First, we have to remember that recessions aren’t something that just happens (like global warming :)). Recessions are caused by one of two things: either the Fed brings them on as a result of raising interest rates to combat inflation or a bubble bursts throwing the economy into a recession.
Taking these in turn, if the Fed were raising interest rates in response to actual inflation (and not the creative imagination of FOMC members) then we would presumably be looking at a higher interest rate structure throughout the economy. In that case, the Fed should then have more or less as much room to maneuver as it has in prior recessions.
The bubble story could be bad news, but it is important to think a bit about what a bubble bursting recession means. There has been a serious effort in many circles to treat bubbles as really sneaky creatures. They just pop up when no one is looking and then they burst and sink the economy.
That is a convenient view for all the people who were in positions of responsibility in the housing bubble years and ignored the threat the bubble posed to the economy. But the reality is that the housing bubble was easy to see for anyone with their eyes open. We saw an unprecedented run up in house prices with no increase in real rents at all. Vacancy rates were hitting record highs even before the bubble burst.
And the deterioration in loan quality was hardly a secret. The business press was full of stories about “NINJA” loans, which stood for no-income, no job, no assets.
And most importantly it was evident the bubble was moving the economy. If a bubble in the barley or platinum markets burst, it’s no big deal unless you happen to be employed or run a business in these sectors. But the housing bubble had pushed residential construction to a post-war high as a share of GDP at a time when a flood of retiring baby boomers might have suggested it would be unusually low.
Similarly, the $8 trillion in housing equity created by the bubble led to a surge in consumption as people spent based on their newly created housing equity. This also was hardly a secret; Greenspan even co-authored a paper on it.
In short, the bubble was easy to see and it was entirely predictable that its collapse would lead to a serious downturn. There was no easy mechanism for replacing the lost demand from residential construction and plunging consumption that were certain outcomes from a collapse. The same is true of the stock bubble — the surge in bubble driven investment and the boom in stock wealth driven consumption were both easy to see in the data at the time.
The point is that missing a bubble that endangers the health of the economy requires an extraordinary degree of incompetence from the Fed. Greenspan demonstrated this level of incompetence twice. I don’t think the Yellen Fed is likely to make the same mistake. (In other words, there is evidence of intelligent life at the Fed.)
The other main reason I am not as pessimistic as Bernstein and Krugman is that I don’t accept that fiscal policy is off-limits. The key point is that Republicans don’t really give a damn about deficits; they just hate to see money going to someone who is not rich.
Suppose that the economy plunges into a recession during Hillary Clinton’s first term. Of course the Republicans will do their deficit hysteria routine if she proposes counter-cyclical infrastructure spending, jobs programs, revenue sharing, etc.
But suppose Clinton suggests some tax cuts for rich people. Saying tax cuts for rich people in front of Republicans is like waving an ice cream cone in front of a little kid. They can’t resist it. Republicans will inevitably want nothing but tax cuts for rich people and they will want them to be permanent. But at the end of the day, being good politicians, they will accept some counter-cyclical spending and settle for less than permanent tax cuts.
In short, there is a clear path toward counter-cyclical fiscal policy. It may not be pretty, but it sure beats a deep and prolonged downturn.