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Thursday, February 27, 2020

Family Finances Improving under Trump

There is more good news from the Trump economy. 

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I have already reported that we are steering clear of a recession and how this economy keeps churning out jobs like nothing we have seen since at least the 1990s. But the good news is not over yet.

Figure 1 reports three key ratios for the assessment of household financial strength: the tax burden (blue), the debt burden (grey) and the savings rate (green) out of personal income. Covering the past 40 years, Figure 1 plows through four key episodes in the American economy:

Figure 1
Sources of raw data: Bureau of Economic Analysis (personal income, taxes, savings); Federal Reserve (Debt service ratio)

The first episode, the 1990s, was one of strong economic growth. Our GDP expanded by more than four percent per year four years in a row: 1997-2000. This was a respectable achievement under President Clinton and the fiscally conservative Republican leadership in Congress, but it came at a price. The tax burden on personal income climbed steadily, from 11.3 percent in 1992 to 14.3 percent in 2000. 

Part of the reason for the increase in the tax burden was the strong growth in the economy that pushed more people up in higher tax brackets, but there was also the policy from the Clinton administration to continue the reversal of the Reagan tax cuts that had begun with a small step under Bush Sr. After the last leg of the Reagan reform had reduced the number of tax brackets from five to two, and the top rate from 38.5 percent to 28, Bush Sr. introduced a third bracket at 31 percent. Clinton and the Democrats - who controlled Congress to the 1994 election - added two more steps, taking the top federal rate up to 39.6 percent.

Clinton's argument was that it would help close the budget deficit, but it was not until a fiscally conservative majority took over in Congress in 1994 that the real deficit fight began. Under the leadership of Speaker Gingrich and Appropriations Chairman Kasich, the Republicans hashed out a budget strategy based on spending restraint, one that could be accepted by the White House. 

At the same time, the Clinton tax hikes remained in place, nibbling unsustainably at household income throughout the '90s. The trajectory of the savings rate reveals this: it declines steadily throughout the decade.

Debt service, however, increased its share of personal income, showing that while American families were confident thanks to a strong labor market they also became financially less independent. Borrowing more to buy, e.g., houses and cars, they slowly exposed themselves more to the unforgiving costs of principals and interest rates.

The second episode, the Millennium Recession, illustrates with crisp clarity the dangers of having government rely on a small, highly taxed margin of income earners for its revenue. As the recession unfolded, millions of Americans fell out of the highest-taxed income brackets, plummeting the average tax burden back to where it was during the last years of the Reagan administration. The difference, of course, was that during Reagan the economy was growing at a healthy pace.

The Bush Jr. tax cuts further reduced the tax burden, but also got the economy going again. The rise in the debt ratio that began as soon as the Millennium Recession broke out, plateaued but did not decline again. The savings ratio hovered at a low level; in combination, the steady debt ratio and the volatile but generally low savings ratio suggest that American families never really got on a track toward increased financial independence.

Part of the reason, in fairness, was the ultra-low interest rate policy that the Federal Reserve instituted after 9/11, but that only explains part of the trend. Household income did grow as a result of the Bush Jr. tax cuts, but the economy as a whole never quite mustered a return to the '90s rates.

The third episode, the Great Recession, illustrates well the precipitous nature of household finances - and how they affect the federal government budget. The tax burden plummeted again: despite a cut in the top tax rate from 39.6 to 35 percent, the Bush tax cuts still made the federal government dangerously dependent on a small, high-earning segment of the population. An almost-balanced budget in 2007 turned into a deficit train wreck only two years later.

As unemployment skyrocketed (by U.S. standards - it was far worse in Europe) the debt ratio began falling. Defaults ravaged banks and sent the housing market into a tailspin. The savings rate jumped up, but not for good reasons (more on this in a moment).

The fourth episode is the Trump economy, where for the first time since the late 1980s we see good tendencies in all these three variables. The tax burden is moderate, and despite a very strong economy we have not seen the same spike in the tax burden as we saw in the 1990s, the last time the economy was this strong. The savings rate has been ticking upward since Trump took office, and doing so for a different reason than under Obama. The debt ratio, lastly, is flat, indicating that American families are not going into debt at the same perilous rate as they did during the Clinton presidency.

To see in more detail what this fourth period means in a historic context, let us look more closely at the debt and savings ratios. Figure 2a highlights the former:

Figure 2a 
Sources of raw dataBureau of Economic Analysis (personal income, taxes, savings); Federal Reserve (Debt service ratio) 

As mentioned, we saw a long stretch of increase in the debt service ratio, from the early 1990s right up to the Great Recession. The increase slowed down noticeably in the first years after the Millennium Recession, thanks in part to the Bush tax cuts, in part to the low-rate interest policy of the Bernanke-led Federal Reserve. 

Nevertheless, the debt service ratio increased, something that over time is not healthy for the economy.

With the Great Recession, the ratio declined, and declined fast. The reason was, of course, a default bonfire across the economy. 

The decline tapered off as the economy slowly began recovering, but due to the tepid nature of the Obama recovery the debt-service ratio was not caused by rapidly growing household earnings. It was, rather, the result of moderate lending policies and a sluggish market for consumer credit. 

With President Trump at the helm, the U.S. economy skipped an expected recession in 2017-2018. Instead, we saw continued growth, job creation and rise in household earnings. One of the key effects of this is a rise in the savings rate - which is a clear improvement over the 1990s. By saving more, American families are on firmer ground when it comes to protecting themselves against financial uncertainties; by keeping debt costs at a steady pace they have further improved their independence. 

Figure 2b highlights both the debt and savings ratios, identifying three distinct episodes in the latter:

Figure 2b
Sources of raw dataBureau of Economic Analysis (personal income, taxes, savings); Federal Reserve (Debt service ratio)

The decline in savings that began in the wake of the stagflation era under Carter, was broken by the Reagan tax cuts - giving families back some of their financial independence - but fell again during the Clinton era. It jumped conspicuously under Obama, when the economy really did not know where it was headed. 

With Trump at the helm there is again a steadier course for households to chart. For the first time in three decades American families can work toward attaining financial independence. If this trend continues, it represents a tectonic shift in our economy.

Only one thing could really disrupt it: a fiscal crisis. If Congress passes the Trump budget for 2021 which sets us off on a moderate but realistic course to budget balance, we can fend off the risk of such a crisis, at least for now. If, however, Congress decides to go down the Democrat path with big, new entitlements and a drastic upset of the Trump tax reform, we would quickly end up with a tanking economy  and a fiscal crisis as a direct result of it. 

That, in turn, would bring about heavy spikes in interest rates, financial-market volatility and, in response, even more drastic tax hikes. Only this time, the tax hikes would not only be much worse than we have seen in the past: they would also be coupled with exorbitant money printing under the auspices of Mad Monetary Theory.

With hyper-inflation lurking around the corner, a Democrat tax-print-and-spend strategy would make just about any depressive economic scenario possible. Any one of them would rapidly and violently reverse all the gains in household financial strength that we have seen since Obama left office.

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