The US and Europe stand on the brink of possible recession that will bring job loss and misery. Even if a downturn is narrowly avoided, high inflation and falling asset values have already destroyed wealth and made everyone poorer.
Pandemics happen, and so do market downturns. But some of the pain the world faces today stems from policymakers' attempts to avoid economic loss in the first place. For the past decade, central banks and governments pursued policies that aimed to eliminate downside risk and ensure stable, predictable growth. But that's impossible. The next recession should remind us that better policies cultivate resilience to economic setbacks in institutions and individuals instead of trying to avoid loss entirely.
The fallacy that stable, predictable growth is possible isn't new. Politicians like to promise it, and it's human nature to delude ourselves into believing we can get something for nothing—growth without the risk of loss. Even smart people fall for financial scammers like Bernie Madoff. But recently the belief that economies can grow without risk became more pervasive and began to guide our policies. Much like in a financial scam, this blind faith won't end well.
Economic growth and destruction go together the same way bullish and bearish financial markets do. Risk is what propels markets and the real economy. The innovation that's necessary to improve lives and make us wealthier is inherently risky. Entire industries shrink or disappear, some people lose jobs, and some make the wrong bets and lose money.
The 2008 financial crisis appeared to be a failure of a capitalist system that embraced freer, less-regulated markets. It destroyed significant wealth, and the deep recession that followed hurt many of the poorest people. It led some to question capitalism altogether. Shortly after the financial crisis, I attended a meeting in Paris at the Organization for Economic Cooperation and Development (OECD) where a division chief announced that the crisis and global recession proved that a culture of growth based on risk was the wrong approach. But there is no free lunch. Less risk also means less growth, and no one at the meeting was willing to acknowledge that hard truth.
To be fair, not everyone experienced downside risk equally during the financial crisis. Banks got bailed out, and they went back to paying high salaries to some of the very people who'd messed up. Saving the financial system was necessary, but policymakers never grappled with the righteous anger those bailouts provoked. Instead, the thinking shifted that next time, everyone should be bailed out.
Our disillusionment with unfettered capitalism coincided with the rise of the Chinese economy. At the time, even famous capitalists and globalists speculated that the Chinese had the superior economic and political model. And in the depths of the Great Recession, that was easy to believe. Under the firm grip of the Chinese Communist Party (CCP), the economy grew quickly and steadily from 1992 to 2019. If you accept Chinese statistics at face value, gross domestic product growth barely dipped below 6% in almost 30 years. It looked much better than the 2% to 3% growth—and a few recessions—in the US and Europe. And this was no accident. The CCP did all it could to keep growth high. If there was trouble in the Chinese housing market because too many apartments were built that no one wanted, the government cleared slums and put people in the new, empty homes. If demand for exports fell, the currency could be manipulated. If prices for commodities fell, the government would buy them. Money and people were directed to the most promising industries, and they were propped up, too.
The economic success of China added to the illusion that if we just pick the right policies, we can have growth that is predictable and stable. (China's Covid-zero strategy reflected a similar government belief that Beijing can remove downside risk.)
Western countries never fully embraced the Chinese model. But since the financial crisis, there's been a shift toward being more aggressive in trying to remove risk from the economy.
Central banks became more involved in the economy. History tells us monetary policy doesn't have much impact on the real economy, but when done well, it can make it less volatile. A central bank can't prevent recessions but can make them less severe. It can't ensure everyone has a job, but it can limit unemployment in a recession.
After the financial crisis, the Federal Reserve expanded its mission. Quantitative easing was supposed to be an emergency measure, only used in severe recessions, but since 2008 the Fed has been easing during 8 of the past 14 years. The Fed also kept its policy rate below neutral (at or below zero after accounting for inflation), with the exception of just a few months, for more than a decade—long after the recession passed. Instead of just softening the edges of a risky economy, it was trying to keep it growing at all costs.
In late August 2020, in the wake of the racial justice protests that seized national attention, the Fed changed its objective. It would now target maximum inclusive employment and tolerate inflation rising above its 2% target to reach this goal, instead of just balancing maximum employment (normally defined as the employment level that doesn't overheat the economy) with maintaining stable target inflation. Discrimination is a scourge on the economy, but the Fed doesn't have the tools to eliminate it. (This is better addressed through fiscal and legal policy.) Nor does it have the power to reduce unemployment caused by structural issues such as mismatches in skills and geography. The slow recovery that followed 2008 is often interpreted as proof that the government should have done more. But the problem may not be that fiscal stimulus was too small, or that monetary policy wasn't accommodative enough—instead it could be that there was only so much that these policies can do.
