The time to prepare for the next recession is now

The Republican-controlled Senate has accomplished what it wished with a one sided tax giveaway to corporations and the super-rich—it has no interest in a legislative agenda left. Yet, while the economy continues to grow, there are sharp warning signs because of the exacerbation of income inequality in the United States that threaten the expansion’s sustainability. These yellow flags point to an economy that has little resiliency and so is very vulnerable to shocks.

Now is the time to create legislative markers, set legislative records and flesh out details of fixes that could be quickly passed should the political dynamics change in 2020. I would argue that, in this climate, it is necessary to triage such efforts, so as not to detract from other important legislative markers that must be passed by the Democratic controlled House of Representatives, so that in 2020 a clear set of programs is also ready to address ever-expanding inequality.

The urgency comes after the historic 2007-2009 downturn showed just how much the divide between Democrats and Republicans turned economic misfortune into a game of political opportunity. Americans found out it was a lie when they had repeatedly been told that Social Security privatization was a fine idea because if the stock market tanked, home prices dove and jobs disappeared Congress would respond to the needs of ordinary Americans. Instead, no consensus could be reached on policies to help workers. Income relief, to compensate for lost job opportunities, lost retirement savings, or devalued housing assets, became political fodder for a larger ideological battle aimed at narrow political victories.

The other problem we face is that the 2008 downturn was likely unique in its size. Because of the size of the housing market, a financial crisis rooted in the decline of the primary household asset is not likely to re-occur. Consequently, the economy is more likely to face a downturn the size of the one that took place in 2001. It should be noted, however, that the downturn in 2001 was accompanied by a huge tax cut, initially targeted at the wealthy, but balanced by a Democratic-controlled Senate to also benefit middle-income households for its initial years.

Still, with the tail winds of easing monetary policy following the stock market bubble burst from the dotcom calamity and the economic malaise following September 11 and the huge stimulus of a large tax cut, and a deficit propelled by massive expenditures for the Iraq War, it still took until March 2007 to get payroll numbers back up to their February 2001 level. So, if an unprecedented job loss in 2008-2009 could not generate a consensus to address a downturn, there is little chance a milder downturn will generate better behaviors.

Clearly, many things could go into a stimulus package. But there were two important countercyclical components of the economy that will not be present in force as needed in the next downturn; these must be prioritized now, so that in the event of a downturn they can be quickly put in place.

First, one of the key elements of preventing 2001 and 2009 from being worse was the role of the unemployment insurance system. Gratefully, it is an element of the Social Security Act and the New Deal that centrist Democrats did not give away. By replacing lost earnings without relying on passing new legislation, it helps put the brakes on a downward spiral in aggregate demand and jobs. But, the system passed in 1935 relied on state based models of unemployment benefits aimed at smoothing hiring by companies cursed by inventory cycle booms and busts in employment. Those systems built in penalties for companies that made a business model of pushing too much of the risk of inventory management on workers, making their wage bills too variable and making all cost adjustments during downturns on cutting employment.

Advances in management and information systems since the 1990s make the old inventory business cycle an unlikely event. Firms have too much information to build up unsold items forcing massive layoffs. Today, downturns are more likely the result of macroeconomic shocks, many coming from the financial sector. These are larger than inventory shocks, and are bigger than a state-based program can address.

Because the system requires each state to raise its own unemployment insurance trust fund to pay out benefits defined by the state, the unemployment insurance system has another deficiency in that it makes states want to compete on lower unemployment insurance tax rates. That is a further disincentive for states to build a robust program with adequate benefit levels to address macroeconomic downturns.

When states fail to have adequate trust funds during a downturn, they must turn to the federal government and borrow to replenish their trust funds. But those debts must be repaid to the federal government, which the last two downturns has meant states raised taxes—or tried to find ways to cut benefits—long before the labor market has returned to full health. Consequently, an unemployment insurance system that starts out being a strong countercyclical tool suddenly becomes pro-cyclical.

To address the latter difficulty with the trust funds, Congress has stepped in to offer federally funded extended unemployment benefits and offer temporary relief to the indebted state trust funds. However, this necessary step again requires political consensus. And, in the Great Recession, Republicans refused to make the necessary adjustments last through the full labor market cycle, so the unemployment insurance system shrank too early.

