Republicans Must Plan for the Coming Perfect Storm

By Kevin A. Hassett

Monday, November 7, 2022

 

Only once since World War II have we seen two negative quarters for GDP growth outside of a recession. While many economists have calculated that a recession is likely next year, for the most part there has been quite a bit of recession denial this year, especially by Democrats and members of the Biden administration. The denial chorus became Wagnerian after the release of third-quarter data, which showed that GDP had increased by 2.6 percent.

 

The problem is that the third-quarter report was worse — in terms of the state of the economy — than those of the first half of the year. Can a positive be worse than a negative? It can when the positive happens for bizarre reasons.

 

Net exports added 2.77 percentage points to economic growth in the third quarter. Absent this net-export surge, GDP growth would have been negative for the third quarter in a row, and nobody outside of the West Wing would dare deny the recession. The problem is that the net-export spike, which caused the trade deficit to decline so much, was a result of final demand’s dropping faster in the U.S. than it did in our trading partners. This is in part because we had a bigger stimulus over the past couple of years, and the removal of a bigger stimulus has a larger negative effect. Adding to that drag, however, is the Fed’s tightening, which is more aggressive than that of our trading partners’ central banks’, and Biden’s tax hikes and runaway regulation. So, we imported less because our consumers and businesses are cutting back expenditures sharply, while our exports held steady because our foreign customers are doing better than we are.

 

This bizarre net-export spike is a regular pattern in the history of U.S. recessions. Indeed, a spike in growth from declining trade deficits happened at the beginning of every single one of the five recessions we’ve experienced since 1980. And the only quarter that saw a bigger impact from net exports was the third quarter of 1980, when net exports added 4 percentage points to GDP in a deep recession that was destined to turn into an economic rout in 1981. As was the case back then, the rest of the world catches up to the U.S. with a short lag; the negative effect on GDP from the reversal of this blip is sudden and about the same size as the positive blip. It happens virtually every time.

 

This brings us to the election. The odds are that the recession we are probably now in is about to get much worse, while inflation stays stubbornly high. This will cause the deficit to skyrocket, a movement that will be exacerbated as the Fed continues to hike interest rates. Normally, a deep recession leads to bipartisan discussion of stimulus, but in this case, given how little fiscal ammunition is left, discussion of stimulus would likely lead to a bond disaster at least on the scale of that which upended the government in the U.K.

 

But that doesn’t mean that doing nothing is an option. Indeed, there is a clear prescription for exactly this scenario in a vast economic literature that my co-authors, Andrew Biggs and Matt Jensen, and I reviewed a few years ago. When a country is on the ropes financially, a major “fiscal consolidation” that slashes government transfers and spending to restore fiscal sanity has been shown over and over to have big positive effects on output. Deficit reduction through tax hikes has not been shown to work, but spending cuts are powerful medicine. The reason is simple. Looking ahead to the worsening mess, investors and consumers are frightened and keep their powder dry. But if the government gets its act together, fear of future tax hikes or meltdowns goes away, and economic activity heads back to normal.

 

There has never been more room for easy, sharp deficit reduction. In 2019, the Congressional Budget Office forecasted that government spending would be $5.3 trillion in 2023. The latest estimate is that spending in 2023 will be $5.9 trillion. Back in 2019, spending over the next ten years was estimated to be $57.8 trillion. Today, it is estimated to be $72.2 trillion over the next decade.

 

Given what sharp net-export reversals have historically signaled, restoring spending sanity is the best shot we have for avoiding a sharp and enduring contraction. If Republicans control Congress, they should start designing a major consolidation immediately.