How will we respond to the next recession: Bail out the financial sector or the American people?

There seems to be consensus among experts that the next economic downturn is looming in the horizon. Though they can’t predict the exact time of the crisis, they agree on the red flags and their magnitude. Some of the red flags include high levels of corporate debt, economic slowdown in China, U.S trade tensions with China, a potential round of Italian debt crisis, a hard Brexit, a housing price crash (deflation) in Australia and Canada, highly indebted emerging markets which could be hit by capital repatriations, and unsustainable public debt (some of which dollar denominated) in developing countries which could collectively add fuel to the weakening global economy.

The ingredients of a crisis seem to be present, i.e., the combination of leverage (the ratio of a company's loan capital (debt) to the value of its common stock (equity), and a misguided belief in liquidity, i.e., the degree to which an asset or security can be quickly bought or sold in the market ( translated into cash) without affecting the asset's price. Global debt has reached an all-time high of $184 trillion in nominal terms, the equivalent of 225 percent of GDP in 2017. On average, the world’s debt now exceeds $86,000 in per capita terms, which is more than 2½ times the average income per-capita ( IMF). Whether the global economy will experience a downturn that could amount to a financial or a debt crisis is not the question, but whether the current political situation around the world will allow a sound crisis management is the worry of most experts.

The rise of nationalism and the weakening of international cooperation and coordination will make it difficult for the Federal Reserve to rescue European banks through Feb ‘swaps’ like it did during the last recession. Highly polarized domestic politics will also less likely allow the government to bailout out the banks and non-bank financial institutions (which hold two-thirds of all credit-markets)-AND RIGHTLY SO; and U.S unfunded tax cuts will leave little room for U.S fiscal policy response. When there’s a problem that needs international cooperation to solve, and, at home, the U.S Congress is in a dreadlock, the postponement of the problem will make the problem even worse. But the most problematic fact is the limitation of monetary policy to respond to the next crisis. With global interest rates this low (2.5% in the US, and 0% in the Euro Zone), and the confluence of risks in systematically important countries, advanced economies have no room for quantitative easing to stimulate the economy (borrowing and consumption)

What should the proper response be? Helicopter money? Debt restructuring or forgiveness?

The impact of the next economic crisis on the middle and low income earners could be devastating. A decade after the great recession, most are struggling to recover. Household income, adjusted for inflation, for the wealthiest 5% of Americans has increased while it barely budged for the median family, and decreased for the bottom 10%. Although Structural issues that caused inequality started way before 2008, the response to the financial crisis exacerbated the income and wealth gap, and made the recovery slow and unequal. Taxpayers bailed out the rich (with lower propensity to spend) instead of the middle and low classes that are the true engine of growth, in a quasi-trickledown scheme.

On Tuesday February 12, the New York Fed reported that household debt rose to $13.5 trillion in the fourth quarter, i.e., 7% higher than its previous peak of $12.68 trillion in the third quarter of 2008. Credit grew in all other areas except for mortgage balance that flattened. But the most worrisome trend was the number of Americans delinquent on student and auto loans.

Student loans have seen almost 157 percent in cumulative growth over the last 11 years. Undergraduate student interest on subsidized and unsubsidized loans rose 5% last year, the highest since 2009, and graduate and professional degree student interest rate increased to 6.6% according to the U.S Department of education.

Student debt has delayed household formation and led to a decline in homeownership. Sixteen percent of young workers aged 25 to 35 lived with their parents in 2017, up 4 percent from 10 years prior, shows Bloomberg Intelligence. As Powell testified before the Senate Banking Committee, he stated “You do stand to see longer-term negative effects on people who can’t pay off their student loans. It hurts their credit rating; it impacts the entire half of their economic life. As this goes on, and as student loans continue to grow and become larger and larger, then it absolutely could hold back growth.”

Given the financial distress that many Americans still experience, the response to the next economic downturn should include some form of helicopter money (giving money directly to people to boost consumption), and debt restructuring, and/or even forgiveness. The middle class should not bear the burden of another crisis while the financial elite gets bailed out. Any intervention to the deleveraging that hurts the middle and low income earners while enriching the wealthy (that have benefited from financial crises in the past) could lead to a serious political crisis.  Since austerity (cutting spending) is not an option the government should consider, one option could be printing money to buy government bonds but since only a few (mostly) wealthy Americans own financial assets, this response will not put money in the pockets of those will the highest propensity to spend (middle and low classes). The safest option which won’t hurt the people who are already struggling will be the Feb to print money, and lend it to the government which will spend it on unemployment benefits and other goods and services to stimulate spending (with the only consequence of increasing the deficit, and debt). Increasing taxes on the wealthiest Americans could also be another way for the government to find money to spend and stimulate the economy, if it doesn’t face backlash from the right.