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VIDEOThe Risk of Recession in 2011
And if we slip into recession and deflation, the Fed is likely to react with more quantitative easing.
The Risk of Recession
I’m on record as saying I think there’s a 50-50 chance we slip back into recession in 2011, as I think the economy will soften in the latter half of the year and a large tax increase in 2011 (from the expiring Bush tax cuts) will tip us into recession.
This wasn’t based on data, but rather on research that shows that tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. If you cut taxes by 1% of GDP, then you get as much as a 3% boost in the economy. The reverse is true for tax increases. Christina Romer, Obama's head of the Council of Economic Advisors, did the research along with her husband, so this isn’t a Republican conclusion.If the economy is growing at less than 2% by the end of the year, then a tax increase of more than 1% of GDP could and probably would be the tipping point. Add in an almost equal amount of state and local tax increases (and spending cuts) and you have the recipe for a full-blown recession -- at least the way I see it.
I was asked at my recent speech in Milan, what sorts of things could make me wrong? There are a few. First, it could be that tax increases and cuts don't matter. Some very smart people (like Paul McCulley) feel that tax increases on the wealthy don't really figure into Romer's analysis.
Or maybe bank-lending starts to pick up and the economy is actually growing at 3-4% by the end of the year -- although the chart below suggests that bank-lending is still in freefall. Notice that if this trend continues just a little while longer, bank-lending will have fallen by 25% in about two years. This is a truly scary chart. It’s unprecedented in modern history. Also notice that after the 2001 recession, bank-lending continued to fall for over two and a half years.
Or perhaps Congress decides to extend the Bush tax cuts or phases in the increase over time. That would be better and maybe not push us into recession. Maybe they vote for more stimulus, although that doesn’t look likely. If Congress cannot extend unemployment benefits, as happened this week, then other stimulus is unlikely.
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