The Three Economic Levers

Posted: March 16, 2020 in It's All Important Stuff

As an Economics and Finance double major in the early 80’s, I watched, with great interest, how the Ronald Reagan administration responded to the 1980 recession. An economic recession is identified as a period of temporary economic decline during which trade and industrial activity are reduced as identified by a fall in Gross Domestic Product (GDP) in two successive quarters. As Reagan took office in 1980 Inflation was quite high, largely due to the oil crisis and concomitant skyrocketing oil prices.  The Federal Reserve Bank (Feds) increased interest rates to keep inflation in check.  Job losses were high and with an increase in household expenses because of inflation, this tipped the US economy into recession.

Every Econ 101 student is taught that two big Economic levers that the federal government can wield to stimulate an economy in recession are through Fiscal Policy and Monetary Policy.  Fiscally, under the Reagan administration, the US significantly increased federal spending, which led to budget deficits (see Chart 2) and increasing national debt (see Chart 1) and the US also dramatically reduced federal income tax, both in an effort to stimulate the economy.  Monetarily, the Fed felt it had few options to lower interest rates to stimulate the economy for fear of worsening inflation.  The fiscal spending and lowered taxes eventually worked and the economy recovered and inflation rates somewhat normalized; however, the appetite to pay that “temporarily” increased national debt back down was lost. (see Chart 1)

Chart 1

national debt image


Chart 2

budget deficits by year


Our economy enjoyed peacetime expansion through 1985.  Then, inflation began to increase and the Federal Reserve responded by raising interest rates from 1986 to 1989. This weakened but did not stop growth.  The budget deficits also decreased during this period. (see Chart 2) In 1990 we experienced another oil price shock. This increase in the rate of inflation and the debt accumulation of the 1980’s led to consumer pessimism producing a brief economic recession.  This time the George H. W. Bush administration responded by increasing deficit spending (see Chart 2).  But, he also famously agreed to a tax increase to stave off increasing budget deficits (“read my lips no new taxes”).  The tax increase and the following reduced budget deficits slowed, but did not reduce our national debt (see Chart 1).

When Bill Clinton took over in 1993, the economy had just passed bottom and was arguably already starting to turn around. Then came the longest period of economic expansion in American history of ten years. (until the 11-year period that just ended in March 2020). This long run-up included the too-fantastic expansion of the dot-com era.  Interest rates fell through this cycle.  During Clinton we reduced the budget deficit) and even had four years of budget surplus (see Chart 2).  With this we actually made the first dent in the national debt since 1980.

George W. Bush takes over in January of 2001.  A few months later we saw the collapse of the dot-com bubble with a fall in business purchases and investments, and the September 11th attack which ended this decade of growth. If you didn’t work in the tech sector, you might not have been impacted. Bush returned to the same toolkit and increased government deficit spending and reduced taxes – resulting in of course more budget deficits (see chart 2) and put us back on a near vertical trajectory of national debt increase (see Chart 1).  The 2001 recession was brief and shallow and this stimulus fueled inflation worries leading to a spike in interest rates in 2003.

In 2005 Credit Policy became the third lever in the US economy with arguably an even larger impact than Fiscal and Monetary Policy.  Massive deregulation in the financial industry permitted banks to engage in hedge fund trading with derivatives. Banks then demanded more the ability to offer more mortgages when flush with cash from the profitable sale of these derivatives. The government reduced the rules for making mortgages. Cheap borrowing costs encouraged Americans to load up on debt to buy homes, even when they had no savings, no income and no job prospects.

The subprime mortgage crisis led to the collapse of the US housing bubble in 2008.  This is referred to as “The Great Recession”.  Falling housing-related assets contributed to a global financial crisis even as oil and food prices soared. The crisis led to the failure or collapse of many of the United States’ largest financial institutions: Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and AIG.  We also saw a crisis in the auto industry.  Barrack Obama takes office in January 2009, right square in the middle of this.  His response was a $787B Fiscal stimulus package and a $700B bank bailout. Interest rates are drastically reduced.  The Great Recession lasts eighteen long months.  Credit Policy changes include significant reversal of the policy changes of 2005 and the mortgage industry spends the next eight years shoring up their loan portfolio.  Interest rates settle out and under Obama still, deficit spending is reduced substantially year by year (see chart 2) and the auto industry and the banks pay back what they received under the bailout.  This begins what was the longest economic boon in history, but we continue adding to the national debt at an alarming rate, following a similar pattern recovering following the Great Depression in the 30’s and WWII.