Fiscal policy also became more active. The US government has created more tariffs and subsidies to shelter companies and industries from the vagaries of trade. The welfare state no longer just helps people down on their luck when something bad happens; it now shields even the middle and upper-middle class from financial setbacks. During the pandemic, the US paid out three rounds of stimulus. The first two were justified: Many people were out of work and needed support. But the 2021 package was three times the size of the GDP shortfall—and the economy was already recovering. Instead of just smoothing over the drop in economic activity, the American Rescue Plan attempted to give everyone a pay-out for their trouble, too. In some parts of the country, unemployed people were paid more than they would've earned working (with extra unemployment benefits). And we provided funds to people with jobs whether they needed it or not, in the form of stimulus payments and child tax credits that went to almost everyone, even higher earners.
Reducing risk in the economy is a noble goal. Governments and central banks have the ability to cushion severe downside risk, protect the most vulnerable from extreme hardship, and regulate risky behaviour that causes harm to others. But there is a big difference between risk reduction and near-elimination. That's the hard truth in financial markets and in the real economy. Growth and risk are tied together—it's a law as firm as gravity. If you try to remove risk from the economy, at best you end up with stagnation; at worst, you create distortions in the financial system that bring even worse recessions.
It does no one any favours to remove risk from their life. It's better to accept that downturns happen, that sometimes wealth is lost, and then help people become more resilient during the setbacks the economy throws at them. This involves more modest monetary policy and a safety net that provides insurance against the very worst shocks, protecting the most vulnerable, but otherwise allowing for failure. Attempts at risk elimination make people less resilient. Promising households and the private sector that they'll always be bailed out encourages more debt—and less resilience to shocks. One study estimates that stimulus payments didn't meaningfully improve economic well-being; they may have even increased financial stress.
Risk also plays an important role in prices, which makes markets more robust. The risk associated with new ventures determines what entrepreneurs pay for capital. Accurate risk pricing creates market discipline, giving investors valuable information about what ventures are worth funding. When we take away risk, this information is less meaningful, and markets are more prone to destructive bubbles.
The Chinese economy is showing signs of strain from its no-risk economic strategy. Years of directing capital to favoured industries such as real estate caused bubbles, and now there's too much housing no one wants. The Chinese government can only move people out of slums so many times. Real estate developers are defaulting and threatening middle-class savers' money in the process. Meanwhile, the Covid-zero policy revealed to the world that China may not be a reliable trading partner.
The real test of any economic regime is how well it can produce sustainable growth, which comes from innovation. That means some ideas and investments fail, and some industries are disrupted. China was able to grow for so long because it was able to put many people to work and import existing technology from abroad. But it can't grow that way forever, especially as its population ages. China has yet to prove it can produce the innovation required to sustain its growth. Taking risk out of the economy–and constraining access to capital to companies the government deems too risky or subversive isn't a good sign.
Too much risk suppression has also caused problems in the West. Years of sub-zero real interest rates led to ballooning corporate debt and more investment in risky assets such as cryptocurrencies and opaque private equity. The desire to give everyone multiple checks while keeping rates low contributed to inflation, and now a worse recession may be in our future.
A recession may be inevitable, despite our best efforts to build a no-risk economy. And next time it could be worse. If we run up too much debt to give people and corporations money so they never experience downside risk, eventually interest rates rise, and it might be harder to support families when they really need help. Inflation and enormous debt levels are the immediate costs of our attempts to eliminate risk. The second-order effects may be felt in time with a recession and less fiscal space in the future.
If the 2008 financial crisis spelled the end of neoliberal economic policies that embraced markets and the risk that comes with them, the re-emergence of inflation and the buckling of the Chinese economy should put an end to the fallacy that policymakers can remove risk from the economy. Policies should instead focus on building resilience to future shocks by strengthening the social safety net to help the neediest.
We need to accept that downturns are the price of growth—companies fail, and markets go up and down—and stop trying to keep the economy booming at all times.
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.
