We think that the U.S. economy has ended its pandemic-induced free fall. Tentative signs of the recession’s nadir are evident in near real-time data across the economy.
The status quo is not going to return. The pandemic is shattering what is left of the old social contract that survived the financial crisis.
It is now time to begin considering the shape of the post-pandemic economy: What it will look like, whose interests are given preference and how fiscal and monetary policy will drive the American economy.
In our estimation, the depression-like shock of the pandemic will result in a wholesale destruction of what the scholar Mancur Olson called distributional coalitions – groups like, for example, lobbyists that play a significant role in the allocation of wealth and income that often negate economic reform. These groups have blocked the modernization of the American economy for some time.
The fact that these well-heeled lobbying groups themselves are seeking the same federal bailouts as favored sons such as the domestic airline industry is an illustration of the great changes that are before us. Moreover, does anyone think that there will not be significant structural changes to the domestic health care system following the pandemic?
The status quo is not going to return. The pandemic is shattering what is left of the old social contract that survived the financial crisis. The special interests, cartels and policy coalitions, which shaped the political economy before the pandemic, will likely not survive the magnitude of the shocks working their way through the economy and society. What lies ahead will include a major shift in the balance of power between state and society, labor and capital, and the individual and government.
These changes will require a set of policies including government spending and monetary accommodation to support the multiyear recovery ahead that are quite different from the policies that prevailed before the pandemic. Large budget deficits, real negative interest rates and government-sponsored initiatives such as the Federal Reserve’s Main Street Lending Program and worker retraining are all going to be necessary.
The following is a brief synopsis of what we expect the economy to look like during the early phase of recovery in employment, inflation, wages, fiscal policy and monetary policy.
Our baseline forecast has been predicated on the notion of “depression-like shock, no depression.” The bottoming of economic activity and rebound in equity prices underscore that call and we are sticking with it until economic data or policy implies otherwise.
But it is important that the idea of a depression-like shock without a depression is predicated on a sustained policy response from the U.S. fiscal and monetary authorities. Large fiscal support and real negative interest rates should prevent negative feedback loops of budget cuts at the state and local levels. Those cuts would result in wholesale layoffs of well-paid public-sector employees such as teachers, firefighters, medical personnel and police officials.
Should that policy of fiscal and monetary support give way to premature austerity policies, there is a significant risk that the recession will rival the Great Recession of 2007-9; the double-dip recession of the early 1980s; or, worst of all, the Great Depression of the 1930s. At this point, the difference between a deep recession and a depression is a policy choice and not fate. We are still early enough in the policy response process that the U.S. political authority has the capacity to prevent a depression.
The Great Depression was solvency-induced (and precipitated by the 1929 stock market crash). The 2020 recession, by contrast, is a byproduct of an ill-advised trade war and the global shutdown of economic activity due to an overwhelming health crisis. It will almost certainly be followed by a solvency crisis particularly among small firms in the retail, leisure and the hospitality sectors. All of this will take place amid elevated unemployment.
Given the record of the past decade, if the policy responses are misdirected, insufficient and short-lived — all of which are likely to prolong the misery of those not fortunate enough to adapt to changes in workplace requirements — then the risks of an outright depression will rise.
Shape of the recovery
We expect an elongated and frustratingly slow recovery that will look like a Nike swoosh rather than a W or a V in the near to medium term. Our base case anticipates a solid economic rebound in the final quarter of 2020, followed by a more modest multiyear period of recovery. We do not expect expansion beyond January 2020 levels until the middle of the decade.
We do not expect expansion beyond January 2020 levels until the middle of the decade.
Our alternative to the baseline is a W-based recovery that is defined by a second wave of the virus and another dip in economic activity in early 2021, followed by another round of layoffs and rising unemployment.
The difference between our baseline and the alternative forecast will be the combination of macroeconomic policy and individual behavior that mitigates the disease later this year. Should policymakers pull back on support for the economy or should the recent reopening of the economy prove premature and a second wave of infections occur, then we will begin talking about depression-level economic growth and policy responses.
