These are tough and challenging economic times. It seems that the bulk of current commentary on the economy runs from poor to catastrophic. As scenario planners, we are interested in exploring what a positive economic scenario might look like as well. For this, we asked FSG economist Robert Avila what could go right. The following exchange was edited for length and clarity.
FSG: Robert, The Economist recently wrote that they expected the US’s next recession to be “milder and more pedestrian” than either the Great Recession of 2007-09 or the pandemic downtown of 2020. But they also said that with asset markets and America’s politics still fragile, it could all turn out “nasty” with unpredictable consequences. What would be the case for a mild, brief recession — or maybe even none at all?
Robert: Let me start by saying that recessions usually are characterized by a decline in production and thus employment because for some reason no one is able or willing to buy stuff. With the so-called Covid recession, no one could get to the stores or were willing or able to hang out at bars, resorts, etc. In the Great Recession there were too many houses that no one wanted. And before that too many dot-com start-ups. You also get problems when critical stuff is suddenly not available AND there is no immediate market solution: the late 70’s oil embargo or Paul Volcker’s recession in the early 80’s when Fed money stopped flowing. That one was a controlled replay of what happened in the early 1930’s when the banking system was allowed to collapse.
So, what’s your point here?
My point is none of that is really happening right now. Demand is high, business is scrambling to expand production to meet demand, employment is high, there are no unwanted excesses. More importantly there are no constraints on supply that the market cannot respond to. Yes, Russian oil is being kept off the market, and yes pump prices are high and yes poor people are hurting, but market solutions exist that did not exist 50 years ago: telecommuting, solar power, wind power, electric vehicles, cities are swarming with home delivery on electric scooters, etc. Also, consumers still appear to have deep pockets, and there seems to be a lot of pent-up demand for vacations, travel, weddings, parties and all that service and hospitality stuff that suffered so badly during the height of the pandemic.
But is the business sector feeling the love?
On the business spending side there is a great willingness to invest since there are so many opportunities to make money. It’s obvious what the market is willing to pay more for and we know how to provide it. Businesses just have to hustle to get it to market. The big problem is that so much has to be changed at the same time to respond to the changed environment. But recessions have rarely happened when there were too many opportunities to make money.
You knew this was going to come up sooner or later. What about inflation? What’s the soft-landing scenario for prices? How do we get to a positive economic scenario from here?
The old, pre-globalization macro model in the back of everyone’s head was that expansionary policies increased demand which increased employment and production up until unemployment fell to some floor level and then labor supply constraints would increasingly push up prices with little increase in employment or production. With globalization, expansionary polices led to an increase in employment and production globally and there were no significant labor supply constraints. Sure, there were non-trivial financial constraints having to do with trade balances, exchange rates and real interest rates, but they were not big problems for the US, given the dominant roles of the dollar and US financial services in global trade.
So, the inflation question is really a question of what is the outlook for the globalization model going forward?
Yes, but. It should be obvious that business concepts like just-in-time and sole source have taken some serious hits while inventory carrying costs and close to end-market production have acquired attractive attributes. Less obvious may be the idea of more sophisticated supply chain management systems with greatly strengthened risk-abatement components. The point is: The advantages of globalization are not going away but the risks and the control of those risks will add costs. And figuring out how to get from our current mess to a working supply chain risk-management system will also have costs.
So what will the near term transitional period look like?
The most debilitating shortages will be dealt with first: New US based chip foundries are already under construction; sales of electric cars and trucks along with home solar panels are being seen by consumers as possibly viable alternatives to wildly fluctuating oil prices. Specific US labor market shortages have long been dealt with through another aspect of globalization, immigration: Indian physicians, East Asian and Russian programmers, Latin American service workers, and so forth. Politics might constrain immigration but there are no economic reasons to constrain it in the future. However, to the extent that some mixture of Covid and politics might severely limit immigration, the resulting labor shortages and wage increases would only accelerate the move toward capital investment in smart technologies to replace people. This was a big concern even before Covid.
We’re in a transition period, and transition periods are always messy and confusing with plenty of great ideas that fail and who’d-a-thunk-it ones that succeed. Typically less than expected happens in two years’ time and much more than anticipated happens in five years. The real challenge is not in what market economics can do to respond to a significantly changed business environment, but rather how rapidly and frequently can nature and politics change and disrupt that business environment.
Final question: You started off this conversation saying that consumer sentiment is still relatively bullish. Stocks and bonds appear to be tanking again this week, under the weight of bad inflation and interest rate news. At what point does all this derail consumer sentiment and send us down the recession path?
There is always a certain degree of tension between consumer sentiment and consumer actions, between what people say and what they do. The University of Michigan Survey of Consumer Sentiment has hit a record low and the stock market is in bear market territory. The question is will confident consumer spending plunge as well?
By “confident consumer spending” I mean the sorts of things people have no trouble spending money on when they are feeling flush about their lives: jewelry, perfume, restaurant meals, recreational vehicles, fishing boats, jet skis, air travel. In short, extravagant things one doesn’t absolutely need but it would be fun to indulge in. For the couple of years before Covid, both the Index of Consumer Sentiment and data on nonessential consumer spending had been virtually flat. In real terms this type of spending was growing maybe 0.5 percent a year. In 2020 when the Covid shutdown hit, this type of spending in total dropped 60 percent and was still down 25 percent in June 2020. Over the same period the Consumer Sentiment Index dropped by a similar magnitude. But – and get this — since June 2020 this type of spending has been growing at a steady annual rate of about 25 percent. It had fully recovered by April 2021, a year after the shutdown, and has continued to grow at this historically high rate through April 2022. And yet, over this same period of exuberant consumer spending on things one doesn’t absolutely need, the Index of Consumer Sentiment has been falling to an all-time low.
Maybe record inflation, a bear market, and rotten sentiment will dampen this consumer spending binge. But maybe record low unemployment and rising wages will keep the party going. It has been noted that much of the stimulus money and much of the rise in wages have mainly benefited younger and less affluent US consumers, who may care little about the stock market or interest rates and may be under-represented in the Consumer Sentiment Index. My point is that if confident consumer spending continues to grow, a recession is unlikely.