Should Trade Escalations Have Us Worrying about a Recession?

Recession

People have been worrying about a recession for some time now, and they are really starting to worry now that the trade war is heating up. Is this a reason for concern?

Recessions involve a period of 6 months or more of negative growth, and are indicative of a contracting economy, the opposite of our goal to expand it. It’s not even that we need real growth to fend this off, meaning that we are more productive in the current period than in previous ones, as in this calculation, we’re just looking for nominal growth, where the economy actually does not shrink.

Imagine us getting a little raise each year, which may or may not keep up with inflation, but we at least get this raise. When our pay gets cut, this is something no one wants and it at least appears that our buying power has been reduced, although it may or may not depending on inflation.

If we make 1% less money next year and inflation is at –1%, we’ve actually ended up in the same place, as we’re making 99% of what we used to make and things cost 99% of what they used to.

When we get our raises, how these raises stack up with inflation also matters, and if we get a 1% raise and inflation is 2%, we’ve fell behind by 1% and this is not something we should be celebrating, even though some people do.

Often times though, this disparity will be pretty obvious to just about everyone, and people will do plenty of complaining about this and even go on strike to get increases that don’t leave them worse off on a net basis.

In the world of economics, we tend to have almost an infatuation with nominal statistics, like economic growth independent of inflation, and for whatever reason this view is a pretty persistent and pervasive one. When even the Federal Reserve, the central bank of the United States, puts such a focus on nominal statistics, you know that this runs pretty deep indeed.

It’s not that the Fed doesn’t pay attention to inflation as well, and they pay more attention to inflation than anything else, but whenever we look at these two statistics separately, we risk not appreciating what really matters, which is the net effect of their relationship.

Inflation does have to be managed separately due to its impact upon wealth. We can see both a 10% increase in economic growth and a 10% inflation rate, and this might seem like a wash, but when you consider that wealth has been devalued by 10% as well, we have fallen behind overall by quite a bit.

Deflation tends to scare people even more than inflation does, but deflation actually increases wealth, so on this measure it’s better to have deflation than too much inflation. The upshot of all this is that if we could somehow manage to set inflation at zero and growth at or above zero, that would be the ideal economically.

Since we tend to be so preoccupied with growth and inflation and do so separately, we can both be lulled into a false notion of progress when inflation exceeds growth, and also not fully appreciate how devalued wealth becomes when inflation runs higher.

Our Management of the Money Supply Is the Real Key to our Success

Over the last decade, we’ve managed to keep closer tabs on inflation, and while our growth rates are on the lower side as well, this is a very nice situation indeed as it allows for us to keep us from losing ground as far as real economic growth goes as well as keeping wealth depreciation within acceptable parameters.

Seeing inflation drop to 1.5% should therefore not be much of a concern in itself and this should actually be desirable over higher rates such as 2% or 2.5%. It’s not that dropping inflation is a problem and this is in itself a good thing, it is what may be behind declining inflation that is the worry.

What we don’t want here is things dropping because the money supply has declined too much, and money supply is the guiding force behind all of this. When the money supply increases, this sends both growth and inflation higher, and when it decreases, it does the opposite.

We might therefore think that a higher money supply is a good thing as it expands the economy and a lower money supply is bad because it contracts it, but we actually want this to be neither too high nor too low as both have negative consequences. Too low and we limit growth too much, and too high is too inflationary and will reduce wealth too much.

When people talk about the risks and consequences of a recession, what they are really worried about is the money supply shrinking too much. This is what happened during the crisis of 2008-09, as all those defaults and the tighter credit market greatly reduced our money supply and this means less money is made, less is spent, less people have a job as a result, and other undesirable economic consequences.

If we’re worried about an economic environment that we will find undesirable, it’s important that we at least realize what it is that we’re looking to avoid, because otherwise we may not even be paying attention to the right things.

Fortunately, the Fed does pay attention to money supply a lot, and managing money supply isn’t just the most important thing they do, it’s the only thing. Since money supply makes the economic world go around, they don’t really need to worry about anything else.

When they cut or raise interest rates, the goal of this is to increase or decrease the money supply. They will also buy or sell treasuries to accomplish the same thing, which is similar to their printing more money to increase money supply or taking some off of the table to decrease it.

Stock markets love expansionary measures by the Fed such as interest rate cuts, increasing their balance sheet by way of open market operations, and relaxing reserve requirements. All of the operations of the Fed seek to control the amount of credit in the marketplace, and all of their expansionary tactics increase it while their tightening tactics decrease it.

It is this credit that is the engine that drives both economic growth levels and inflation rates, so it is a healthy credit market that is the ultimate goal of this, not too much or too little of it but a desirable balance.

Credit markets are determined by two main factors, the amount of money that is loaned, and the rate of repayment. Low default rates are ideal, and we know what high default rates do if we were around during the crisis of a decade ago.

Even though this period came to be known as the Great Recession, it wasn’t the recession that got us in trouble, it was the massive defaults and the massive drop in the credit market that resulted from all that money not being paid back. If we did not bail out the financial industry like we ended up doing, essentially giving them hundreds of billions of dollars to lend, we would have indeed been thrown into a real depression, due to the credit market and money supply being even more decimated.

Worries Tend to Grow Larger in the Dark

When we worry about a recession around the corner, we need to look at what the risk of this sort of thing happening instead, because it is the money supply decreasing that delivers the punch and is what needs to be feared.

The good news is that we are not seeing anything that we really need to worry about here right now, in spite of economic growth around 2%.

This is even the case with all those tariffs out there, even though tariffs do contract money supply. They do so because they are a form of taxation, and lowering taxes stimulates the economy and increasing them constricts it.

This is of a scale that can be managed by monetary policy though, and it’s no coincidence that these tariffs were cited as a determining factor behind our getting our first rate cut in 11 years from the Fed. Their ending their reducing their balance sheet immediately also serves this goal.

What the Fed cannot manage very well though is widespread default. People look back upon economic crises and see the Fed not managing these properly and think that their tools aren’t that effective, but they are plenty effective in normal circumstances and just can’t deal with situations involving the credit market shrinking through too much default.

Our default rates are very low right now, and there are no significant events on the horizon to change this very much, like the housing bubble and all that collateralized debt that caused the cascade of events that led to that particular crisis.

In our situation, tariffs tax money out of the economy and monetary policy can replace this quite well. If the economy was really struggling, these tariffs would have more of a detrimental effect, as it would make things harder to manage, but our economy is a healthy one at its base and therefore can take the hit that these taxes place upon us with a little help from the Fed.

The effect of these tariffs on GDP is actually quite small, with these new ones estimated to have an effect of only 0.14%. That’s a long way from taking us where we are now at our 2% growth rates and sending us into the negative, as the impact of this is far too negligible to even be able to have this conversation.

It will take a lot more than this to bring GDP growth underwater, and this is not even including a response from the Fed, which we have already seen. More can be done if needed, to keep us well away from negative growth even if that’s all we’re looking at.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.