Finally, our alternative to the W would be a V-shaped recovery along the lines implied by the improvement in financial conditions and equity markets. Under this scenario, the virus ends and a massive return to work and a boost to the economy by fiscal and monetary measures result in a strong recovery starting in the third quarter of 2020.
But none of these scenarios are pre-ordained. How the government responds is a choice, one that can be informed by the experience of past recessions. If policymakers choose to reaffirm the status quo, it runs the risk of a far larger economic catastrophe.
In the analysis that follows, we look at the reaction of the labor market, consumer prices, wages and the federal budget deficit in the 14 economic downturns since 1929. Though the current episode is unlike any other recession, and despite the many uncertainties, it will certainly share characteristics with the worst of the lot.
Employment: American labor dynamics
This recession is uniquely distressing. Instead of a gradual drop in demand and production causing a gradual drop in demand for labor, the rug was pulled out from under 40 million employees virtually overnight, leaving them unemployed or furloughed and pushing the economy into recession.
We expect roughly 25% of those 40 million to permanently lose their jobs. That implies an optimistic outcome of greater than 10% unemployment over the next few years. This will be the baseline of what one should anticipate is a much larger government role in how the labor force is managed, trained and retrained. Greater government regulation of the labor force and expenditures on training are going to be the equilibrium going forward.
As the figure below illustrates, the unemployment rate has reached its lowest point at the end of each business cycle since the Great Depression. The unemployment rate then begins to climb as each recession takes hold. It will typically increase for months past the official end date of the recession as businesses delay furloughing employees due to contractual reasons or out of loyalty.
In the table below, we show that the high point in the unemployment rate has occurred anywhere from 11 to 27 months after the start of the recession (excluding the first dip of the 1980-81 double dip recession).
On average, the peak rate of unemployment occurs 15 months after the start of the recession. If this holds true, then that implies double-digit unemployment rates well into 2022 or further.
What’s most important for policymakers to consider is that not only does it take one to two years for the unemployment rate to reach its peak once a recession has begun, but it also takes an even longer time for the unemployment rate to move back below the 5% equilibrium level.
In the table below, we show that the average length of time for the unemployment rate to reach 5% or lower has been 32 months after the peak month of unemployment. This underscores our forecast of the economy not reaching January 2020 levels until mid-decade.
That suggests that a quick end to income assistance for the unemployed is unreasonable and counterproductive. Given the high multiplier effect of low-income spending, a dollar of assistance for those who have no other source of income creates more than a dollar of spending throughout the economy and is beneficial to all.
The equilibrium rate is referred to as the natural rate of unemployment – which refers to the normal level of joblessness as workers transition to new jobs or locations or life-changing situations. This 5% natural rate lines up with the postwar average unemployment rate of 5.7% shown in the figure above, particularly if the 10% rates of unemployment during the 1980s and 2007-9 recessions are treated as outliers.
During the Great Recession, businesses substituted technology for labor and shifted manufacturing offshore.
We do not expect expansion beyond January 2020 levels until the middle of the decade.
In recent years, the natural rate concept has given way to an idea called the non-accelerating inflation rate of unemployment, or NAIRU. As the demand for labor increases during business cycle upswings and as unemployment dips toward the assumed NAIRU level of 5%, wages were thought to increase, pressuring inflation higher.
NAIRU is thought to evolve over time with changes in the business cycle. So in recent periods of high growth, NAIRU was thought to dip to 4.5% or lower, perhaps as a way of explaining a low level of wage increases. In our discussion of inflation and wages that follows, recall that the unemployment rate before the coronavirus crisis was at a post-World War II low of 3.5%, with inflation in decline and below the Federal Reserve’s targeted 2% rate.
We argue that as labor unions lost their sway and as sophisticated technology was integrated into the production of goods and provision of services, the supply of labor became no longer fixed. Businesses can now offshore production to low-wage centers, outsource low-skill tasks to firms that draw on unprotected workers, or substitute technology for labor, driving down costs and increasing profits. .
Businesses took the opportunity of the 2007-9 Great Recession to substitute technology for labor and offshore manufacturing. There is little reason to think that this trend might not continue after this recession. In fact, this recession will pull forward trends in technology like artificial intelligence and machine learning-that will hurt many blue- and white-collar workers.
