Despite the persistent post-Covid strength of the US jobs market, the preponderance of evidence in recent months strongly suggests it will be hard to avoid a recession in 2023. Rapidly increasing Federal debt levels preclude significant fiscal stimulus and the Federal Reserve Board (Fed) is determined to lower inflation by reversing monetary stimulus. With the geoeconomic problems resulting from the war in Ukraine, continued tensions with China, a looming debt crisis in the developing world, and lack of dynamism in the European and Chinese economies, it is difficult to conceive of external factors providing a lift to the slowing US economy.
The post-Covid bounce in the US economy, driven by pent up demand and workers returning to the job market, proved to be short lived. GDP growth was a tepid 1.1% in the first quarter, down from 2.6% in the fourth quarter of 2022. Consumer spending, the traditional pillar of growth in the world’s largest economy, was the only strongly positive factor, as the trade and investment sectors weakened, and government expenditures moderated. Led by the rapidly deteriorating real estate sector, gross private investment fell 12.5% in early 2023. Rising interest rates to address stubborn inflationary pressure was a major factor in the fall of 19% in housing investment in the first quarter relative to the same period last year.
US policy makers had hoped that the stimulus contained in the CHIPS and Inflation Reduction Act (IRA) would result in higher investment figures. It is undoubtedly premature to draw conclusions about the accuracy of this ambition, but early evidence is not uniformly promising. In the first quarter, investment in structures such as factories was only 2% above 2022 levels, while the important category of equipment for new or upgraded manufacturing fell.
Overarching fiscal stimulus is no longer feasible, as the average gap between Federal revenues and expenditures ballooned to an average of 9.2% of GDP annually since 2019. Total debt at the Federal government level is now over 122% of GDP. Total debt has tripled since 2008.
A lingering and potentially serious problem from actions to reduce the high levels of inflation which are sapping the purchasing power of active workers and the growing number of retirees is Federal Reserve policy. The Fed has raised basic interest rates at historically unprecedented speed and also (albeit more gradually) removed liquidity from the financial system after again historically unprecedented growth in the money supply to keep the Covid economy from cratering. US banks had bet on a more gradual reduction of liquidity and slower increases in interest rates, resulting in short-term dominated assets and longer-term dominated liabilities. The three bank failures thus far in 2023 represent more total assets than those of the total bank failures in the crisis year 2008.
Analysis from the Stanford Graduate School of Business estimates that the difference between the current value of assets and the book value of the 4800 US banks tops $2 trillion. Adding to distress levels is a looming crisis in commercial real estate loans that represent some 25% of assets at US banks. Because of the historic changes in work patterns after Covid, in which only half of all urban office workers have returned to downtown offices, the value of commercial real estate, again according to the Stanford study, has declined by 33%.
These factors create a volatile and potentially dangerous situation for further bank failures. At a minimum, banks are being forced to reign in lending to all customers to preserve capital. Recent data show that demand for commercial real estate loans is down as much as 60 to 70% in 2023 and most banks have tightened their lending standards. The 2008-09 crisis caused a “credit crunch” affecting both large and small borrowers and helped produce the worst US recession since the 1930s.
It will be difficult for the Fed to reverse course on fighting inflation and, with a divided government at odds over addressing historically high debt levels, major changes in fiscal and monetary policy are remote. Further stimulus from fiscal policy would undoubtedly supercharge inflation and lead to a loss of confidence in the huge and globally critical US bond market.
The major economic question for the remainder of President Biden’s term is, in the absence of major Federal Reserve or fiscal stimulus: what is the plausible driver of economic growth? External demand is likely to remain weak as Europe and East Asia are growing slowly, if at all. Recent data from China indicate that imports are down, industrial production and consumer spending are slowing, and youth unemployment registered over 20% last month. Total unemployment in China would be considerably higher than the reported rate of 5.2% if what the authorities label as “flexible workers” with intermittent employment opportunities were properly counted. In late May the Chinese government reduced estimates of growth in 2022 because of even more negative performance of its real estate sector than originally calculated.
The debt crisis in the developing world is also a negative factor for global demand, as the International Monetary Fund warns of widespread defaults like those of the Asian Financial Crisis a generation ago.
The Biden team is committed to new domestic industrial policies which rely on domestic demand for a new green economy. But new investments in sectors like semiconductors and electric vehicles require years to execute and will be somewhat hampered in the near term by reduced lending due to the issues constraining the banking sector. Additionally, other components of the Biden strategy, such as discouraging production of fossil fuels, will be a drag on capital investment. Related sectors such as chemicals and metals will also lose dynamism as energy prices for fossil fuels increase as a result of administration policy.
Development of supply chains for electric vehicles, including batteries, are made more difficult by policies which discourage domestic mining due to environmental and safety considerations and restrictions on use of public lands. In the best of circumstances bringing new mines into operation requires lead times of ten years or more for permitting alone. The US has very little of the mining and processing capacity for producing the minerals, including rare earths, required for most green technologies. The new green economy therefore, at least in the medium term, will do more to stimulate imports than domestic production.
Finally, as noted earlier, the real estate sector, which is a traditional swing source of growth, will detract from investment and related job growth for at least the next few years.
In short, current policymakers have few options for stimulating the sort of sustainable growth needed to avoid a looming recession. Finding a middle path between stability and avoiding a truly hard landing is the best they can hope for. And any middle path assumes there are no exogenous shocks from the volatile global economic and political environment or the precarious domestic financial situation.