Stage is Set for Next Recession*

The economy has been riding a crest as of lately. It should. Since the last recession began in 2008, between deficit spending by the federal government and monetary expansion by the Federal Reserve, over $10 trillion has been pumped into the economy.

But that’s come to an end. The Federal Reserve’s QE-whatever program has tapered to nearly nothing and ends in October. And perhaps more importantly, federal deficit spending has slowed to the point where it exactly matches the trade deficit. Check this chart of the growth in the national debt vs. the cumulative trade deficit:  Debt-Trade Deficit. The significance of this is that every time – every time – the growth in the national debt slows to the point where it begins to lag the trade deficit, the economy lapses into recession.

To understand why this happens, draw a line around the economy. Then add up the money flows that cross that line. Exports put money into the economy while imports take money out, meaning that a trade deficit is a net drain on the economy.  Taxes take money out of the economy while federal spending puts money back in.  So deficit spending (putting more money back into the economy than is taken out through taxes) has a stimulative effect on the economy while running a budget surplus is a net drain on the economy.  (The sustainability of deficit spending and the long-term effects are a whole separate discussion.)  Foreign investment puts money into the economy while American investment takes money out. In this case, net investment has consistently been a huge drain on the economy for decades as corporations have sunk all of their money into emerging foreign markets for a long time.

Add all of these up and we are now entering a phase where there is a net drain of money out of the economy. The problem is that economists and politicians lean on deficit spending to pull us out of recessions, but then grow nervous as the national debt soars. Eventually, the deficit spending has its predicted effect and the economy begins to recover.  Americans grow more confident, open their wallets, and take on more debt.  Federal revenue grows as incomes as corporate profits rise, and federal spending moderates as the need for social safety net spending (like unemployment benefits) decline, and as politicians grow eager to show fiscal restraint.

That’s all fine, but what economists and politicians alike fail to recognize is that, over the long haul, it’s impossible to balance the federal budget without first restoring a balance of trade. Otherwise, it’s inescapable that the net drain of money from the economy will drive it into recession.

It happened at the end of the Reagan-Bush era in the early ’90s.  It happened again at the end of the Clinton administration, when Clinton balanced the budget while simultaneously granting most-favored-nation status to China and sending our trade deficit soaring.  It happened again at the end of the “W” administration.

And now it will happen to President Obama.  He could avoid it, but he won’t.  He could boost spending, but that would forever label him as a reckless spender and give a boost to Republican candidates running on a platform of fiscal restraint.  Besides, Republicans in Congress wouldn’t stand for it, even if he wanted to do it.  Instead, he’ll fall into the same trap as his predecessors, hoping that history will remember him as one who did what needed to be done to end the recession, put the economy on solid footing and then restored fiscal sensibility – an economic trifecta that hasn’t happened before and won’t happen now because it can’t happen.

It may take a year or two for the net drain of money from the economy to bite, but it’s coming, so get ready.

* * * * *

* All “recessions” are determined by macro-economists to occur when the macro-economy, as measured by GDP (gross domestic product), shrinks for two consecutive quarters.  But there are actually two different kinds of such recession – the one we traditionally think of as being bad, and another kind that we’ve never witnessed that is actually beneficial.  The latter occurs when the decline in GDP is accompanied by a decline in the population when the population is above its optimal level, as it is in the U.S. and throughout most of the world.  In that scenario, the decline in population actually unleashes pent-up per capita consumption that has been strangled by over-crowding.  The decline in GDP is slower than the decline in population, resulting in an increase in demand for labor and rising incomes.  This is the recession that we’ve never seen before but should all be hoping for.

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