The U.S. economy goes through cycles of boom and bust. For example, from April 1991 to February 2001 the U.S. had a booming economy driven largely by investments in the internet. In March 2001 the economy went bust and we had the 2001 recession. From 2002 to 2007 the economy boomed due to derivatives and the housing bubble then crashed leading to the 2008 bust and the great recession. In 2009, the economy began responding to quantitative easing and the American Recovery and Reinvestment Act. It has been in a boom cycle since then, the longest boom cycle ever. We don’t know yet but the current correction in the stock market may be a sign that the economy is once again going from boom to bust. No one should be surprised. It is the nature of the economy to go boom, bust, boom, bust, etc. If we don’t have a bust this year, one will come in the next few years. That is certain.
When the economy goes bust, unemployment increases, the stock market tubes, and businesses stop expanding. The U.S. government has three options to try to get the economy going again. The Fed can cut interest rates to make it cheaper for companies and individuals to borrow and spend, thereby increasing demand. The U.S. government can create demand directly by increasing spending on things like roads and bridges and other infrastructure improvements. Congress can cut taxes in the hope that consumers will spend the retained dollars, thereby creating demand. Tax cuts are most effective when they are targeted. For example, when lower-income people receive tax cuts, they are more likely than rich people to increase their spending.
Two things affect the ability of the Fed to cut rates and Congress to increased spending and/or cut taxes. The U.S. Government deficit and the Fed Funds Rate. During a Bust, government revenues decline, and the deficit grows. Tax cuts result in even less revenues. The only way the government can increase spending is by borrowing money, thereby increasing the deficit. The Fed’s ability to cut the funds rate depends upon how high the funds' rate is when the bust begins. Obviously, the Fed has more leverage if the funds' rate at the beginning of the bust cycle is 5% than if it is at 1% since the Fed cannot cut the rate to less than 0%.
During a Boom such as we have been experiencing since 2009, the smart thing to do is let the Fed Funds Rate slowly rise. You lower it until the economy is gets going and then gradually raise the rate but not so fast that you slow the recovery. Second, you avoid tax cuts and gradually raise taxes in order to pay down the deficit. Again, you do this gradually to avoid slowing the recovery. The objective is to get the Funds Rate back up, so the Fed has room to cut the rate during the next Bust and pay down the deficit so that there is room to engage in deficit spending or to adopt targeted tax cuts to create demand in a downturn.
Since 2016, the Trump Republicans have done just the opposite of what they should have been doing.
In 2008 at the beginning of the Great Recession, the Fed Funds rate was at 3.5%. The Fed cut the rate all the way down to 0.25% before letting it gradually rise to 1.75%. That’s much lower than you would want at the beginning of a Bust or deep recession since this time around the Fed will have less leverage in rate cuts. We are fortunate that the current Fed Rate is not lower. Trump and Republicans have been pressuring the Fed to cut the rate. If they had their way, the Fed Rate would now probably be under 1%, a disastrously low level at the beginning of a Bust.
The Deficit as a % of GDP was at 3.1% in 2008, went up during the recession and was back down to 3.1% in 2016 and trending down. Trump Republicans pushed through an unnecessary tax cut coupled with a massive increase in military spending. As a result, the deficit as a % of GDP shot up to 5.1% in 2019, just what we would not want to happen. The Debt to GDP Ratio, another measure of the deficit, was at 67.7 in 2008, a sustainable level. The ratio increased to over 100 during the recession and recovery and was just beginning to decline when Trump took office. Under Trump, the debt to GDP ratio has resumed its upper path and is now at 105.5 and climbing. Most economists say a debt to GDP ratio around 60 is probably okay and but over 100 is not sustainable for more than a few years. The World Bank says a debt to GDP ratio over 70 slows economic growth. So, there is disagreement about when to worry. There is no disagreement that a lower number is better than a higher one. The highest in the U.S. was 120 at the end of World War II.
In summary, the U.S. Government needs the ability to step in to revive the U.S. economy when a downturn occurs, which always happens. If the Fed Rate is relatively high and the U.S. Debt is low, then the Fed has a lot of room to cut the Fed interest rate to stimulate spending and increase demand. Congress has a lot of room to increase government spending and to cut taxes to pump money into the economy without worrying about creating an unsustainable debt such as a debt to GDP ratio well over 100.
Instead of facing a possible economic downturn with a high Fed Rate and low debt, we currently have a relatively low Fed Rate and high and increasing debt to GDP ratio, just the opposite of what we would want.
Trump Republicans are to blame for putting us in this difficult situation. They cut taxes at the wrong time. They failed to target the tax cuts, so they had little positive effect on the economy. They dramatically increased military spending at a time when the stated goal of the Trump administration was to withdraw from conflicts and bring the troops home. That policy should have called for less, not more, military spending. Finally, Trump has consistently pressured the Fed to cut the Fed Rate at a time when the rate should have been gradually increased. We don’t know if the Fed would have raised the Fed Rate faster without the pressure from Trump, but Trump’s pressure probably did have an impact.
It took the United States nearly 10 years to fully recover from the 2008 Recession, in spite of drastic cuts in the Fed Rate (down to almost 0%) and deficit spending that while massive was much less than required given the severity of the recession. In fact, most economists would agree that the recovery could have been shortened with a larger stimulus.
Thanks to Trump, the next time we have a downturn, the FED will have less room to cut interest rates than it did during the 2008 recession. Congress will find it difficult, and perhaps impossible, to pass a stimulus the size of the stimulus it passed to combat the 2008 Recession because of the huge Trump deficit.
It took 10 years for the U.S. economy to recover from the last major downturn. Thanks to Trump’s economic policies we may face an even longer recovery the next time our economy goes bust. The chance of the U.S. economy going bust someday, maybe someday soon, is 100%. It is going to happen.