Mark Zandi: The Economy Is Sending a Warning

The unemployment rate in the US rises by more than half a percentage point from the low in a 12-month period, you get recession. That didn't work a couple, three years ago. And so I created a new index that's a takeoff on that. So, not only account for unemployment, which we all get, but also for how many people are in the labor force coming and going. And if you do that, it's signaling recession. But I've been doing this for 35 years, and there's only a few other times in history where I've been as unsure about things.

Never in the 35 years has there ever been a time when all of the measures are screaming, you know, we got a problem. The war itself has already cost about $150 billion to the American economy. The point is that we're issuing a lot of debt.

You know, the one thing that makes me nervous is the US Treasury bond market. I think it's almost inevitable we're going to see a crisis generated by higher interest rates. And I really worry about it because I can't tell you exactly how, when, and how it manifests. And it's very vulnerable. Well, if you get into a scenario like that, then you got a problem.

Uh, it's growing. It's, uh, you know, economists look at, uh, something called GDP, gross domestic product. That's the value of all the things that we produce. It's kind of like the benchmark for how the economy is doing globally. That's growing 2.5% year-over-year. That, you know, that's okay. Uh, not bad. Actually, in some sense, it's surprisingly good given all the stuff that's going on out there. You know, the Iran war and everything else. Uh, you know, the economy has been amazingly resilient.

Uh, but two and a half percent, I'll take it. I wish it was a little bit better. It's not quite what we need to absorb all the folks out there looking for work. So, you know, the job market's a little bit on the soft side, but, you know, in the grand historical scheme of things, it's okay. You know, it's hanging in there.

Uh, I don't think so. You know, that VCI, Vicious Cycle Index, it's, um, a way for me to learn AI, right? Uh, you know, it's my vibe coding.

And there's this regularity in the US where it's called the Sahm rule. There's a very good economist, Claudia Sahm, who was at the Federal Reserve, and she observed that, you know, if the unemployment rate in the US rises by more than half a percentage point from the low in a 12-month period, you get recession. That particular indicator didn't work a couple, three years ago. And so I created a new index that's a takeoff on that, that just accounted for the impact of labor force participation. So it not only accounts for unemployment, which we all get, but also for how many people are in the labor force coming and going. And if you do that, the indicator predicted also the fact that it got it right when the Sahm rule got it wrong. So it's kind of cool in that way, but right now it's signaling recession, but, you know, I'm not sure I believe it. There's, as I said, the economy is doing okay. We're kind of navigating through. I think there's a lot of risks out there, a lot of threats. We could potentially go into recession, but, you know, if you said to me, Mark, today as of right now, is the US economy in recession? I'd probably say no. And that would be the first time the VCI got it wrong. But, you know, maybe the VCI is more predictive than I think, and it turns out to be right.

Uh, just one other point about the VCI which you might find interesting. Uh, I call it the Vicious Cycle Index because the intuition behind this indicator and also the Sahm rule is that when unemployment starts to rise in a meaningful way in a short period of time, you know, people see that, they feel it. You know, they can't get hired, they start to lose their job, they can't get back into work, they get their pay cut. So they get very nervous. They grow more cautious in their spending and may even cut back on their spending, which causes more problems in the job market. Businesses start to lay off more. You get into this kind of self-reinforcing vicious cycle. Thus the Vicious Cycle Index. And I came by myself without Claude. I came up with that name. What do you think of that?

Absolutely. But I suspect that it's not getting this period exactly right, but, you know, we'll see. Time will tell.

No, I use AI to build the, you know, to do the name. You come up with the name, do the arithmetic and all that kind of stuff, but the VCI, the name, that's me, that's human. [laughter]

Uh, it matters. I mean, the US is a big economy. I mean, going back to GDP, the value of all the things that we produce, the US accounts for, you know, at least 20, maybe as much as 25% of the global GDP. Just for context, China, which is second, is probably 15% of GDP. I'm making these numbers up, you can check it with, you know, Claude or ChatGPT, but, you know, rough order of magnitude.