During the 1980s recessions, state unemployment trust funds went through a similar debacle. The result was increased competition to rebuild state trust funds through a race to the bottom in terms of benefit levels and access to unemployment benefits. The weaker unemployment system made the economy more vulnerable to both the recessions of the late 1980s and in 2001. A primary tool of limiting access were punitive earnings tests, which made it hard for low wage workers and part-time workers to access unemployment benefits. An attempt during the Great Recession to encourage states to “modernize” their unemployment systems by removing punitive measures that blocked access to benefits did encourage some states to improve access. But, several states that took steps forward, quickly took those steps back.

Another glaring issue with the state-based unemployment insurance system is that, while it is within the Social Security Act, its benefit levels are state based and divorced from the benefit levels of workers who receive federally set benefits under the Old Age, Survivors and Disability Insurance provisions of the Act. During a downturn, this has added complications. While workers may move from away from the state where they filed their unemployment insurance claim, they face bureaucratic issues in collecting benefits if they move to another state to look for employment. And, one of those barriers is that the benefit levels across states make some benefits wholly inadequate in other states. For instance, the average weekly unemployment benefit in Tennessee was $144.19 in the 3rd Quarter of 2018. If spring flooding of the Mississippi destroys jobs in Memphis, a worker seeking to relocate to a booming job market in other parts of the country would face a huge financial struggle.

The other problem is that Disability Insurance, under the OASDI program of Social Security, is tied to a workers lifetime earnings and to the OASDI benefit formula. That formula is very progressive to low-income workers. Unemployment Insurance benefits are tied to a shorter work history, and typically have a very low replacement rate. For instance, in Tennessee, the average weekly benefit is just 15.4 percent of the average weekly wage. For that reason, during economic downturns, the share of workers who seek DI benefits goes up. A prospect of long-term unemployment becomes impossible with unemployment benefits. In addition, workers on DI automatically are eligible for Medicare, so it further addresses health insurance issues, especially for workers with poor health. Because DI benefits are federal, a worker faces little difficulty in moving about from state to state, with a fully portable income and health insurance benefit.

The solution is obvious. The state-based unemployment insurance system does not work in the long run, and in the short run of a business cycle downturn, it is only a second best to a federally instituted automatic stabilizer. In the next downturn, we will face a system where the maximum duration of unemployment benefits has fallen below 26 weeks, and where replacement levels have shrunk and the share of unemployed workers getting benefits has slipped to inadequate levels.

Now is the time to transform the unemployment insurance system to a federal program with benefit levels set using the DI formula of the OASDI program and setting durations for unemployment benefits to macroeconomic triggers tied to beginning and full recovery of the labor market. Current state unemployment trust funds would be bought out, giving states with positive balances money that could be directed to job placement and matching and total debt relief to those states with negative balances.

The state unemployment insurance tax rates are surprisingly low, and cap at very low levels of earnings. So, transforming the system to a federal system could be down mostly through raising the cap on earnings on which unemployment insurance taxes are collected. Making the benefits equal to DI benefits, setting the unemployment insurance earnings cap equal to the Social Security tax ceiling would be more than sufficient to pay for implementing a new federal plan. Oddly, the current cap makes employment taxes higher for employers of low wage workers than high wage workers. In part, that is justified because of higher turnover among low wage workers, and so the greater use of the program by low wage employers than high wage employers. But, the higher employment tax also means that during the recovery from a downturn, there is a higher cost to hiring a low wage than a high wage workers.

The other adjustment to unemployment benefits has to be the ability to authorize employers and their workers to negotiate short work hours. That would allow firms rather than adjusting for weaker demand by firing, or laying off workers, to reduce their hours instead. Germany adopted such an approach and its unemployment rate peaked at a much lower level than the 10 percent level reached in the United States. This is the other great lesson of the Great Recession. In manufacturing, in particular, firms overreacted by cutting workers. A large part of the rebound in manufacturing employment came from firms trying to quickly adjust back to “normal.” But many firms lost out because they could not easily re-employ their laid off workers, who had scattered or left the labor force.

State and local governments had historically been a secondary but important source of economic stability in all past downturns. Because a higher share of state and local revenue comes from property taxes, and often downturns are short enough for two or three quarters of falling aggregate income to get fully reflected in big drops in fiscal year tax receipts, state and local governments have not cut public expenditures or investment during downturns. They have especially not cut employment.

This stability in public investment is vital because so much of the nation’s public investment is at the state and local level. Important projects like education, overwhelmingly a state and local function, continue apace through business cycles. Other important investments in maintaining streets, water and sewage systems and public safety are also ongoing.

