The Federal Reserve is about to destroy the American recovery
Former Federal Reserve Chairman Ben Bernanke once remarked that he did not think economic expansions died of old age. Rather, they get murdered – generally by mistaken policymakers.
If the past is prologue, then the economic history of the 1970s suggests America's current recovery is at high risk of becoming a victim – the combination of tighter credit and successive supply shocks were a recipe for economic contraction between 1969 and 1981.
For perspective, in any given year there is a 16pc chance that the US economy enters a recession – a period of declining economic activity spread broadly across the economy and lasting more than a few months. The UK is rather less recession-prone, with just a 7pc probability of entering recession in any given year.
However, during the period of high inflation from the late 1960s to the early 1980s, the homicide rate for economic recoveries in both countries roughly doubled. Following what was then its longest expansion on record, in late 1969 the US entered an unlucky 12-year period of relatively short recoveries punctuated by four recessions.
According to the latest academic research the UK fared slightly better, with two recessions between 1973-75 and 1980-81, though both were long and deep by historical standards.
The reason for the marked decline in life expectancy for economic recoveries was not just an increase in the frequency of energy price shocks, but also that those shocks made impact at the same time that the Bank of England and Federal Reserve were struggling to bring inflation down through tighter credit conditions. Current evidence suggests that neither institution has fully learned its lesson from this period.
The energy shocks are familiar to most: the 1973-74 Arab oil embargo in response to the Yom Kippur War and the sharp drop in world oil supply following the 1979 Iranian Revolution. But the 1973-75 recession was also preceded by “the Great Grain Robbery,” a global food shortage triggered in part by harvest failures in the Soviet Union’s breadbasket, Ukraine.
A few years earlier, the relatively mild 1970 recession in the US was preceded by the start of a 102-day strike by 160,000 workers at General Motors, whose supply chain at the time included 39,000 suppliers and whose revenues accounted for 2.3pc of the US economy.
Yet it was another two months before the US officially entered recession, while in 1973 the UK had already entered recession during the three months before the surprise Yom Kippur War and subsequent oil embargo. So while the supply shocks mattered, it was not just about supply shocks.
Rather, all six recessions in the US and UK between 1970 and 1981 occurred in the context of sharply rising nominal interest rates as the Fed and BoE battled to contain an inflation problem they had themselves allowed to persist and fester.
Higher rates not only raised the cost of credit, they also lowered the quantity of credit flowing to the economy because higher rates meant higher expected payment-to-income and debt-to-income ratios, which lowered the number of borrowers able to qualify for a loan, and the amount of credit qualifying borrowers could qualify for. In real terms, credit conditions were therefore already tightening sharply heading into each of the shocks of 1969-81.
Which brings us back to today. After inflation, the total volume of bank credit in the United States declined in the 12 months through April.
Historically, this is a rare phenomenon—since 1960, it has only happened during or in the immediate aftermath of a recession.
Since the March 12 collapse of Silicon Valley Bank, total bank credit has contracted by a cumulative total of $248 billion. The Federal Reserve’s survey of senior loan officers at US banks shows a large percentage reporting tighter conditions for commercial and industrial (C&I) loans to firms of all sizes. The credit retrenchment is possibly even more acute in the UK, where total lending contracted 1.3pc in the year through March, consistent with a decline of more than 8pc after inflation.
Because of their colossal error in 2021, monetary policymakers on both sides of the Atlantic now have little choice but to maintain restrictive policy and hope that after the 70s-themed food and energy price shocks of 2022, 2023 is a boring year.
It’s not inconceivable that history may oblige them. Despite the failure of three large U.S. banks, the stampede of deposits exiting the US banking system appears to have stabilised.
Though global energy supplies remain tight, that is likely to keep prices high, but not necessarily higher. More generally, given the unprecedented stimulus in 2020-21, some degree of balance sheet contraction is to be expected.
Nonetheless, it is hard to imagine that more banks will not come under pressure as they continue to slowly hemorrhage deposits to higher-yielding money market mutual funds, intensifying the credit contraction already underway. On the asset side, commercial real estate remains a vulnerability, as recent academic research indicates the labour market is unlikely to return to pre-pandemic levels of working from home.
And as we learned in the 1970s, the nature of shocks is that they can come as a, well, shock. The 2022 energy price shock and 2022-23 industrial action in the UK were unanticipated supply shocks with a distinctly 1970s feel.
In the US, 2023 is bringing $115 billion in new taxes on corporations, with the UK likewise hiking taxes on businesses. All these shocks are accumulating on economies whose labour markets have yet to fully recover from the 2020 pandemic, and in which business investment remains well below pre-pandemic trend.
Large, diversified economies like those of the UK and US are remarkably resilient complex systems, as we have witnessed over the past two years. However, a lesson of the 1970s is that history happens, and in the context of a central bank-induced credit contraction, adverse shocks can kill even relatively youthful recoveries.
Considering the current macroeconomic outlook, even the one-in-three recession probability from the 1970s US experience seems optimistic.
Dr. Goodspeed is a Kleinheinz Fellow at the Hoover Institution at Stanford University, Senior Fellow of the Adam Smith Institute, and Chief Economist at Greenmantle LLC. He chaired the White House Council of Economic Advisers, 2020-21
