The next recession could be a doozy

No one knows when the next recession will hit, but historically speaking, we're due for another.

And it could be even longer than the last one.

"In the next few years a recession will come and we will in a sense have already shot the monetary and fiscal policy cannons," Larry Summers, treasury secretary under President Clinton and head of the National Economic Council under President Obama, told a Bloomberg panel on Wednesday. "That suggests the next recession might be more protracted."

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Now, the economic profession doesn't have an exact definition for when recessions begin and end, but most everyone puts the length of the Great Recession at 18 months — easily the longest economic contraction in over 70 years. So "more protracted" would be bad indeed.

At the core of Summers' worry is the Federal Reserve's leeway to adjust interest rates. The central bank hikes rates to slow inflation, and it cuts them to boost job creation and fight off recessions. For every recession, there is theoretically some drop in interest rates big enough to counteract it. As Summers told the panel, the Fed's historically had to cut about 5 percentage points.

Interest rates were at 5.25 percent going into 2008. But the Great Recession was so bad that even cutting them all the way to zero wasn't enough to adequately stimulate the economy. That's the "zero lower bound" you may have heard of. It's a big reason why the recovery has been so agonizingly slow. It's why the Fed didn't begin hiking interest rates again until 2016, and why it's proceeded at the moderate pace of 0.75 percentage points per year — bringing us to 1.5 percent now.

You can probably see where this is going. At the current pace, it will be almost five years before we get interest rates back to 5 percent.

So to return to Summers' artillery analogy, it will take till 2023 or thereabouts to fully reload the monetary policy cannon. But we're already overdue for another downturn. And if it hits when interest rates are still so low, the next recession won't have to be nearly as big as the Great Recession to run us right back up against the zero lower bound again.

Now, maybe the recovery will strengthen and the Fed will pick up the pace of rate hikes. But things are shaky enough that the Fed could have to slow down as well. Ultimately, conditions in the economy decide the Fed's freedom of movement. If it raises rates too fast, the Fed will just kneecap the recovery. As I and plenty of other people have pointed out, the Fed is likely hiking rates too fast already.

And it gets worse.

There's something called the natural rate of interest. It's the sweet spot: the interest rate that maximizes employment without sparking continuously rising inflation. No one knows exactly where it is; policymakers have to estimate from other data. But all the evidence tells us the natural rate of interest has steadily fallen in recent decades. (Summers calls this "secular stagnation.") The economic mainstream isn't sure why it's happening. But the left wing of the profession has a pretty strong case that rising inequality is a major culprit.

The upshot is that interest rates might never return to 5 percent. The Fed might be forced to stop at 3 or 4 percent (or lower) to avoid damaging employment. Then we'd really be in a pickle.

Now, is there any good news?

Well, there's no guarantee a recession is imminent, or that it will be especially bad. There are worrying trends like the student debt load, the auto loan debt load, and a possibly overvalued stock market. But while lots of people will feel lots of pain if one of these bubbles pop, they really don't look big enough to spark another 2001 recession, much less another Great Recession. The stock market suffered its two biggest single-day point falls in history a few weeks ago, and job creation and wage trends didn't even twitch.

Of course, the Trump administration is also eager to dismantle the regulatory safeguards lawmakers put around Wall Street after the 2008 crisis. If they're removed, who knows what could happen.

There's also the fiscal policy cannon Summers mentioned, meaning Congress' ability to deficit spend.

Contrary to popular belief, the federal government can't suffer a debt crisis, because it has the legal power to issue currency. (You'd never have to worry about debt either, if the law empowered you to print dollars.) But federal deficit spending can stimulate so much employment that businesses can't keep up with the wage increases. That'll drive inflation up, and force the Fed to hike interest rates to contain the price rise. With unemployment down to almost 4 percent, and with the recent tax overhaul set to increase deficits, a lot of observers think Congress is already out of room.

But this gives the tax overhaul way too much credit. It will deliver little genuine stimulation and mostly be a useless giveaway to the rich. There's also plenty of evidence that we're further below the economy's maximum employment capacity than the official unemployment rate suggests.

Finally, don't forget: We want an economy that justifies higher interest rates. The whole problem is the economy may never get there under its own power.

There's probably a lot more ammo left in the fiscal policy cannon than Summers realizes. The question is, will Congress fire it?