What Will Cause the Next Recession? A Look at the 3 Most Likely Possibilities

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The economic expansion in the United States celebrated its ninth birthday last month. If it survives another year, it will be the longest on record.

But eventually something will kill it. The question is what, and when.

While it’s impossible to predict the details or timing of the next recession with any confidence, we can identify some emerging threats to the expansion — and with a bit of imagination, picture how the recession of 2020 (or 2022, or whatever year it ends up being) may unfold.

To be clear, the economy is going gangbusters right now. The nation’s G.D.P. rose at an annual rate of 4.1 percent in the second quarter, the strongest quarter of growth since 2014. But when you speak with some of the people who fret and worry about economic risks for a living, a few factors come up repeatedly.

Perhaps most worrisome, many of the culprits in ending the expansion wouldn’t necessarily arise in isolation. Rather, each one could make the others worse, meaning the next recession might have multiple causes.

So, with a bit of creative license, here are the three most plausible scenarios for the good times to end.

The Wile E. Coyote Moment

The Federal Reserve has had a relatively easy time over the last year or two. Both inflation and employment have been gradually moving toward healthy levels as the Fed has gradually raised interest rates.

The job facing the Fed and its chairman, Jerome Powell, is on the verge of getting trickier. The risk that the Fed will miscalibrate interest rate policy and cause a slowdown or a recession is rising, in part because of the timing of the tax cuts and spending increases enacted this year.

Krishna Guha, head of global policy and central bank strategy at Evercore ISI, has a term for their likely dilemma: the “train wreck 2020” scenario.

The United States economy is either at or near full employment, and inflation is already near 2 percent. With growth still strong, Mr. Guha says, the Fed may soon find itself needing to raise interest rates more aggressively to keep inflation in check.

But at the same time, mainstream macroeconomic models have the economic lift from tax cuts fading sometime between 2020 and 2022. That means the Fed could be raising interest rates to slow the economy just as tax policy is also working to slow the economy.

Both affect the economy with unpredictable lags, so it could prove hard for the Fed to set policies that can prevent both overheating in 2019 and 2020 and a downturn in 2021 and 2022.

“There is probably some kind of perfect path where the Fed could thread the needle on this,” raising rates just enough to prevent overheating but not enough to leave rates so high as to risk a recession once the impact of tax cuts fades, Mr. Guha said. “But what’s the likelihood that you’ll thread that needle? It’s not one you’d want to be betting the farm on.”

The former Federal Reserve chairman Ben Bernanke put it more colorfully at a conference in June. The stimulative benefit of the tax cut “is going to hit the economy in a big way this year and the next year,” he said. “And then in 2020, Wile E. Coyote is going to go off the cliff.”

Pop Goes the Debt Bubble

The last two recessions started with the popping of an asset bubble. In 2001 it was dot-com stocks; in 2007 it was houses and the mortgage securities backed by them.

So it makes sense to look to various markets that might be getting bubbly in dangerous ways. And that search leads quickly to debt markets, both in the United States and overseas.

Corporations have loaded up on debt over the last decade, spurred by low interest rates and the opportunity to increase returns for shareholders. The value of corporate bonds outstanding rose by $2.6 trillion in the United States between 2007 and 2017, according to data from the McKinsey Global Institute — rising to about 25 percent of G.D.P. from about 16 percent.

The rise in debt loads overseas, especially in emerging markets, is even greater, according to McKinsey’s data — as is a shift toward more debt being owed by riskier borrowers.

Essentially, businesses have been in a sweet spot for years, in which profits have gradually risen while interest rates have stayed low by historical measures. If either of those trends were to change, many companies with higher debt burdens might struggle to pay their bills and be at risk of bankruptcy.

The 2020 train wreck narrative could intersect with the corporate debt boom. If inflation were to get out of control and the Fed raised interest rates sharply, companies that can handle their debt payments at today’s low interest rates might become more strained. Moreover, with federal deficits on track to rise in the years ahead, the federal government’s borrowing needs could crowd out private borrowing, which would result in higher interest rates and even more challenges for indebted companies.

The International Monetary Fund included a warning about this run-up in global corporate debt in its most recent Global Financial Stability Report. If inflation were to rise more quickly, Tobias Adrian, an I.M.F. official, said in a news conference, it could “trigger a sudden tightening in financial conditions and a sharp fall in asset prices,” which is I.M.F.-speak for the kind of thing that can endanger economic growth.

Susan Lund, a partner at McKinsey, does not see the rise in debt as likely to cause some macroeconomic crisis, but said it could cause distress for individual companies.

“I think there will be a rise in defaults, but I’m not alarmed,” she said. “I don’t see systemic interlinkages.”

The 2007 housing downturn became a 2008 global financial crisis because mortgage-backed securities were stuffed throughout a highly leveraged global financial system. The 2000 dot-com crash became a 2001 recession because it triggered a broader pullback in corporate investment.

The question is whether the potential challenges for corporate borrowers in the years ahead can remain more isolated than in those precedents.

The Trade War Cometh

Many words have been devoted to the economic risks of the trade war with China and other trading partners.

It is relatively easy to identify individuals and companies with plenty to lose. But exports are only about 8 percent of total G.D.P. in a $20 trillion United States economy. The direct economic cost of the American tariffs on imports and retaliatory actions by other countries announced so far should be half a percent of total G.D.P. or less, hardly enough to raise recession alarm bells.

“Trade just isn’t that big,” said Eric Winograd, senior economist at AllianceBernstein. “I have a very hard time coming up with numbers that would be big enough to cause a recession based on the trade math alone.”

For the trade war to trigger a recession, then, it would need to escalate to a much larger scale than the limited tariffs on steel, aluminum, solar cells, washing machines and $34 billion in Chinese products currently covered.

Even if it were to expand to encompass hundreds of billions of dollars worth of imports, as President Trump has threatened, in order to cause a recession it would need to prompt a broader crisis of confidence.

Perhaps the economic damage will be higher in other countries that are more reliant on trade than the United States, causing a slowdown in the global economy that reduces demand for American products over and beyond what tariffs might cause.

A global slowdown could also cause huge losses in American stock and bond markets, as American companies’ revenues abroad could plummet. That means a hit to Americans’ wealth and more expensive capital for businesses. It could be the thing that triggers a popping of the corporate debt bubble.

For the trade war to cause a recession, it would probably need to do major damage to business confidence, and lead companies to hold back from capital investments because of uncertainty over the future of trade policy.

So a trade war alone might not directly cause a recession in the United States. But a trade war that causes a global economic slowdown, a market sell-off and an evaporation of business confidence certainly could.

What are the odds of that? In a recent report, Moody’s Analytics puts what it calls the “trade conflagration” scenario, which includes a late 2019 recession, at 10 percent likelihood.

More likely, the report argued, trade brinkmanship will continue until global financial markets weaken, leading to a deal that results in some of the most severe risks being taken off the table.

Each week seems to bring alternating signals of the risks of a trade war. In mid-July, President Trump floated threats to apply tariffs to all Chinese imports, which would drastically escalate the trade war. By late July, he was making more conciliatory gestures toward the European Union about striking a deal to lower tariffs across the board.

Regardless of the true odds of the three scenarios, this much we know: The seeds of the next downturn have almost certainly already been planted. The question is which of them will grow into a problem big enough to matter.

Neil Irwin is a senior economics correspondent for The Upshot. He previously wrote for The Washington Post and is the author of “The Alchemists: Three Central Bankers and a World on Fire.” @Neil_Irwin Facebook

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The Three Most Likely Recession Starters
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