The gives even more impetus for a government-initiated infrastructure policy that includes rebuilding transportation networks and electrical grids, expanding and increasing broadband coverage, developing on-shore manufacturing capacity of medical supplies, and creating a well-paid corps of educators, researchers and health-care providers to help the elderly and disabled and to trace and treat victims of pandemics.
The mantra for anti-government forces has always been “more government spending equals runaway inflation.” Even after deflation had crippled the economy during the Great Depression of 1929-33, the government decided that the public needed a dose of austerity in the midst of a recovery, sending the economy back into another deflationary spiral from 1937 to 1938.
The economy has gone into deflation in seven of the 18 recessions beginning with the post-World War I recession of 1920-21 and including the 2007-9 Great Recession and today’s coronavirus-induced recession.
As shown in the following figure, runaway inflation occurred in only two periods. The first occurred after World War II, when the economy was transitioning from wartime shortages and price controls, and was reducing the value of real government debt. The second took place during the oil embargoes of the 1970s, which drove up costs of production and consumer prices and drove down demand (the era of “stagflation”). But the Federal Reserve under Paul Volcker proved that monetary policy could control inflation and that the Fed knew how to do it.
And so it has been four decades of inflation targeting by the world’s central bankers, aided and abetted by the now infinite size of the global labor market. Inflation has been squashed out of the global economy like stepping on an over-ripe cantaloupe. Interest rates have been compressed across the board and wages of the working classes have stagnated, all while corporate profits have taken off due to the consumer-driven, worldwide demands of an ever-expanding middle-class.
That last part about the ever-expanding middle-class spending is showing signs of faltering, however, as we enter what looks to be another disinflationary or outright deflationary period. As the figures below indicate, inflation declines and usually reaches its lowest point in the cycle an average of 22 months after the start of the recession.
And then it has taken another 27 weeks for inflation to recover to its 2% target. This is important because the cost of a recession will need to be financed by the government through the sale of Treasury bonds. Rather than tax the public to pay the dividends, it would be less costly if those costs were inflated away — that is, paid off with inflated dollars.
There have been arguments organized around the return of inflation. Most of these are predicated on outdated dogma and are not linked to the significant structural changes that have occurred in the U.S. economy.
The argument that inflation is always and everywhere a monetary phenomena is true only under certain conditions. Those conditions prevailed quite nicely in between 1965 and 1985. They are not here now, nor were they during the great financial crisis of 2007-9. During that period, for example, banks took extra reserves and pushed them into the economy, creating a situation where too much money was chasing not enough goods in a relatively closed U.S. economy.
For the U.S. to experience an inflation problem would require two major events:
- A significant supply shock. An example would be cutting off China and closing the economy to what we would consider a reasonably open global trading system. Most times when one speaks of inflationary risks, it is an argument that is based on nationalism, anti-globalism and repatriation of supply chains.
- A major upside surprise in the economic rebound. By this, we mean a recovery over the next number of years that results in the release of assets held on reserve at the central bank to meet major demand. That would require the Federal Reserve and Treasury Department to acquiesce and create inflationary conditions. And if they did, it would be directed at reducing the real value of public and private debt obligations.
Under current economic conditions, an inflation problem would be one of choice either through trade policy or an explicit decision by the government to reduce the real value of public and privately held debt. It will not occur automatically due to an increase in the money supply or government spending.
We’ve divided our analysis of wages into three groups to capture the separate effects of de-unionization, the global supply chain and outsourcing of essential labor. As such we look at the impact of recessions on manufacturing wages, average hourly wages and the minimum wage.
Our findings support the notions of wage rigidity, pent-up deflation and a rational labor force since 1985, with employees in the production sector facing competition from an infinite supply of labor (willing to undercut domestic manufacturing wages) and employees moving to a growing and more educated service sector.
Manufacturing wages — The modern manufacturing sector grew out of wartime mobilization and formed the backbone of the U.S. economy from the late 1940s into the early 1980s. The figure below shows wild swings in manufacturing wages as the price and wage controls were lifted after the war and as the economy went through two low-unemployment recessions in 1945 and 1948-49. After the post-Korean War recession, manufacturing wages began an upward trend that lasted until the early 1980s.
