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Powell’s Warning to Congress About the Next Recession

Karl W. Smith

(Bloomberg Opinion) -- Federal Reserve Chair Jerome Powell had a message for Congress in his testimony Wednesday before the Joint Economic Committee: The Fed won’t be able to fight the next recession all by itself — it’s going to need help from Congress.

Powell is undoubtedly correct that fiscal policy will have to play a major role in any response to the next economic crisis. But he should also be realistic about what it can achieve. The Fed will also need a better monetary framework.

There is no escaping the fact that unless the U.S.’s economic conditions change substantially, the Fed will not be able to cut interest rates enough to significantly mitigate (let alone turn around) a major recession. As Powell noted, during a downturn the Fed has historically cut interest rates by about five percentage points. Currently interest rates are at 1.75%. While it’s technically possible for them to go below zero, doing so causes significant problems in the financial sector and the Fed has all but ruled out the possibility. That implies that the Fed has only roughly a third as much room as usual to cut rates in response to a recession.

In theory, that gap could be made up through fiscal stimulus — that is, by the federal government either cutting taxes or increasing spending. In practice, this will prove to be almost impossible.

It is Congress that would have to pass a stimulus, and politicians have sharp disagreements over taxes and spending to begin with. During a recession, these disagreements are even more pronounced, as any tax cut or spending increase passed as an economic stimulus becomes the new baseline from which to argue over future policy.

This creates an enormous incentive for the opposing political party to criticize any proposed stimulus as irresponsible. This is a view shared by taxpayers who analogize the federal budget to that of a family: When you have less, you spend less. As much as economists push back against this view — during a recession, a government should run a deficit, as tax revenue falls while spending on unemployment insurance and other social services rises — it remains deeply rooted in the public psyche. Congress needs to take this reality seriously.

Taken together, these forces create a powerful resistance to effective stimulus.

The Democrats had a united government in 2009, remember, yet the stimulus they passed was much smaller than the economy required, in large part because politicians (justifiably, as it turns out) feared a backlash. After losing the House in 2010, President Barack Obama emphasized not the need to provide more stimulus but to reduce the deficit. This made political sense, but it meant that the government began withdrawing its stimulus long before the recovery had firmly taken hold.

There is little reason to expect the politics to be different when the next recession hits, regardless of which party is in control. And if the government is divided, negotiations over a stimulus could cause it to be delayed or reduced.

There are ways around this problem. One the most promising is a proposal by Fed economist Claudia Sahm to send payments directly to households whenever the unemployment rate rises above a given level. There would be no time wasted while Congress debated when and how to spend the money.

But there are limits to how effective such a policy could be. In 2008, White House economic adviser Christina Romer suggested that $1.8 trillion would be necessary to counter the Great Recession. Providing that level of stimulus through the Sahm rule would have required nearly $15,000 to be sent to every U.S. household. It’s simply unrealistic to think that Congress would ever set an appropriation of that size on autopilot.

In the next downturn, it’s likely that the Fed will run out of room to lower interest rates. The Fed should not count on fiscal policy filling in the gap; it’s likely that whatever stimulus Congress passes will be inadequate to the problem. The bottom line is that the Fed has to continue to look for ways to stimulate the economy in a world of persistently low interest rates.

To contact the author of this story: Karl W. Smith at ksmith602@bloomberg.net

To contact the editor responsible for this story: Michael Newman at mnewman43@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

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