And the US does a lot of trade with the rest of the world, you know, including Australia, and we run a large trade deficit. So we buy a lot more stuff from overseas than we sell overseas. So if our economy is struggling, if we're not out there buying things, if consumers aren't doing their thing, you know, that affects businesses all around the world. And also it has impacts financially. You know, if the US economy is not doing well, if it's in recession, the US stock market is probably down, taking it on the chin. And the US stock market drives a lot of stock markets around the world. You can see that right now on the flip of that, the US stock market's up a lot because of all the AI euphoria, and that's driving stock prices up around the world and kind of lifting, you know, the ability of businesses to invest. In many parts of the country, stocks are important to household wealth, particularly the well-to-do. So there's lots of other linkages through investment and investment flows, migration flows. So there's a lot of links. The US economy is very important to the rest of the world. So if we're having trouble, the rest of the world can make it through. You know, it hurts, it will hurt the rest of the world as well. And that's [clears throat] one reason why, you know, the US economy is okay. It's kind of, as I said, on the soft side, and that's reverberating around the world. The rest of the world is kind of on the soft side as well. It's growing, but it's not, you know, growth that makes you feel really great about how things are unfolding.

Uh, well, you know, ironically, the US is feeling it least, um, you know, because we in the US produce a lot of energy and oil. Uh, so the consumer gets hurt because we're paying more, like everywhere else, for gasoline and for diesel, which is key to grocery prices and anything you get delivered to your doorstep.

It affects airfares if you travel, you know, those kinds of things. But the US produces a lot of energy. So the energy companies do quite well and they're investing more and hiring more. So the net of all that, at least so far, has been a negative, but it's been a very kind of modest negative to the US economy. The rest of the world, most of the rest of the world, it matters a lot more, it's more negative because outside of the Middle East, because we consume, the rest of the world consumes a lot of energy but does not produce a lot of energy. You know, Europe is very vulnerable, for example. They don't produce a lot of energy and also they depend not only on oil from the Middle East but natural gas from the Middle East. That's really critical since, in the wake of the Russian invasion of Ukraine, Europe turned away from Russia for its natural gas and turned to the Middle East and now obviously, you know, struggling as a result of that. The Middle East itself, that's where the problems are most severe, obviously, because they're in a war. You know, Iran is battling it out with their neighbors, and Israel and Bahrain and Qatar and Saudi and UAE all struggling, all at this point in recession. There's only two countries in the world that are actually benefiting from this. You want to guess which two they are? One's pretty obvious. China and...

Yeah, there you go. Russia, they're benefiting more than anyone else on the planet from this. Uh, because they obviously produce a lot of energy. That's their key export to the rest of the world. And the price for that is now a lot higher. And because of the need for their oil, all the sanctions have been eased on them. There were a lot of sanctions put in place after they invaded Ukraine, but they've all been eased. The only other country is Norway. Believe it or not, yeah, Norway [clears throat] produces a lot of oil as well, a lot of energy, and that's benefited. But outside of Norway and Russia, the rest of the world has gotten hurt. But the bulk of the pain is felt by the Middle East and to a lesser degree Europe, and then of course Asia to some degree. You make a good point about China. China's kind of navigated through reasonably well because they had large stockpiles of oil and it helped them kind of manage through, you know, even though they get a lot of their oil from the Middle East, they had very significant, vast reserves of oil sitting in the country and that helped cushion the blow at least up to this point in time.

The Aussie economy is a marvel, really. I mean, correct me if I'm wrong. I don't, you know, follow that carefully, but I don't think you guys have had a recession in, you know, 35 years. I think it's been...

Was it GFC? Yeah. GFC. Okay.

