Those Damn Laws of Economics

Those Damn Laws of Economics: How Manipulating Budget Deficits and Trade Deficits Can Create Investment and Economic Growth, Despite Popular Perception

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It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

                        Attributed to both Mark Twain and Josh Billings, 1870s

 Most economists have publicly criticized the US Congress for enacting tax cuts that will significantly increase the budget deficit. They indicate that this will lead to unwanted consequences for the economy, including inflation above 2%. Furthermore, they expect the Federal Reserve to move to offset the positive impact on US growth from the tax cuts. And lastly, they state that the blowout in the budget will lead to higher trade deficits due to an accounting identity in economics as well as the government crowding out investment from the private sector.

While all these criticisms may stem from some past historical events when the economy stood close to potential, such as in the late 1960s, with US growth having averaged only 2% for 8 years under the Obama Administration and experienced an Industrial Production recession in 2015 and 2016, these historical references do not necessarily fit today’s circumstances. Today, the economy stands some $3 – $5 trillion dollars below its level if it had grown at its historical rate of 3% – 3.5% during the Obama Administration instead of 2%. Gross Capital, the economist’s term for total investment assets in the US such as plants and roads, stands $2+ trillion below where it should, with the concomitant impact on productivity. Lastly, overall US annual Gross Fixed Capital Formation (GFCF), the annual investment made in the US, stands 4% below historical levels as a percent of GDP or almost $800 billion per year below normal, before factoring into the equation the ~$4 trillion in missing GDP which would add another $800 billion in annual investment. Given these facts, the historical events used as analogies here bear little resemblance to the current state of affairs. A more relevant historical model may be the late 1930s, post the 1937 – 1938 recession, when investment accelerated, employment grew, and real incomes rose.

Most economists base their conclusions on a static equation that does not take into account the element of Time. This equation is as follows:

S + (T-G) = I + (X-M)

The symbols in this equation stand for the following:

S = Savings

T = Taxes

G = Government Spending

I = Investment

X = Exports

M = Imports

In other words, at any point in time, the amount of Savings in the economy less the Government budget deficit equals the amount of Investment in the economy less the Trade Deficit. Or so the logic goes according to the economics textbooks. The only problem is that this equation does not necessarily hold in the real world. For example, in the late 1990s when the Government went to a budget surplus under President Clinton and Savings were strong, the Trade Deficit expanded significantly. Theoretically, X-M in the above equation should have gone to a Trade Surplus. And while the Savings rate has fallen from 6.3% of GDP in February 2015 to 3.4% of GDP in February 2018, the Trade Deficit remained static and Investment, as measured by GFCF, went from $885 billion in Q1 2015, 4.95% of GDP, to over $1 trillion in Q1 2018, an estimated 5.03% of GDP. In other words, the equation does not balance in the real world when Time is taken into account. Thus, its practical application seems limited. In fact, there is a whole branch of economics, called Intertemporal Economics, that shows that optimizing these static equations provides sub-optimal results when the element of Time is taken into account. In other words, it gives you the wrong answer.

However, when we return to basics to consider the fundamental equation of the economy, this equation does balance over Time. The equation is as follows:

GDP = C + I + G + (X – M)

In this equation, the various symbols stand for the following:

C = Consumption

I = Investment

G = Government Spending

X = Exports

M = Imports

This equation makes intuitive sense. It basically states that the economy consists of how much Consumers spend, how much the Government spends, how much the country Invests, and adjusts for whether we supply our own demand or have it done by another country. (Note: If a country has part of their demand supplied by another country’s production by running a trade deficit, the question is the ability to finance the deficit. That is because the other country is accepting IOUs from the deficit country.   The surplus country will be willing to finance this so long as it can turn the IOUs into real assets. However, if they cannot turn them into real assets, their willingness to finance the deficit comes into question.) So, the change in GDP over time will look like the following:

ΔGDP = ΔC + ΔI + ΔG + Δ(X-M)

If Consumption and Government spending in the US grow and the Trade Deficit is forced down through tariffs and import restrictions, then to supply the goods that are needed in the economy, the US must increase its productive capacity to cover the shortfall in goods as Net Imports shrink. Thus, Investment growth must accelerate to meet the demand for goods in the economy. And with Consumption growing, Government spending growing, Investment growing, and Net Imports shrinking, the rate of economic growth should accelerate.

