There Has Not Been Any Supply-Side Revolution

by: Shareholders Unite

Consider the following quote from Moneynews:

Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity.

Wasn't there supposed to have been a supply-side revolution, produced by lower taxes and rising inequality (more money and incentives for 'job creators')? Apparently not, at least not so far, and there is little to assume this will change any time soon. Rising inequality is the root problem.

In short, rising inequality has been holding back the economy as the rich save much more than the middle-classes and the poor, creating a potential wedge between what the economy can produce and what it can buy.

'Tricks,' like increased household borrowing (until the financial crisis) and public sector deficits (after that), can only close that wedge for so long.

Rising inequality
No single graph sums up the economic predicament of the US as well as the one below:

The essence of this is that workers increasingly produce more than they can consume. Recently, this movement has been reinforced by a break-down in the labor share of production:

Where does the difference go? Well, mostly to the 1% of incomes:

In the years of economic growth between 2002 and 2007, 65 percent of the income gains went to the top 1 percent of taxpayers. [Der Spiegel]

But a disproportional part went to the 0.1% of upper incomes, which keep a substantial part in offshore accounts:

The world's super-rich have taken advantage of lax tax rules to siphon off at least $21 trillion, and possibly as much as $32tn, from their home countries and hide it abroad - a sum larger than the entire American economy. [The Guardian]

While this sum is a world total, the US isn't immune from capital flight.

Despite the professed determination of the G20 group of leading economies to tackle tax secrecy, investors in scores of countries - including the US and the UK - are still able to hide some or all of their assets from the taxman.

This study of hidden wealth shows that inequality is even much worse than official statistics suggest, and the level of concentration is breathtaking:

In total, 10 million individuals around the world hold assets offshore, according to Henry's analysis; but almost half of the minimum estimate of $21tn - $9.8tn - is owned by just 92,000 people. And that does not include the non-financial assets - art, yachts, mansions in Kensington

This tiny upper-echelon of the super rich are not included in any household surveys on which measures of inequality are based (like the Gini coefficient).

Now, the reason why this hasn't (yet) led to a classic overproduction crisis is that workers ran down savings and borrowed to make up for the difference. You see that during the last couple of decades, an ever greater part of personal income was spent (that is, personal savings declined).

But it's the poor and middle classes that borrow, the rich save and lend:

In 1983, the bottom 95 percent of the U.S. population owed 62 cents in debt for every dollar they earned, the economists find, CNNMoney reports. By 2007, that number had risen to $1.48 of debt for every $1 in earnings. Meanwhile the rich were paying off their debts, with their debt-to-income ratio dropping from 76 cents of debt for every dollar earned in 1983 to 64 cents in 2007, CNNMoney adds. [Moneynews]

Household debt was on a steeply rising trajectory, helped by financial deregulation and (initially) supported rising house prices. But that was clearly not sustainable either. When house prices collapsed (wiping at least 40%, or $9T of household wealth), the debt that was supported by houses remained. Households started to deleverage, that is, save more and spend less in order to rebuild their damaged balance sheets.

Their balance sheets are very damaged indeed:

A new survey by the Federal Reserve shows a shocking decline in the average net worth of U.S. households from 2007 to 2010. According to the report, which adjusted figures for inflation, the average American family saw their net worth drop 40% in that three-year time period from $126,400 to $77,300. Overall net worth has fallen to levels not seen since the early 1990's, long before the housing bubble even began. [Yahoo]

Public expenditures
Now that the private sector is deleveraging (that is, spending and borrowing less, paying off debts), the result is a private sector surplus, it saves more than it invests.

Something needs to fill this gap in order to keep the economy afloat. As a matter of accounting identity, the public sector, private sector, and net exports must sum to zero. Since net exports (exports minus imports) are still negative, the only sector that can fill the gap in the economy is the public sector. And indeed, this has moved into huge negative.

The way this adjustment has happened is mainly through low economic growth (reducing tax receipts which moves the public sector into deficit) and tax reductions (the stimulus was one of the largest tax reductions in history).

Federal tax intake, at just over 15% of GDP, is already at a multi-decade low and corporate tax intake is at an all-time low:

Now, Government filling in for the (deleveraging) private sector, running large deficits to keep the economy afloat isn't sustainable either. In fact, the process is already winding down somewhat as public spending is decreasing:

However, as long as the fundamental problem remains (that is, wages not rising in tandem with productivity increases), some other 'trick' will need to be working to let the US economy produce close to capacity.

And one should realize that the fundamental problem seems far from having disappeared, quite the contrary:

In the "recovery" of 2009-2010, the top 1% of US income earners captured 93% of the income growth [Stiglitz]

So what 'trick' is available, besides the one that were already operative (household borrowing or public spending), to fill the gap between production and spending? Well, theoretically only two 'tricks' are left. Either a trade surplus fills the spending gap (which at present, isn't on the cards) or a slower growth in the production capacity itself could do the trick.

In fact, the latter 'adjustment' has already been going on for quite some time as well. Here is that quote from the top of the article again:

Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity [Moneynews]

This simple truth is a pretty worrying statistic for those that claim that rising inequality will benefit economic growth. More money to 'job creators' has not led to an investment boom in the real economy, quite the contrary (it has led to a bloated financial sector instead).

And why would it, if wages lag productivity growth ever more, demand increasingly lags potential output, diminishing the need to expand production capacity.

Of course, the most viable solution would be to restore the link between productivity growth and wages...

Disclosure: I 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.