Yes, I think that's a good thing. Uh, I mean, because it would be problematic if you saw a lot of speculation and a lot of debt and leverage building up and there were a lot of what economists call imbalances in the economy, real estate markets being vastly overbuilt or, you know, overinvestment. But, you know, I don't sense that in the Australian economy. Uh, I do think, I mean, Australia has benefited from its links to China. I mean, the US is important, but China's also important. China's been, up until recently, a juggernaut, you know, in terms of growth, and that's really helped to propel things through thick and thin. Uh, and also, you know, I'd say Australia's a well-managed economy. I mean, I think monetary and fiscal policy, that's really important, what the central bank does and what the government does in terms of policy. I mean, there's, you know, there's always reasons to complain, but broadly, comparatively speaking, you know, compared to how we're managing ourselves in the United States, I mean, you guys are fantastic. I mean, you and the Canadians, I think, are doing a really good job, and that really helps because if you have a kind of a stable political environment and regulatory environment, uh, it's good for business in the long run. Businesses want to invest there and be there, uh, because they have the certainty of the policy that's being made. Uh, and that's something the US has historically had, but that's certainly not the case now. And another reason to be, you know, more nervous about the US. And if you got countries like the US that are looking less attractive as a place to go when times are tough, a place like Australia looks a little bit better, you know, and it's a small economy. I think you have 35 million people, something like that. It's a relatively small economy, and so it doesn't take a whole lot to lift the economy, and, uh, I think that's also helped.

Well, uh, I, you know, I'm Moody's, right? We're a rating agency. So that means we rate bonds. So I'm very focused on the bond market. This is where businesses and governments raise debt to finance whatever they're doing. And, uh, you know, the one thing that makes me nervous is about the US Treasury bond market. You know, this is Treasury bonds, or bonds issued by the US federal government to finance everything from what's going on in the Iran war to the tax cuts that, you know, we've now enjoyed. And we run these very large deficits. And I, you know, I've been following the fiscal situation in the US ever since I became a professional economist 35 years ago. And I have a few measures I look at to gauge, you know, the health of the fiscal situation. Never in the 35 years has there ever been a time when all of the measures are screaming, you know, we got a problem. I mean, debt to GDP is 100% and all the trend lines look pretty disconcerting. No one's paying any attention. I mean, the war itself has already cost, you know, about $150 billion to the American economy. Uh, you know, that gives you a sense of magnitude and it's rising by the day. Um, if you look at our deficits, that's, you know, what we're taking in right now and spending out. That's massive. It's $2 trillion. It's 6% of the nation's GDP.

Excluding interest payments on that debt, that's what economists call the primary deficit. That's 3%. And, you know, if you're an economy that's pretty close to operating like we are now, we should have no primary deficit. But we have 3%. And the interest payments on the debt are rising very rapidly. So the point is that we're issuing a lot of debt. The fiscal situation is eroding. You mix that in with the increasing skepticism of global investors in investing in the United States because of, you know, what policy has been put in place over the last couple of years. And I think that's the recipe for much higher interest rates. And right where they've been pushing higher because of the war, but they're still kind of sort of in the range they've been over the last few years. So they're manageable, but if they jump because investors fear that they're not going to get, there's going to be some reason why they might not get paid on time, uh, that would be a real problem. A real problem not only for the US economy but for the entire global economy because our Treasury interest rates, uh, they determine rates everywhere, including in Australia. So if our rates go up, your rates are going up, and that's going to make life very difficult for everybody. [clears throat]

And it also is really critical to valuing stocks and other assets. I won't go into any detail unless you ask, but if the interest rate rises, that reduces the value of stocks and other assets. So we could actually, that could be the catalyst for a sell-off in other asset markets. You know, stock, particularly tech companies and AI companies, they're very sensitive to interest rates because a lot of their earnings they're going to get are well into the future, and interest rates really matter well into the future. So we could see a sell-off, and that would be a problem, you know, not only for the US economy but for the entire global economy. I'm not the only person saying this, you know, there's other smart... I didn't mean to say I'm smart, but there are smart people saying this, you know, like a Ray Dalio, the very famed investor, you know, everyone knows Jamie Dimon. He's the CEO and chairman of JPMorgan Chase, a large bank in the United States. You know, they're saying roughly the same thing, but I think with good reason. I can't tell you when that day of reckoning might happen. All I can tell you is that all the preconditions for that are coming into place, and I don't think that's appreciated. I'll say one more thing about that. I think it's almost inevitable that we're going to see an event like this because I don't think the American political system and people can make the changes that are necessary to address our long-term fiscal problems without being pushed by something like a crisis generated by higher interest rates. I mean, the one thing about Americans that I think is important there, and maybe I'm speaking my book because I'm American, obviously, but, you know, when push comes to shove, this is a Winston Churchill quote, you know, Americans try everything and ultimately do the right thing. And I believe that to be true, but we only do it when we're pushed to do it. And [clears throat] so, you know, it's almost inevitable in my thinking that we're going to have that event, that crisis. And that's what I worry about. And I really worry about it because I can't tell you exactly how, when, and how it manifests, but again, all the preconditions for that are in place.