The decline of union bargaining power during the Reagan years coincided with an expansion of the supply of labor. The end of traditional manufacturing began with factories being lured away from regions with high costs of labor to the lower-wage areas of the South, which had state-enforced guarantees of a non-unionized labor force. That shift was then superseded by the development of the global supply chain and its cheap foreign labor.
The lack of union representation left a shrinking workforce subject to wage rigidity that we attribute to several factors. These include the decline in the demand for labor resulting from the general decline in domestic manufacturing — due to offshoring and changing consumer tastes — and to the substitution of labor with automation. Though wages were not going up, they were not declining either, as employment opportunities in the growing service sector put a floor on manufacturing wages.
Finally, manufacturing wages often increased at the outset of recessions before falling again as the recession matured. This is attributed to the last-in, first-out dismissal of lower-paid employees at the outset of the downturn, leaving higher-paid employees operating the facility. As the recession deepens, the higher-paid employees are finally laid off and average wages deteriorate.
Average private hourly earnings — As we mentioned at the outset, this recession is unique; 40 million employees were put out of work virtually overnight. The result has been a huge jump in the average pay of those who remain in the workforce and fortunate enough to work at home.
Though manufacturing remains a driving force of local economies — with production wages supporting downstream spending — the service sector has overtaken the production of goods as the dominant employer nationwide. As the figure below shows, private-sector wages (which include both production and service sectors) tend to drop during recessions and then increase during economic recoveries as employers compete for a shrinking pool of available labor.
The increase in wages in April has to be treated as an outlier – a data event in a unique set of circumstances. As the table below indicates, in the three recessions during the period of ascension of the service sector, the average number of months for wage growth to bottom out was 40 months after the start of the recession. It then took another 42 months for earnings growth to recover to 3%, which is the average growth of earnings from 1985 to February 2020, and which we’ll consider to be the normal level of growth.
We could expect labor costs to be moderate once the economy is back to work again. The fear of inflation-driven wage increases seems overblown. As we’ve shown above, inflation has mean-reverted around 2% since the 1980s.
The minimum wage — One thing that is almost certainly to be done after witnessing the horror of the pandemic is to increase the wages for those workers who keep our hospitals clean and who feed and change the diapers of our elderly and infirmed. If the past is any indication, we should anticipate an increase in the national minimum wage in 2021. That will move toward what is quickly becoming a consensus living wage of $15 per hour. Minimum wage increases have occurred in seven of the 12 recessions in the post-World War II era as shown in the figure below.
And as shown in the table below, a family of four requires a wage of $12.50 per hour for the breadwinner to be at the federal poverty-level income of $26,200 per year. A wage of $15.75 per hour would generate an income of $32,760 per year, which would put the family at 125% of the poverty level.
The federal budget deficit
This is the first recession since the end of World War II and the Korean War in which the budget deficit was already deteriorating going into the economic downturn. As the figure below illustrates, this will be the fourth year in a row that the budget gap has widened, which is unusual in a growing economy when tax revenues should be increasing.
After shrinking to 2.2% of gross domestic product in January 2016, the federal budget deficit had deteriorated to 4.9% by February 2020, the month before the coronavirus health crisis shut down the economy. The current output gap is the result of corporate tax cuts — which have reduced revenues but failed to generate investment — and a military buildup that has increased spending.
We have divided our budget analysis into two periods: The pre-Keynesian world of the 1930’s to the 1950s, and the modern Keynesian world of monetary and fiscal policies working to maximize output within a system of stabilized inflation and unemployment.
In plain English, the modern economic system accepts modest deficit spending – borrowing against ourselves – to finance economic growth and to promote the well-being and opportunity for all. As the figure below illustrates, we have rarely had a budget surplus since 1960, the latest occurring during the late-1990s economic boom that ended with the 2001 dot.com bust and recession.
On average, budget deterioration has continued for 21 months after the start of a recession, and then for another 38 months for the deficit to rebound to normal levels. (We have defined a normal budget deficit to be 2.5% of gross domestic product, which is the average of deficits recorded from January 1960 to February 2020.)
