, along with overly high leverage, leads to trouble.
It’s really hard to argue that monetary policy is that tight right now. While it’s reasonable to argue that the Fed should consider some reduction of the Funds rate, today’s interest rate is nothing like the punishing rates in the late 1970s and early 1980s that led to the long and steep 1982-84 recession. In fact, most measures of the “Taylor Rule” that suggest an appropriate stance for monetary policy suggest that current policy is not tight, and perhaps even a little too accomodative. (See here for calculations of the Taylor rule).
Mispricing of risk, however…there are a surprising number of potential trouble spots here. Just consider:
The big surge in AI investment, as I recently wrote, will very likely go too far. A lot of that capital will underpreform, and that will, in turn, limit profits and push down stock prices. A stock market decline itself won’t trigger a recession—but the welter of SPACs and private equity deals underlying all that AI investment won’t be unwound without some pain. And we have no idea how much this investment has been leveraged, which is the real danger. Opaque ownership and lax market supervision don’t bode well.
Tariffs themselves may not cause a recession, but we may see bankrupticies in surprising places as supply chains are broken by the new pricing structure. Just as with AI investment, today’s complex ownership systems and non-bank lending are almost designed to create the conditions for a significant financial “event”. So far, importing firms have managed to avoid experiencing the worst of the tariff hit. Or maybe they are hiding it. But don’t be fooled. The tariffs will hurt supply chains and there will be some surprising victims. Surprise never turns out well for financial markets.
Crypto remains a huge source of risk. Worse, lax regulation may allow crypto problems to propogate through the financial system. During the early 2020s, crypto prices were extremely volatile, but the sector was ring-fenced from the wider financial system by a combination of regulation and traditional players’ suspicion of the new systems. Both of those seem to have gone by the wayside. Don’t think that “stablecoins” will avoid the pain. Stablecoins are just banks by another name, and, like banks, will always be tempted to overleverage. Worse, if the wider financial system is too invested in crypto, the impact could be much wider than in earlier crypto crashes.
The US budget deficit (and the budget process) remain potential problems. In fact, this may be part of the reason global investors are souring on the dollar. At some point, the large US deficits—and the lack of any political will to do anything about them—will concern global investors enough to induce a race to get out of the US currency. That is a “sudden stop” ad would have drastic effects on the US economy. I’ve long thought that day was pretty far away—but maybe it’s closer than we think. Even a more benign version of foreign disinvestment could send US interest rates soaring and stock market valuations plummeting. Add in the existing leverage and lack of transparency in today’s markets, and the outlines of a potential financial crisis become clear. A possible trigger is closer than you might think: observers think another US government shut down is likely. That won’t look good to global investors.
In truth, that’s a long list of potential triggers. And, to help things along, the current Administration is unlikely to strike investors as competent enough to respond to a crisis in a reasonable way.
So: no recession in the economic data. The economy may be slowing, but growth continues. But the risks are greater than usual that something bad will happen. Right now, most financial market “participants” are in the usual shrug it off mode that precedes the crash. Afterwards, we’ll all say it was obvious.