Let's say the catalyst for a sell-off is in the bond market, interest rates starting to rise, starting to jump, is, you know, some kind of governance issue here in the US because there's a lot of political problems. We got an election coming. There's a lot of concerns about the sanctity of the election. Let's just say, you know, it doesn't go as well as it should. The democratic process is questioned, you know, is questionable. And again, I'm not forecasting this. I'm giving you a scenario. Investors say, 'Oh my gosh, what the heck is going on? I'm not going to invest in a Treasury bond. I'm a French insurance company. I'm an Australian pension fund. I'm a Japanese institutional investor. I'm just going to wait and see how this all plays out. But I'm not going to invest.' Interest rates go from the 10-year Treasury bond today is 4.5%. That jumps to 5.5% to 6% to 7%. Stock investor says, 'Oh my gosh, my stocks are worth a lot lower.' Starts selling stock. And this reverberates around the world immediately. Your interest rates go up, mortgage rates go up, the cost of a credit card if you borrow on your credit card goes up. If you get an auto loan, that's going up. If you're a small business person getting a loan from a bank, the cost of that goes up.

And of course, it's not just about the interest rates. It's about all the uncertainty that creates and the angst that creates. People are very nervous, you know, how does this end? You know, how does this all play out? What does it mean? And people start calling their investment managers and the wealthy start selling whatever it is that they own. That's the kind of crisis that I worry about. Now, you know, there's ways out of that. I mean, the Federal Reserve could step in and start buying bonds, but, you know, we can do it, but it's going to be very painful and everyone would suffer in that scenario. And as we started, the economy is okay. It's not gangbusters, though. It's not great. It's okay. And it's very vulnerable. And if you get into a scenario like that, then you got a problem.

Well, it's actually worked out pretty well, I'd say. Uh, you know, it's been around for 100 years, a little over. Before the Federal Reserve was put on the planet, uh, we had regular financial crises, you know, every five, six, seven, 10 years. The scenario I just described for you played out in the US and in many parts of the world. We were less integrated financially, so it didn't matter quite as much back 100 years ago, but the rest of the world, you know, experienced the same kinds of things that we did. And, uh, you know, since the Federal Reserve has been put on the planet, they've been good stewards of US monetary policy and guiding interest rates. They've got a very well-laid-out framework for how to conduct policy. They have historically been increasingly transparent about how they do that and what they're thinking, and that's led to the prosperity that we're living in today. So maybe there's a better way to do it. Uh, you know, maybe the proponents of crypto, you know, Bitcoin and Ethereum, thought that was a better way to do it, but I doubt it. Uh, you know, this has worked out pretty well, at least so far. Now, it doesn't mean that doesn't come with some risk. So, for example, there is a risk that the Federal Reserve's independence is impaired. You know, because the president, President Trump, has been saying he wants lower interest rates and he will, you know, put people into the Fed that will go along with that, that they'll set policy not based on this framework I described, but based on politics and trying to get through an election. And if that were to happen, that would be a real problem, you know. That would be a real problem. Now, fortunately, I don't think we're going down that path. You know, when you ask me what I'm worried about, I might have answered Fed independence six months ago, but I'm not worried about that nearly as much today. But the question is, is there a better way of doing it? And the answer, at least in my mind, is no, at least not to this point in time. And even in Bitcoin and Ethereum and other crypto, you know, you're setting monetary policy effectively by algorithm. And I'm not sure I want that just yet. I mean, give me the human, well-educated, experienced human that can think about how to do these things, to weigh all the pluses and the minuses and all the issues that are involved and be careful about the politics that are involved. Uh, you know, that is still the best way of doing it, at least so far.

