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Friday, July 26, 2019

Despite Strength, Trump Economy Bound for Recession

We do have the strongest economy in 20 years. That, however, does not change the fact that Trump's tax cuts have almost run out of steam. In fact, we are seeing some clear signs of a recession ahead of us.

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The latest GDP numbers from the Bureau of Economic Analysis show two things:

On the one hand, the Trump economy remains the strongest we have had in 20 years;
On the other hand, its strength may be tapering off.

There are, plainly, more signs of a recession in the near future. It likely won't be a serious one, but it will be a cooling-off period for the economy that normally would not be of any major concern.

Except these are not normal times. The reason? The budget deficit.

More on that in a moment. First, let us put the Trump economy into perspective. Annual GDP growth (not annualized) in the second quarter of 2019 was 2.29 percent, down from an annual 2.65 percent in Q1. We had two quarters in 2018 of more-than-three percent growth; an annual revision of the GDP numbers for 2018 by the Bureau of Economic Analysis has adjusted the Q4 numbers down to 2.52 percent. 

Consumer spending is currently growth a bit faster than GDP, which is encouraging. The margin is not spectacular, but if we are to stave off a recession, this is one of the things our economy needs to do more of.

As for gross fixed capital formation - business investments - they are growing steady in the aggregate, but disaggregate data point to a recession in the near future. More on that in a moment.

Does this mean the Trump economy is a dud? Not at all. In fact, as Figure 1 shows, he is still presiding over the strongest economy in 20 years:

Figure 1
Source: Bureau of Economic Analysis

For comparison:

1. The Bush administration presided over a return to growth after the Millennium recession. This growth was driven by the 2001 and 2003 tax cuts, which - respectively - stimulated private consumption (its growth rate picks up early on in the marked period) and business investments, i.e., gross fixed capital formation. The boom in business investments was normal for the growth period of a business cycle, but ended abruptly in 2007. 

2. The Great Recession came with a solid period of negative GDP growth with an even bigger decline in consumption below GDP. When both are negative and consumption falls more deeply than GDP, it is a sign of a serious economic downturn (note that during the Millennium recession GDP continued to grow). The worst part, however, was by far the deep decline in business investments. While this variable is always more volatile than GDP or private consumption, the difference between the decline in GDP and the decline in investments was twice as big at the depth of the Great recession as it was in the previous downturn. 

3. After the Great Recession the economy began working its way back to growth again. It was not easy, with the Obama administration's unending barrage at the business sector with regulations and such growth-stifling "reforms" as Obamacare. This in itself led to more short-sighted economic behavior, as visible in the sawtooth-like investment growth pattern during Obama's presidency. On top of that, economic development (a.k.a., corporate welfare) came to play a bigger role in capital formation. Its impact at the macroeconomic level was probably not significant, but on the margin it has likely made a difference. Since economic development is politically driven and explicitly designed to pick winners and losers among private businesses, it will also be erratic in its impact on economic activity over time. 

4. After the damage done by the Obama administration the economy was ripe for another recession. We can in fact see a blip in business investments, and a slight tapering-off of private consumption. The election of Donald Trump as president appears to have halted the recession in its making. 

5. Deregulation and business-targeted tax cuts have stabilized capital formation and given corporate America a sense of long-term confidence again. The annual investment growth rates are not spectacular, but they are steady: they have been in the 4-6 percent bracket for nine quarters in a row now. Compared to the last two investment-growth periods, during Bush and Obama, the Trump economy has traded high but volatile capital-formation rates for steadiness and stability. 

Broken down by presidential term, here is what the last two decades look like:

Figure 2
Source of raw data: Bureau of Economic Analysis

So far into his first term, Trump has presided over stronger economic growth than the last two of his predecessors. Clinton still beats them all, but that still means Trump's economy is the best we have had in 20 years. 

That said, my earlier warnings about the corporate bias in the Trump tax cuts remain in place. Especially capital formation is showing signs of a cooling-off, probably even a recession. There are two main signs:

1. The construction of homes has been declining for a full year, signaling saturation in the market for new homes. We saw this happening a year before the Great Recession erupted. During the recession blimp in 2015-2016 residential construction kept up well, encouraged by low rates and the macro effect of improving consumer credit (making mortgages cheaper). Today's scenario is not like that, but more in line with 2006-2007.

2. Non-residential capital formation is divided into three categories: structures (factories, warehouses, offices, private communication systems); equipment (vehicles, tools, computers); and intellectual property products, IPPs. In a normal business-cycle growth period investment in structures rise first, followed by investment in equipment. Last comes IPP spending, making for a triple-peak phase that tells us when businesses are saturated with capital. Today we have passed the structures peak - investment in structures even declined in the second quarter this year after barely increasing at all in Q1 - and on the downslope of the second peak (equipment). It now looks like we have reached the top of the third investment peak, signaling a recession just around the corner.

Judging from the numbers currently at hand, we are not looking at anything like the Great Recession, more a normal cool-off period. However, there is a big wild card in the deck: the budget deficit. If the economy really slows down, so will tax revenue; as the budget deficit widens - and widens rapidly - the debt market will be less inclined to help out now than they have been in the past. You simply do not borrow to fund 20-25 percent of your spending at the height of a business cycle, without being duly punished by the market.

So long as Congress refuses to take responsibility for its deficit, the Federal Reserve again becomes our only hope. It will have to step in to prevent a debt disaster. I have my serious doubts that their monetary policy will make a meaningful difference, so pinning the U.S. economy on their ability to help the U.S. government avoid runaway debt costs is not very encouraging.

Yet deficit monetization may be the only way Trump can avoid a deep recession in 2020. The main alternative from his vantage point would be to raise taxes or drastically cut spending. Neither is going to fly with Congress.

There is one thing that would really help us avoid a recession: consumer spending. How would that happen? Loosen the tax grip and lower the cost of health insurance. Since very few low-to-middle income Americans pay any significant amount of federal income taxes anymore, the former would have to come from the states. The latter would require the necessary reforms passing through Congress. There, Democrats will block any meaningful legislation, hellbent as they are on running out the clock on the Trump administration.

Is there a chance for consumer resiliency? Yes. How strong? Let us get back to that. For now, here is one reform that would help, at least over the long term.

For now: my recession warning stands.

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