If one were to examine the Trump Administration’s economic policies, they focus on increasing Investment and decreasing the Trade Deficit over time in exactly the pattern outlined above. Their plan to accomplish this through a 4 Part plan, the first two of which were accomplished through the tax legislation and the third through the budget legislation. In Part 1, they cut taxes on businesses to bring US tax rates in line with Europe to remove the economic incentive to locate plant in Europe instead of the US.   By cutting US tax rates for Consumers as well, they insured that consumer incomes and spending would grow. And, given the large tax cut, businesses felt free to share a portion of the tax savings with their employees, further aiding Consumers. In Part 2, the Administration wrote the law to encourage repatriation of the trillions in capital sitting overseas. And while in the short term this will not impact Investment, as demand increases for a variety of consumer goods over time, this will provide the dry powder to increase manufacturing capacity. In Part 3, the government increased spending in real terms, something that did not occur during the Obama Administration. This real spending increase will produce government stimulus to the economy on top of the tax cuts, which will become evident in late 2018, 2019, and 2020. And in the last part of the plan, Part 4, the government went after poorly written trade agreements, such as NAFTA and the WTO, to force production back to the US and to put tariffs on Chinese goods that were targeting US industry through government subsidies and the outright theft of Intellectual Property. In this way, the government increased demand for US manufactured goods, encouraged the relocation of capacity back to the US, and provided the incentive to invest to expand US capacity by starting to address the issues in these trade agreements to provide some certainty to manufacturers that their output would not find itself undercut by subsidized products from overseas.

Unlike the commentary in the newspapers and on TV, the above analysis makes clear this economic approach will produce faster growth and begin to close the gap with US Potential GDP which stands $3 – $5 trillion above its current levels. However, there is no free lunch in life. Assuming the US economy produces higher economic growth, the corollary to faster growth is usually higher inflation. They tend to go hand in hand. This means that inflation will likely pick up above the 2% level. In other words, if the US economy is to experience faster growth, it must accept higher inflation, as it has historically in the past. This is where the Federal Reserve comes into the picture. For some reason, the 2% inflation number has become gospel. However, over the past 120 years, the average US inflation is 3.2%, well above the 2% level. Thus, the Federal Reserve will face a choice: choke off the economy when it is just getting going and real incomes are rising for the first time in two decades or allow the economy to exhibit higher levels of inflation to enable fundamental economic growth to accelerate. While the Federal Reserve is raising rates today, they have one eye on the Yield Curve, which is flattening. The flattening Yield Curve signals that the Federal Reserve is going to slow economic growth if it does not relent from its tightening campaign, potentially in a significant manner, as it is also taking Money out of the economy. Should the economy slow significantly or enter a recession, despite the tax cuts and significant government spending growth, the Federal Reserve would find itself the Bullseye of the recession blame target. In this case, the Congress and the President would come down hard and likely act to remove some of the Federal Reserve’s powers. Given the politically sensitive nature of the Fed, the likely best course of action will be for the Fed to relent at some point later this year when it becomes apparent their actions are too much too soon. This would lead the economy down the path similar to what happened in 1966 – 1967 when the economy slowed but did not enter a recession, as the following chart demonstrates:

Assuming the Federal Reserve relents, then the economy should begin to reaccelerate in 2019 into the 2020 elections. This action will then allow the economic plan put in place above to truly come to fruition and fundamentally begin to accelerate the US growth rate in a sustainable, long term manner.

Furthermore, with the pickup in Investment and the aging of the Millennials in the workforce, Productivity should fundamentally accelerate, reinforcing the growth dynamic above. As is well known by economists and the Federal Reserve, Investment, what is known in economic parlance as Capital Deepening, leads to Productivity growth as the following chart demonstrates:

In addition to the fundamental acceleration due to the above dynamic, there is an important demographic negative that has been a headwind to Productivity growth that is soon to turn into a tailwind. That is the entry of the Millennials into the workforce. As they entered the workforce over the past decade, economists estimated that they produced a demographic drag of 0.4% per year to overall productivity growth. In other words, highly productive Baby Boomers retired and were replaced by less productive Millennials. However, as they age into the workforce and become more productive, the Millennials will begin to add to overall Productivity. It is estimated that the drag should turn into a positive over the next few years adding up to 0.5% to Productivity growth per year and increasing the long term economic growth rate of the economy by almost 1%.

With the Fed likely to pause later this year or early next and the Trump Administration’s economic plan in full swing, the US economy appears headed for its best growth in over a decade. This growth will occur Despite Popular Perception to the contrary focused on Those Damn Laws of Economics which do not have data to back them up. Instead, the fundamental economic equations, proven true time and time again, will hold sway. These equations demonstrate How Manipulating Budget Deficits and Trade Deficits Can Create Investment and Economic Growth. And with these actions riding high and the wind in its sails, it is Full Steam Ahead for the US Economy to the horizon and beyond. (Data from Census Bureau, Federal Reserve, and other public sources coupled with Green Drake Advisors analysis.)

 

 

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