The Deeper Dread Lurking Behind the Stock Market Sell-Off

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WASHINGTON, DC - FEBRUARY 24:  Federal Reserve Board Chair Janet Yellen testifies during a hearing before the Senate Banking, Housing and Urban Affairs Committee February 24, 2015 on Capitol Hill in Washington, DC.  Yellen gave the Federal Reserve semiannual monetary policy report to the Congress.  (Photo by Alex Wong/Getty Images)
When it comes to saving the economy, does Janet Yellen have an empty tool kit?Photo: Alex Wong/Getty Images

Over the past week, stock markets around the world have had something of a temper tantrum, ginning up trillions of dollars of paper losses and any number of panicked cable-news chyrons. Today, they seem to be rebounding and quieting, at least in the United States. But there is a deeper dread lurking behind the sell-off. If this years-long period of steady economic growth and quiet markets is over — and that is a huge if — and things are starting to go sour, what are we going to do?

Let’s say that this is not just a market gyration, even if we have no reason to believe it is anything other than that. Economic growth grinds to a halt. Silicon Valley’s bubble bursts. Unemployment rises. Financial institutions falter. The stock market plunges into the red. Why not do what we did in 2008 and 2009, with the Federal Reserve and Congress stepping in to bolster demand, stimulate lending, shore up failing financial institutions, and even aid asset prices, you might ask. Well, we could do some of those things. The Fed is likely much better at identifying and ring-fencing cratering banks than it was a decade ago. But the big fear is that the most powerful policy levers that Washington has are still tapped out from the last crisis. We would be catching a cold with our medicine cabinet bare.

Let’s take monetary policy first. If economic growth markedly slowed, the central bank would want to slash interest rates immediately. That is its first and preferred way to get the economy going again. But it cannot do that: Rates are already at scratch. In late 2007, the federal funds rate was more than 5 percent. Right now, the target is to be under 0.25 percent. It could revamp its asset-purchase programs. But the central bank already has trillions of dollars of assets sitting on its books. Analysts have long been worried about diminishing returns and increasing risks from policies like quantitative easing, and the Fed has long signaled that there is only so much it can do. Granted, it could and probably would experiment with negative interest rates, something that other central banks have done. Still, it seems unlikely that doing so would have a fraction of the power of dropping interest rates by 5 percentage points and then buying trillions in safe assets to spur investors to lend.

So, let’s turn to fiscal policy. The good news is that the government has significantly more capacity there. Judging by interest rates, investors are still wishing, hoping, thinking, and praying for the chance to lend Uncle Sam money. As of today, they will give us a 30-year loan at less than 3 percent interest. The money might as well be free. And there are still plenty of ways to spend it: You could imagine a gigantic infrastructure investment program creating lots of jobs and doing lots of good. Maybe you would finally be able to take a train straight from Los Angeles to San Francisco! Maybe our bridges would stop falling down! Moreover, given that interest rates are so low, there is less chance that Washington’s renewed deficit spending would “crowd out” private investment.

But the United States is carrying a gigantic load of debt in historical terms, making many policy makers queasy. The issue, I imagine, would be more of will than of capacity. It is hard to imagine this Congress or future Congresses wanting to undertake a giant, spending-heavy stimulus proposal, even in the event of another major downturn. John Boehner and other Republicans have stuck to the argument that the 2009 stimulus plan did not really turn the economy around. Might they use the opportunity of a slowdown to slash taxes? Probably, but that is not a terribly effective form of stimulus. Might they use the opportunity to bolster aggregate demand through deficit spending? Maybe — Republicans certainly are not allergic to deficit spending — but it somehow is hard to imagine Congress proceeding according to the best policy evidence.

What is worse is that many other governments are in the exact same position: They are already overextended — or believe themselves to be overextended, which might matter just as much — in policy terms. Were the world to tip into a recession, Washington, Tokyo, Brussels, London, and Frankfurt together would have far less ammunition available to fight it off. So would governments in the lower-income countries. The International Monetary Fund and World Bank are very worried about this, and have repeatedly warned that governments around the world need to rebuild their “buffers” before the next one hits.

Granted, these remain remote concerns at the moment, even if some forecasters have gone into a code-red state of panic about the United States economy. (Not helping, Larry.)

This market correction looks like it might just be a market correction, with the price of stocks dropping to account for a little irrational enthusiasm in the bull market and a slowdown in China. There might be few real-economy effects in the United States. (One upside of inequality? The richest 10 percent of families are feeling 85 to 90 percent of the pain of the drop in stock prices.) The jobs market keeps chugging along. Gas is cheap. Washington is not messing anything up. The Fed might delay raising interest rates on account of the market turmoil.

Still, at some point, likely in the next few years, some kind of recession will hit. It might start with rising default rates. It might start with dozens of start-ups shuttering and technology stocks declining. It might start with investors fleeing stocks for the safety of bonds, even given how expensive bonds are. It might start with Greece finally leaving the eurozone. When it starts, policy makers will know a lot more about fighting financial panics and recessions than they did in 2007. But they will have far less capacity to put those lessons to good use. That should scare you a lot more than those chyrons do.