4% Growth?

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Summary

The incoming Trump administration aims to get economic growth to 4%.

The policy platform is a combination of supply-side tax cuts and deregulation with Keynesian demand stimulus.

We think this will be a fairly tall order, based on structural changes in the economy and earlier experience with a similar policy platform.

The incoming Trump administration has been elected on roughly the following economic platform:

  • Large tax cuts
  • Increase in public spending, in defense, infrastructure
  • No entitlement reform
  • Protectionism
  • Deregulation
  • Repeal and replace Obamacare

It of course remains to be seen how much of this platform will translate into actual policy (there is some backtracking on Obamacare and entitlement reform, for instance), but for the sake of argument we assume it will.

Reagan

What will be the fiscal impact of all this? Apart from the protectionism, it's a policy platform that reminds one of Reagan.

There are many who think that this platform brought the US economy on a higher growth path in the 1980s, so if it can do this again, perhaps we don't have to worry too much about the fiscal impact.

Well, the Reagan mix of higher (defense) spending and large tax cuts did have fiscal implications, in fact, to such an extent that roughly half the tax cuts had to be reversed. Here is Bruce Bartlett, who was actually part of the Reagan administration at the time:

Reagan cared about deficits and supported 11 different tax increases from 1982 to 1988 that collectively took back half of the 1981 tax cut.

What's also not fully appreciated is the fact that growth in fact wasn't higher in the 1980s than it was in the 1970s, while the latter are baked in memory as golden years and the first as a economic disaster decade. Here is Bruce Bartlett again:

But the Reagan tax cut played only a secondary role in the 1980s boom, which wasn't really much of a boom. Real G.D.P. grew 37.9 percent in the 1970s, compared with 36.1 percent in the 1980s. The economy felt better because inflation came down extraordinarily quickly, far more quickly than economists in 1980 thought was possible. But this was primarily a result of the Federal Reserve's tight money policy, not taxes.

The large Reagan tax cuts were supposed to spur savings and investment, but the latter really didn't take off despite the enormous fall in interest rates as inflation came down from double digits.

Without an increase in investment the whole Reagan package cannot really be called a successful supply side package. Insofar as it was successful it's more because of the increased spending, that is, it's Keynesian characteristics.

A Trump supply side boost?

It is entirely possible that the economic package will increase economic growth, if it is large enough. However, just as under Reagan, we think that if this happens, it will be more because of the Keynesian characteristics, rather than a via bigger incentives to save and invest (which is what a supply-side package supposed to achieve). Here are a few reasons:

  • Tax cuts less successful, Brownback experience, taxes are already low
  • Instead of tailwind from dramatically lower interest rates under Reagan, Trump will likely have to cope with rising rates
  • Capacity constraints

Tax cuts work if they are from a very high level. Marginal income tax rates were much higher under Reagan, but still the cuts didn't demonstrably boost the supply side. This is probably the main reason why the supply-side experiment of Sam Brownback has gone so horribly wrong.

State level taxes are simply not much of a bite. Here is Barry Ritholtz:

The elimination of taxes on pass-through income simply benefited existing business, many more of which took advantage of the change than expected. And really, who is going to move to Kansas now that the top personal tax rate is 4.6 percent versus 6.45 percent? I can tell you I'm not packing up the U-Haul.

Can we expect a huge boost in business investment as a result of a reduction in corporate tax from 35% to 15%? After all, that does seem to have more of a bite. However, even here there are reasons for caution:

  • Few companies actually pay 35% profit tax and profit tax receipts itself have declined to some 2% of GDP, despite record profits which have reached 11% of GDP the highest level since data was recorded.
  • Companies enjoy record cash hoardings and profitability and very low funding cost. Lack of funds or profitability doesn't seem to be an important reason not to boost capex.

What about Trump's plan to make it cheaper for the repatriation of those cash hoardings, much of which is held overseas exactly to avoid the taxation here? Would bringing that back unleash a capex boom? Here is Bill Gross on CNBC:

He said it was "doubtful" that Trump's plan to repatriate huge corporate profits to the United States for infrastructure spending would succeed, saying that a similar effort in 2004 resulted in large stock buybacks, dividend payouts and corporate bonuses, but no noticeable pickup in investment.