I don't think under the current technology it is going to come on. It's going to displace fiat currencies, you know, like the dollar or the Aussie dollar. I don't think that'll happen. The value of a currency, of the US dollar, Aussie dollar, is based on the kind of a stable value that it becomes a medium of exchange. Everyone believes that that value is not going to change dramatically overnight and it's a store of value. So that if you hold your wealth in that currency, you're not afraid that it's going to be worth half as much tomorrow or next week. So you need a kind of stability in the value of the currency against everything else. And I don't think the technology lends itself to that, at least not yet. Uh, there's some advances. I mean, stablecoin is an advance and moving in the right direction, but I don't think even that is to the point where that can displace fiat currencies in any meaningful way. Now, having said that, technologies change. You mentioned quantum as a threat. There may be technological innovations that make it more likely to become a medium of exchange and store of value. And when you have some of the best and the brightest on the planet working on a problem, they solve problems. Uh, you know, especially if you can make money, we solve problems. And so maybe some of the inherent difficulties with digital assets will be solved and, you know, I'll be saying something different 10 years from now. But at this point, no. Uh, and I do think you put your finger on something that we need to be very careful about, particularly in the context of AI increasingly being a tool that can be used to hack and facilitate cybercrime. That's a big deal and that could be, you know, not only a significant threat to digital currency but to the financial system more broadly. You know, really significant problem.

I think shareholders and senior managers of companies believe that artificial intelligence can significantly increase productivity and therefore profitability and profit margins. I think they believe that, and ultimately that will be true. I mean, let me take a step back. There's a lot of uncertainty about everything I'm saying. You got to be humble. Uh, I've been doing this for 35 years and there's only a few other times in history where I've been as unsure about things. One of the reasons being AI. This thing can play out in a gazillion different ways.

And I think the most likely way it's going to play out is what has happened historically. I'm an economist. So what economists do to predict the future of something is they look historically, find the best analog, use that analog to say something about how this new technology is going to play out going forward. And if I do that, I go back and look at other general-purpose technologies, the internet being the most obvious, but there are others. The technology diffuses through the economy slowly enough that the economy is able to adjust. Yes, there are job losses over here because of the technology, but there's job gains over there because of the technology. The net of all of that is the economy navigates through reasonably well and we're all better off because the technology improves our lives, you know, fundamentally improves our lives, and the internet fundamentally has improved our lives. AI, I think, will ultimately improve our lives. That's my kind of baseline view, that this will all work out in a reasonable way. And part of that is we need those productivity gains. And I think companies, their shareholders and their senior management believe that AI will lift productivity growth and it's the thing that they're betting on going forward. And I think it's a good bet, a reasonably good bet. But I don't think it's going to be to the point where it's dystopic to the job market. You know, it wipes out so many jobs that we're going to be dealing with massive unemployment and trying to figure out how to take care of all those folks that are out of work. There's going to be dislocations. It's not going to be fun for a lot of people because, you know, if you lose your job as a result of technology, you need to get another one. That's no fun. That's painful to do. But, you know, on the other side of that, in totality, we'll be made better off by that. But I think there's a general sense that this is going to work out, improve productivity and profitability, and this is something we need to invest in. One final point, though. I do think that the technology, like AI, only advances and only diffuses in a significant way when new companies form and optimize around that technology. It's not when legacy companies, like a large publicly traded company, tries to adopt a technology like AI. That's really very difficult to do, hard to do. There's many, many impediments and frictions involved in doing that. It's only when new companies form, and because it takes a while for enough new companies to form to make a...

difference to a big economy, this thing takes a while for it to fuse. And I think that's how this is going to play out.