The Great Recession taught a very important lesson, however. State and local revenues are now very volatile. There is no insurance for state and local revenue streams. So, even after state and local revenues recovered to their pre-Great Recession peak levels, state and local governments did not return to making the necessary increases to return public investment to its pre-Great Recession levels. Instead, state and local governments practiced their own harsh austerity programs. The consequences, especially in education have been far reaching and devastating.

Massive cuts in state support for higher education has transformed even our public universities into money driven enterprises. The result has been devastating to a goal of social mobility they once fulfilled. An embarrassing number of public universities have more students from the top 1 percent of the income distribution than the bottom 40 percent. Further, withdrawal of state support is correlated with, especially the top public research universities, increasing enrollment of foreign students and decreasing their share of low-income, especially Black and Latino students.

Public universities also attempted to make up for revenue shortfalls by raising tuition costs. At poorly resourced schools, with insufficient alumni giving or endowments, this has put a rising burden on students to fund their schooling through debt. The consequence has been a skyrocketing in student debt. And, this has deep racial justice issues because of the low level of wealth in the Black and Latino communities. Further, because poor Black students are significantly more likely to pursue higher education than other groups, 60 percent of Black first-time undergraduate students come from families where their families maximum expected contribution to their college education is $0. So, it is no surprise that this rapid change in public policy resulted in a huge debt burden in the Black community.

At the local education level, austerity was reflected in rising classroom sizes for teachers and the shuttering of school doors. It has also meant a tremendous loss in income for teachers relative to other college-educated workers. The lack of investment was so severe in many school districts that it included rising deferred maintenance. Thus, it is no surprise teachers in places like West Virginia and Oklahoma were forced into the streets to protest conditions that made a mockery of public “education.”

The financial collapse put public pension funds at great risk. As in the 2001 dotcom bust, the assets of public pension funds collapsed. This created great mischief for those who had it in for workers, to attack the pension funds, rather than a reckless Wall Street. State and local governments were pressured to either divert revenue to shore up the pension funds or to gut the funds and turn the plans into profit centers for Wall Street brokers by converting the pensions to defined contribution plans. At the same time, the cash flow of the funds were further stressed by austerity budgets that shrank public sector employment and so in flow of cash into the pension funds. The unprecedented loss of state and local employment exacerbated job losses during the Great Recession. And, state and local employment has yet to recover. Yet, we know that needs for state and local services have not diminished.

Looking ahead, we must ensure the existence of a robust revenue insurance for state and local government. Austerity, state governments’ attempts at discipline and self-insurance, does not lead to the continued investment needed for sustained economic growth and development of the nation. The insurance will reward those states that make investments that help our nation grow. The current system punishes states and local governments that invest.

Economic downturns are the result of national macroeconomic policy failures. When we wake up, we still expect street lights to turn on, first responders to be on the ready in case of natural disaster and teachers to be in our children’s classrooms. So, this is an extension of the type of security envisioned by the Social Security Act, to relieve individuals of bearing the burden when the unexpected happens. The affluent can simply flee to the safe harbor of suburban enclaves, or areas of the nation that weathered the economic storms better. But, those left behind are left with no way out; whether it is a lead poisoned water system in Flint or a bankrupt Stockton.

How do we pay for the revenue insurance? The costs to the system come from financial risks that have externalities. So, we must turn to the financial sector to internalize this risk. A financial transaction tax would both provide the revenue to meet the cost of cleaning up the economic fallout of financial errors, and a more secure way to insure that all financial transactions can be monitored to adequately assess risk within the system.

If these two issues—unemployment insurance and the stability of state and local government investment—can be addressed the next downturn, though mild, will be a lot milder. If these two are not fixed, the next downturn, even though mild in loss of GDP, will be sever in the labor market and in lowering long run potential GDP.

The economy cannot return to full health without addressing the issues that inequality now presents us with: inadequate educational attainment, poor health and inadequate housing investment. Proposals must be put in place to raise wages, because the current extreme level of inequality cannot be addressed through taxes and transfers alone. Restoring access to higher education at the levels our nation will need to sustain economic growth, and insuring all Americans health and the building of adequate affordable housing will take massive public investment, and thus bold legislation. Those are heavy tasks. They limit what time can be devoted to a downturn. That’s why the time to focus on substantial, well-understood countercyclical programs is now—not when the next downturn is already here.