There might be some uptick in capex, perhaps deregulation of some industries will be helpful (although this could also be harmful in other ways, but that's a topic for another day). Whether these supply-side measures will notably increase capex spending remains very much to be seen.

Keynesian Trump?

But, as we argued for Reagan, the policy platform might not yield all that much as a supply-side effort, it could still boost economic growth as a Keynesian boost to demand. There could be two problems here:

  • The economy might already be close to full employment
  • The economy already grows at the long-run possible growth rate

But one of the lessons Keynesians always have to repeat is that this works best in an economy with a large amount of slack. That is, it's best applied directly after a big crisis, like the financial crisis of 2008.

It is really debatable whether there is a meaningful amount of slack that can be filled by boosting demand. Unemployment for instance is running at 4.9%, a level which used to be associated with more or less full employment.

Yes, we are aware that the participation rate of working age population has gone down (although it is recovering somewhat the last two years) but the fact that initial unemployment claims are at a 43 year low doesn't suggest there is all that much slack in the labor market.

If there isn't sufficient slack in the economy, the effort could run into rising wages and ultimately rising prices. It's already likely to run into rising interest rates and a rising dollar, all of which is going to blunt the impact of a Keynesian stimulus at least to some extent.

Long-run structural growth

There are several reasons why the structural growth rate of the US economy might be considerably lower than in the past.

  • Demographics
  • Productivity growth
  • Technology
  • Hysteresis

Demographics alone could easily shave more than a percent off economic growth a year this decade, according to an academic study by Nicole Maestas Kathleen J. Mullen David Powell (pdf). This is huge, and not something that is amenable to much policy action, certainly not in the short-run.

Productivity growth has declined markedly the last decade or so.

Nobody has a firm grip on what has caused this (some even argue it's mostly a measurement error). Years of modest capex expenditures is a likely contributor. Others, like Robert Gordon argue that there is simply less economic pay-off of new technology than in the past.

Then there is the problem that these mechanisms tend to reinforce themselves. A savings glut translates into an output gap, which reduces the incentives for businesses to invest.

This slows the increase in the quality and quantity of the capital stock, that is, it slows productivity growth, and hence possible wage growth, which further slows demand, etc.

Maybe the supply-side measures might help to lift some of these constraints, but as we argued above, based on historical examples the hope here is fairly limited, certainly in the short-term. The main mechanism is lifting business investment, and that will take time.

Possible negatives

We can't exclude the possibility that some parts of the Trump agenda will actually have a negative impact on economic growth either, here are three possibilities:

  • A possibly soaring deficit producing much higher interest rates
  • Protectionism
  • Deporting illegal immigrants

We'll discuss the impact of the Trump agenda on public finances in an upcoming article, but for the meantime we note that a really substantial rise in interest rates is a distinct possibility. The markets seem to agree with that, as there has been a substantial sell-off in the bond markets after the election.

For instance, on deporting illegal immigrants (from the WSJ, our emphasis):

Granting amnesty to illegal-immigrant workers would boost the U.S. economy more than trying to deport them, according to new research that highlights a tension between Republican plans to both crack down on unauthorized workers and rejuvenate growth. A new study puts the economic contribution of the U.S.'s illegal workers at 3% of private-sector GDP

Protectionism is a bit of a wild card. It is one thing to withdraw from TPP (or TTIP, which might be next), deals which haven't been implemented yet, but quite another to retreat from NAFTA, let alone slap tariffs on Chinese and/or Mexican imports.

While we do not really expect that to happen, we have yet to meet an economist who thinks it is a good idea that will boost growth.

Conclusion

The markets seem to be rejoicing in a wave of optimism about the incoming boost to growth. Whether this is achieved through supply-side reforms or Keynesian demand stimulus does not seem to matter all that much to the markets.

However, as we try to show, there are limits what these policies can achieve in the short-run on both accounts. If we're running up capacity and other structural constraints increasing demand will significantly leak into higher inflation and supply measures isn't going to loosen these constraints overnight.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.