Until now we have taken a favourable view of Donald Trump’s ability to reflate the US economy, putting it on a higher growth path, somewhere close to the ‘old normal’. But, in light of the President’s failure to make any tangible progress in implementing the pro-business aspects of his agenda five months into his presidency, along with a series of ongoing controversies which are eroding his political capital and hindering his ability to get things done, we are reassessing the US economic outlook and trimming our US GDP growth and inflation forecasts. We will provide final numbers in our upcoming 2017 Q3 Global Economic and Markets Outlook (GEMO), but we are likely to trim GDP growth to around 2½% and 3% in 2017 and 2018. We will also lower our CPI inflation forecasts.
We still think that Donald Trump will deliver some fiscal loosening, with corporate tax cuts likely to be enacted early next year. And our revised forecasts for the next two years will still have US economic growth and inflation exceeding the levels predicted by most other economic forecasters. We also think that the US economy is better placed to grow faster than most of the other major economies over this time horizon. Accordingly, we expect the US dollar and Treasury yields to rise from their current levels. But, in the absence of a jolt to the economy in the form of a fiscal spurge, escaping the status quo of low productivity, low growth, low inflation and low interest rates for a sustained period, becomes a lot less likely.
High debt and lacklustre productivity growth weigh on the economy
The US economy is saddled with high levels of debt. Household sector debt has fallen in recent years, but this has been more than offset by a rise in government debt. Total debt to the non-financial sector (i.e. household, corporate and government debt) is around 250% of GDP. The world’s other major economies find themselves with similar or higher levels of debt as a share of their GDP. Some debt is good for economic growth, but we have found that when total non-financial debt in an economy exceeds 250% of GDP, economic growth tends to slow significantly, a point reflected by the chart.
The US, and nearly all of the rest of the developed economies, are also suffering from a productivity problem, with productivity growth slowing significantly, and in some countries falling outright, since the 2008 financial crisis. One of the main reasons for this, we believe, is that excessively loose monetary policy is keeping unprofitable firms in business. In fact, by undermining the supply side of the economy, excessively loose monetary policy has now become part of the problem, not the solution.
In the run-up to the financial crisis, US labour productivity grew faster than its long-run average, turbocharged, in part, by an unsustainable rise in debt. After the credit bubble burst, output per worker fell sharply. The economy has failed to claw back the lost ground during the recovery and productivity is growing slower than its long-run average. Barring a change to the status quo, it is hard to see productivity growth rebounding anytime soon.
Is the US turning Japanese?
Japan’s experience serves as a warning, since it, too, lived through an unsustainable credit-fuelled boom and bust, around 15 years before most other advanced economies, including the US. Japan recorded above-trend productivity growth during the debt-fuelled bubble years, only for productivity growth to stall when the bubble finally burst – much like it did in the US. It took 10 years for GDP per capita to fall back to its sustainable long-run level. In the subsequent 15 years it fell well below its long-run sustainable path. Can the US avoid the same outcome?
There are differences between Japan’s economy 15 years ago and other advanced economies today: cultural differences; different economic models; and a failure of asset prices in Japan to return to pre-crisis levels. But will these differences alone be enough to ensure that the West doesn’t suffer the same fate as Japan? Fathom Consulting fears that they will not. In fact, there are a number of similarities between Japan 15 years ago and the West today: high debt; low inflation; ultra-loose monetary policy; ageing populations; weak productivity growth; and sluggish economies.
Within this paradigm, Japanese businesses did not invest, much like businesses in Western economies are reluctant to invest now. A prolonged period of low interest rates did not encourage investment in Japan. In fact, with interest rates so low for many years, too many unprofitable firms were kept in business. Zombie companies were allowed to survive. The Japanese government tried to stimulate the economy using fiscal policy on many occasions, but most of these attempts were half-hearted and unable to convince Japanese business and consumers that a sustainable recovery was forthcoming. Bolder, and more coherent, fiscal policy from the Japanese authorities would almost certainly have led to better economic outcomes, and less overall debt.
Why a fiscal splurge is what the US economy needs
The US economy risks falling into a similar trap to the one that has plagued the Japanese economy for the last 25 years. In fact, the US economy may already be there. A change to the status quo, and the current economic paradigm, is needed to propel the US economy out of this trap. In our view, a fiscal splurge, in the form of large tax cuts and a big increase in infrastructure spending, as promised by the US President during his acceptance speech on 9 November last year, is the medicine that the US economy needs to do this.
With the US labour market approaching full employment, such a splurge would generate a significant increase in wages and inflation. The first-round effect would be to increase debt (especially government debt, although private debt would probably follow suit). But to the extent that this generates inflation, and the Fed allows the inflation to take root above its current two percent target – either by making an ‘error’ or by increasing its inflation target as has been mooted by some economists, including those at Fathom Consulting – this would be beneficial for two reasons. First, it would help reduce the US debt burden in nominal terms. Second, higher inflation would prompt tighter monetary policy, helping solve the productivity problem by putting unprofitable firms out of business.