So with a deficit already twice the size of normal even before the recession began, and with the administration calling for more tax cuts, perhaps policymakers and the public need to rethink the situation.
The 2017 tax cut did not spur investment, but managed only to inflate stock prices through corporate equity buybacks. High-end spending did occur, but how many yachts can one person buy?
In a short period, it does appear that fiscal and monetary policies have become functionally integrated. The Fed has put forward nine different lending facilities, increased quantitative easing and reduced the nominal interest rate to zero, with real negative interest rates dominating the term spectrum out to 10 years.
The large government operating deficits are going to be a defining narrative of the post-pandemic economy, and the Fed will keep interest rates at zero for the foreseeable future.
If this sounds familiar, it is because it should. The Fed subordinated itself to the Treasury during the period of 1942 to 1951, when the federal government ran enormous annual operating deficits to support wartime production and the postwar transition.
The U.S. central bank possesses an institutional memory and knows how to manage such a condition. In addition, given the proliferation of monetary tools used over the past decade and the evolution of monetary policy, there is no reason to anticipate significant interest rate risk with respect to the Federal Reserve’s balance sheet. That balance sheet is now more than $7 trillion and will likely soar well above $10 trillion in the near term.
We expect the Fed to impose the policy of yield curve control, which is quite similar to how it operated in World War II and its immediate aftermath. Essentially, the central bank will pin the 10-year-yield at, for example, half a percent and inform the public that it will remain there until the central bank can attain a specific nominal growth target or inflation target over a specified period of time.
Our assessment of the future of monetary policy is that it does not include nominal negative interest rates as long as the economy remains out of depression. Should that happen, then the Fed could quickly choose to employ a widespread policy of nominal negative interest rates – which is distinct from real interest rates that account for inflation. This would entail changes to the financial regulatory framework that would include penalties against cash hoarding by large firms, insurance companies and pension funds, as well as the phasing out of large-scale cash denominations.
The shape of things to come
In this health crisis, the policy focus needs to be on saving small businesses and the employees they support. The Small Business Administration’s flawed Paycheck Protection Program and the coming Main Street Lending Program put forward by the Federal Reserve are likely to define the near- to medium-term policy response.
Efforts to support employment will likely also include wage guarantees for employees who cannot work at home.
Efforts to support employment will likely also include wage guarantees for employees who cannot work at home. (European governments are subsidizing 80% of wages, which creates a great, real-life experiment for damage control during a recession.)
To shift consumer behavior back toward traditional social and commercial activities will require the creation of a “healthy America” program to fund testing, tracing and treatment programs to fight this pandemic and those to come. And, of course, it would be helpful if the U.S. funds the development of vaccine that is then manufactured and distributed to every person in the U.S. and around the world at no cost.
The behavioral shift to working at home will result in a demand for expanded broadband throughout the economy, including rural America. Rebuilding of the American energy transmission system and transportation system will be necessary to support an economy that has been fractured by the pandemic.
Economic evidence is unmistakably clear that policy stimulus has to be large and applied quickly, and be sustained for as long as it takes to get employees back to work again. Waiting for a miracle to happen is erroneous and more costly than solving the problem in the first place.
The pandemic is causing a plunge in demand that is resulting in significant changes in the way we work and shop. This is accelerating profound changes that were already under way and will, in some cases, make those changes more painful in the near term, requiring that sustained aid.
Employing a period of fiscal and monetary austerity in the near to medium term would be significantly counterproductive. The second half of the Great Depression and the downturn in 1937-38 didn’t have to happen. It was brought on by self-imposed fiscal austerity four years after the worst downturn in history and a budget deficit of only 4.2%.
Similarly, the sluggish recovery from the financial crisis was a choice driven by fears about the debasement of the dollar, interest rate shock, inflation and fiscal solvency that never arrived. The difference between a solid recovery and falling back to barely-there growth following the pandemic is a choice.
The costs of a recession and realities of recovery are not just about money. It is about the degradation of skills, the loss of incentive for those just entering the labor force and the lost hours of output that can never be recouped.
The decomposition of distributional coalitions that have prevented much-needed economic and social reforms over the past two decades presents the chance for recovery, renewal and revitalization of the American social compact and its political economy.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.