Thursday, February 28, 2019

See I Told You So: GDP Growth Tapers Off

Never bark at the Big Dog. The Big Dog is always right.

For the better part of 2018 I kept telling other think tank wonks, blog readers, politicians and others who were on the issue, that the U.S. economy was not at all growing at four percent per year. The 4.1 (revised 4.2) percent growth number pumped out by conservative pundits last summer, was not a correct measurement of annual growth.

I have also pointed out that the profile of the Trump tax cuts would not lead to sustained, high growth rates.

I was right, of course, but people kept telling me that I was not. Well...

Before we get to the actual data, just released by the Bureau of Economic Analysis, and before we get to the explanation of the less-than-three percent number, let me review what I said over the course of last year on this matter.

On June 12 I explained that the growth rate in the first quarter of 2018, 2.8 percent, was the highest it had been in three years. However, I cautioned that private consumption was diverging from the trend of improving GDP numbers, not by much but by enough to pay attention to.

On July 28 I noted that the Bureau of Economic Analysis had shifted base year from 2010 to 2012 (unnecessary if you ask me, but it's their decision) whereupon the inflation-adjusted growth rate for Q1 2018n was adjusted downward to 2.6 percent. So was, of course, the growth number for every previous quarter, so the trend remained positive. However, I also explained that the second-quarter growth rate was 2.85 percent, not the hyped-up 4.1 percent everyone was talking about back then.

On October 2, after having debated these numbers with some intelligent people, I found it necessary to write a separate piece on how you actually read national accounts data. I explained the difference between the artificial annualized GDP numbers, of which the 4.1 percent growth rate was an example, and actual annual GDP numbers. My opponents went predictably silent...

On December 28 I analyzed the composition of the U.S. economy, explaining why a tax cut that benefits corporations is good but won't generate spectacular growth numbers. Contrary to what is often believed among conservative economists, brought up on Austrian economic theory, investments do not drive economic activity. Private consumption does. Since private consumption is four times larger than corporate investments, it was easily predictable that the Trump tax cuts would not be the magic bullet that sustainably would put the U.S. economy back above three percent growth.

Alas, here come the BEA's GDP data for the fourth quarter of 2018, and therefore for the entire year:

Q4 2018 All 2018
GDP 3.08% 2.88%
C 2.66% 2.64%
GFCF 7.05% 5.95%
G 1.75% 1.52%

I have said all 2018 that there was definitely a possibility that we would reach three percent growth this year. It was close, but we didn't, and - again as I predicted - there is a reason for this that is easy to understand if we think outside the Austrian box. Look at the contrast between private-consumption data and the numbers for, respectively, business investments (Gross Fixed Capital Formation) and next exports (NX). Then take a look at this little table, which reports GDP for all of 2018, in 2012 prices:

GDP 2018
GDP                      18,571
C                      12,891 69.4%
GFCF                        3,387 18.2%
NX                          (914) -4.9%
G                        3,178 17.1%
The surge in business investments in 2018 has somewhat closed the gap between private consumption and business investments as share of GDP. It has also led to the fortunate return to a somewhat more healthy combination of domestic absorption, namely where business investments are greater than government spending (18.2 percent vs. 17.1 percent). 

So why did the Trump tax cuts fail to cause a return to the strong growth rates of yore? Why is Bill Clinton still the last man to preside over a U.S. economy exceeding four percent annual growth? 

The answer to the first question inspires the answer to the second. Trump's tax cuts, again, benefited business investments. Looking at the disaggregation of gross fixed capital formation, we see the following for 2018:

Q1 Q2 Q3 Q4
Nonresidential 6.74% 7.08% 6.84% 7.17%
            Structures 3.09% 5.65% 6.30% 4.82%
            Equipment 9.46% 8.16% 6.56% 5.78%
            Intellectual property  5.63% 6.60% 7.60% 10.78%
Residential 0.24% 1.32% 0.53% -2.96%

In other words, for all of 2018 our businesses have been expanding their production capacity (nonresidential investments). Investments in homes have flattened out, which at least in theory means that we are just replacing old residential structures with new ones. 

When businesses invest in new capacity, in the end they have to make money on the production that the capacity is going to be used for. If private consumption is growing at a third of the rate of non-residential investments, eventually America's businesses will scale back their investments. Hence, the boom we have seen this year is going to come to an end in this the first quarter of 2019. Only a strong surge in consumer spending will eventually chain-react into a sustained high level of capital formation; it is difficult to see how that could happen. 

In fact, I pointed out already in the fall of 2017 that the profile of the GOP tax plan - which became law in an even more watered-down format - was not primarily designed to stimulate growth. Its primary purpose was to secure tax revenue, with a bone thrown to private businesses as an effort to get some growth out of it in the bargain.

See I told you so.

In addition to the temporary macroeconomic effect from the tax reform, there is also the problem with ever growing government spending. The deregulation crusade that Trump initiated has certainly been good for the economy, but it is far from enough. One of the bigger regulatory hurdles, Obamacare, remains in place. It has also contributed to a creeping socialization of the health care industry, which contributes up to 14 percent to GDP.

The larger government grows, the slower the economy will grow. In fact, there is a threshold where the negative effects of government on growth become visible. When total government spending, both cash-based entitlements and the kind that shows up in national accounts, exceeds 40 percent of GDP, GDP growth slows to a long-term trend in the vicinity of two percent. Since this level of growth essentially just keeps the standard of living constant, it means that our nation as a whole stops making economic progress.

We are not quite there yet. We are currently at approximately 32.5 percent. However, it does not take much to push us over that threshold: a single-payer health care reform would certainly make it happen; a combination of general income insurance (of which paid family leave is one example) and universal child care would also come close. 

Plainly: if we do not reverse the size of government; if we do not start structurally reforming away the welfare state; we are going to slide slowly but inevitably into the European quagmire of stagnation and industrial poverty.

I pray to God I won't be sitting here a couple of years from now saying "See I Told You So" over this prediction. But unless a miracle happens on the right side of America's political aisle; unless the Republican party cuts ties with the neoconservative delusion of a "more efficient" welfare state; it is a safe bet that I will once again be quoting Sheldon Cooper: I informed you thusly. 

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