In Summary

the recessions of 1980, 1981, 1990 were caused by a combination of a high inflation rate, driven by high oil prices from the oil crisis – a major world issue largely out of our control – with tight Monetary Policy that kept interest rates high in an effort to control the inflation rate.  These were significantly addressed by increasing government spending, resulting in budget deficits and increasing national debt.  Each time the size of the budget deficit was reducing until the next crisis arrived.  In 1990 Bush actually raised taxes to help with concerns over budget deficit.

The 2000 recession was caused by the dot-com bubble bursting and The September 11th attacks, which reduced investment and ultimately crushed consumer confidence and spending. W likely overcorrected with increased spending and lower taxes and the economy soon overheated with inflation the result.  The budget deficits were decreasing, but the national debt growth continued.

The recession of 2007-2009 was the result of a completely self-inflicted crisis – we turned over the keys to Wall Street and they fantastically screwed it up.  This required a huge bail out, deficit spending and concomitant increases to the national debt. But, the economy did turn around, leading to eleven years of growth.

Seven years into and for economic reason, we institute Trump’s 2017 tax cut, which lowered individual and corporate tax rates, especially for the wealthy.  From 2017 through 2019 the Fed lowers interest rates at Trump’s urging.  Our national debt balloons to $23,000,000,000.00 (see Chart 1).  In February of 2020 we hear rumbles of consumer confidence declining despite the interest rates at record low.  Fears of the national debt being 105% of our GDP and growing at an astonishing $1T per year are sparking concerns from all corners of the economy.

Despite weeks of near complete denial, our next crisis is at our doorstep – Coronavirus is real and it is very scary.  Our healthcare system may become overrun. The flow of goods and services has already been disrupted.  The stock market has plummeted with the record one day drop occurring as I write this on March 16, 2020.  ALL of the gain of the last three years has been erased. Travel and tourism, making up 7% of our economy, is nearly halted.  And the crisis could last months.  We will, however, eventually come out the other side.

So… this leads to the three Economic Levers we execute during such an economic crisis.  Are choices once again:

  1. Via Monetary Policy Lowering interest rates – nope, they are at 0% and Trump is wildy throwing out going in the negative. We have already injected $500B into the economy by printing money and the Fed buying various financial instrument from the market to keep liquidity afloat and we have promised up to $1T more of this if necessary. This $1.5 trillion should return as we are able to sell it back off when the economy is resuscitated.
  2. Via Fiscal PoIicy increasing government spending and/or lowering taxes – wellp, we just had a massive tax break and have been wildly overspending for three years. Any action here will further our already massive national debt as we kick this can down the road to our children and grandchildren.  This will most certain rattle consumer confidence as well.
  3. Via Credit Policy easing credit restrictions and/or extending credit. This actually may be our most viable option. For example, we could extend credit to the airlines. We could delay student loan and other payments.

I have been saying this for three years now.  During times of economic growth, we have always reduced deficits and until the last forty years paid down the national debt.  Under Trump, we have done the opposite.

Oil prices are currently at historic lows with OPEC flooding the market with supply in a battle with Russia over market share.  What if this ends or Russia restricts supply to drive up cost?  Inflation increases would force us to increase interest rates, which also have a huge impact on our ability to control our national debt as our interest payments will also increase.

Our economic options are severely limited. We are positioned for an extended and significant economic recession, unless we tread very carefully and thoughtfully.

  1. Paul Sappie says:

    Fantastic article! Clearly written with points well made and supported. I’m hoping that whatever combination of levers are used, it will benefit those impacted the most by this crisis.

  2. Richard D. Cimino says:

    Excellent concise summary! My hope is that the post COVID-19 economy doesn’t focus on one measure: GDP, but rather finds new indexes/measures. New Zealand is trying something new. Maybe the “New GDP” will include a value for stay at home parents (something the architects of GDP considered, but discarded), maybe the new GDP will value services and sustainability. Maybe value our leisure time?

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