It is unclear whether an increase in government debt is any less desirable than an increase in private debt. But as the sovereign of the world’s reserve currency, the US government has significantly more leeway to loosen fiscal policy and not be ‘punished’ by financial markets than other countries. In fact, investors and businesses would clearly welcome more US fiscal stimulus: in response to Donald Trump’s pledge to cut taxes and increase government spending, financial markets pushed up the value of the US dollar, US equities and Treasury yields. Surveys showed that businesses clearly welcomed these proposals, too.
One of the main economic arguments against higher government spending is that it may well crowd out private investment (by pushing up interest rates). This theory did not correspond to economic reality in Japan over the last 25 years. And it does not apply to the economic reality in the West today. Low rates have come to symbolise a broken economy, and monetary policy no longer works the way that classic economic theory suggests it does.
Low interest rates, and in some countries negative rates, are not having the desired and expected effect. Higher interest rates may, in fact, crowd in private investment since it seems very likely that the positive signalling effect from higher interest rates, would trump the increase in borrowing costs brought on by this policy. If businesses are more convinced that more normal economic times are set to return, they are more likely to invest.
An opportunity lost?
It has been five months since Donald Trump took office and there are now serious doubts about the timing and size of the fiscal stimulus package that the President will end up delivering. There has been no tangible progress on cutting corporate taxes or reforming the US tax code so far. A revised healthcare bill may have passed the House at the second time of asking, but it is unclear whether the bill will pass the Senate, when it goes to the floor (possibly next week). Getting this bill passed by the Senate seems to be a precursor to making any more progress on tax reform, even though there seems to be a broad-based desire among politicians to cut corporate taxes.
Cracks seem to have emerged between the President and House Speaker Paul Ryan over the slow progress of healthcare reform and the issue of how to fund tax cuts. Mr Ryan would like to pay for the latter through the so-called border adjustment tax, which the President does not favour. What is more, some senior Republicans such as Lindsay Graham described the budget cuts proposed by Donald Trump as “dead on arrival”, highlighting the lack of consensus within the Republican Party over how to fund large tax cuts. For us, it is crucial that they are not funded.
The legislative agenda has also been bogged down by a series of ongoing allegations against the US President. Not only is this wasting time and diverting attention from the important economic issues, but it is also eroding the President’s political capital and weakening his negotiating position. As a result, it seems less likely that he will get the support he needs from Republicans and Democrats to push through his legislative agenda. The President may need the backing of some Democrats if the Freedom Caucus, who blocked the first healthcare bill, play hard ball over tax cuts. Support from Democrats is likely to be even more important for the President to pass a large infrastructure spending package.
We still expect corporate tax cuts to be enacted early next year. And we do not expect these to be offset by equal cuts in spending. After all, history has shown that Republican administrations typically increase the budget deficit. But the size of the tax cuts is likely to be smaller than we had previously anticipated. And the chances of them being temporary, not permanent, have increased too, meaning that they are likely to have less bang for their buck. What is more, a large increase in infrastructure spending now seems less likely than it did. On balance then, the amount of stimulus we now expect to be enacted is about half as much as we had previously expected.
In our judgement, this will probably be insufficient to generate the impetus necessary to get the economy out of its current low productivity, low rates and low inflation environment. Animal spirits and investment will not accelerate as much as we thought. The uncertainty caused by the ongoing scandals surrounding the US President will also weigh on business sentiment. That wage growth and inflation have continued to undershoot expectations, despite the unemployment rate dipping to 4.3%, below most estimates of the natural rate of unemployment, reaffirms our belief that a bold fiscal stimulus package is needed to move decisively away from the current economic environment.
It’s not all over yet
There is, of course, a significant amount of uncertainty associated with this forecast. There may well be upside risks, which could materialise if:
On balance though, we see the cumulative probability of one of these four scenarios materialising, and the chances of reaching escape velocity – i.e. achieving a sustained pick-up in inflation, allowing the Fed to raise interest rates back to normal levels and entering a new, old normal, of higher economic growth – as less than 50%. We may only shave a few tenths of a percentage point off our forecasts for US economic growth and inflation over the next two years, but the longer-term consequences of failing to deliver a large fiscal stimulus package could be a lot more damaging than that.
The debate over how policy makers should respond to rising debt and low productivity is set to run for the foreseeable future. The thesis outlined in this note reflects our current thinking on the topic, although further research is underway and will be forthcoming on the effect that ageing populations, rising inequality and excessive global savings may be having on debt, productivity and the economy.
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