Those Predicting a ‘Fed-Induced Recession’ Misunderstand the Meaning of Recession

“You’re joking? How big is your fund?” Those questions were posed by a top Lehman Brothers investment banker in the early 2000s. He was on the phone with a top Australian investment banker; albeit at an investment bank that didn’t presently factor in finance’s center of the universe: New York City.

Though the Aussie financier worked at his country’s most prominent investment bank, though he understood private equity financing in a particular way not yet grasped by experts in the U.S., his expressed desire that his largely unknown (in the U.S.) firm play a major role in a pending infrastructure deal was met with ridicule. He was told, “Let me be clear. We would never partner with you. And we would never hire you.”

What the Lehman executive missed was that “the Aussies were there out of desperation.” That’s how Sachin Khajuria described it in his excellent new book, Two and Twenty. The Aussies (one assumes the bank was Macquarie) had to figure out a way to get into private equity and the financing of countless lucrative American deals. And they ultimately did.

It turns out the Aussies understood infrastructure finance much better than did Americans. While American private equity moguls were offering expensive, equity-financing of highways, turnpikes and other major infrastructure, the Aussies viewed infrastructure as the personification of reliable income streams that would enable much cheaper debt financing. Their desperation to break into lucrative deal finance forced them to think differently, only for them to succeed.

Why this digression in a piece about the Fed? It’s useful as a way of reminding readers that contrary to the popular narrative about the Fed as the pipe through which finance flows in little or large amounts, the reality is that the Fed and its fiddling with short loan rates is a non-factor. Precisely because credit is produced globally, and precisely because it flows around the world without regard to borders, there’s no way for the central bank to control how much credit finds its way to the U.S., nor can the Fed control its cost.

Keep this in mind as economists and their media enablers promote the laughable notion that a “tight” Fed will “inevitably” induce a “recession.” Oh please, the view is not even remotely serious. See above. It’s not just that investors want to find their way into the U.S., they’re desperate to win market share here. It’s a simple way of saying that even if the Fed could shrink bank credit access stateside with artificially high rates of interest, what it would allegedly take away would be made up for in seconds by much, much bigger non-bank pools of capital in the U.S., along with global providers of same.

John Greenwood and Steve Hanke, two economists who at least in the past leaned non-interventionist, wrote recently in the Wall Street Journal that “in its panic to raise rates and begin quantitative tightening, the Fed has, in the three months before June, allowed M2 growth to plunge to an anemic annualized growth rate of 0.1%.” By their reasoning, the Fed is inducing a recession. No, such a view isn’t serious. It’s not simply because dollars circulate globally, and they’re directed to their highest use. Given the intense desire among financiers to have exposure to the U.S., there’s no way the Fed could keep “money” out of the U.S. given its relentless flows without regard to border. It staggers the mind that two serious economists could believe that the Fed not only “permits” economic growth, but also apparently plans it.

After which, the economists’ definition of “recession” is wholly flawed. The inconvenient truth is that governments can’t cause recessions given the more important truth that actual recessions paradoxically signal economic recovery. What governments cause is economic slowdowns born of barriers to production. The difference between the two is Pacific Ocean wide. For certain governments can currency devalue, tax, regulate, or tariff economies into slowdown, but that’s command-and-control. Recessions are something quite different.

Indeed, it cannot be stressed enough that the seeds of actual recession are planted during the good times, while the seeds of recovery are planted during the bad. Translated for those who need it, during good times some of us develop bad habits, make lousy hires, commit capital less carefully, and all manner of other things inimical to progress. It’s during recessions that we fix what we were doing wrong.

Equally important, not every individual or business develops bad habits, makes lousy hires, commits capital less carefully, and all manner of other things inimical to progress during the good times. Translated for those who need it, real recessions lay the seeds of powerful economic expansion given the basic truth that the prudent go on buying sprees during downturns. That’s when they can acquire human, physical, and financial capital on the relative cheap.

All of which explains why real recessions could never be engineered by central banks simply because central banks could never plan the release of crucial assets into the hands of better managers, nor could central banks plan the natural and healthy process whereby the individuals who comprise what we call an “economy” fix what they’ve been doing wrong.

At present, economists and their media enablers are claiming the Fed must “tighten” credit and induce a “recession” to stop inflation. It’s the discredited Phillips Curve wrapped in a non sequitur. It’s an embarrassment of foolishness. Not only is the Fed incapable of making credit more expensive, the latter wouldn’t cure inflation even if the Fed could do what it can’t. Arresting inflation is the stabilization of the currency, which is not now nor has it ever been part of the Fed’s portfolio.

Economic growth doesn’t cause inflation, nor does contraction cure it. And whatever the Fed does, it can’t induce a recession. For the credentialed and their enablers to claim it can is for them to wear garishly on their sleeves an impressive misunderstanding of not just inflation, but recessions themselves.