the Dynamist

The Death of US Manufacturing has been Greatly Exaggerated

I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity...also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.

The Dynamist’s Jobs Plan

President Obama is set to give his jobs speech tonight. In it, he will outline a series of proposals to stimulate job creation. I don't know what these are yet, but if I was appointed philosopher-king, the following would be my ideas to stimulate near-term economic activity and hiring while not exacerbating our long-term economic problems:

Employ construction workers by investing in infrastructure. The most obvious hole in economic activity is the smoking crater left by the collapse residential real estate investment. Construction employment has fallen from over 7.5 million in 2007 to about 5.5 million today. Of course with housing inventories well in excess of normal levels and with consumers overburdened by mortgage debt, re-inflating the housing bubble is not an option. The government could put construction workers to work by investing in infrastructure like roads, bridges, commuter rail, power infrastructure, broadband infrastructure, ports, etc. The focus should be on shortening commuting times, reducing trade friction and supporting export infrastructure…stuff that should be done anyway. Do not focus on controversial and dubious items like intercity high speed rail and solar power. The goal should be to employ about 1 million additional construction workers over the next couple of years. After two years or so the housing market will clear and the pace of infrastructure spending can be reduced. Yes, environmental and other types of reviews may need to be streamlined to make projects "shovel ready" this time.

Stimulate domestic investment by reforming corporate taxes. There is clearly an imbalance between the perceived return on business investment made abroad versus domestically. We need to change that. My solution would be to reform the corporate tax code by (i) leaving the rate where it is, at 35%, (ii) make worldwide earnings subject to the tax (now it is only taxed when brought back to the United States), (iii) make investment in research, development and capital expenditures made in the United States immediately tax deductible (as opposed to depreciated over several years) and (iv) make dividends tax deductible. The design here is to reward investment in the US while discouraging the hoarding of cash on corporate balance sheets (particularly in foreign banks) or squandering cash on empire-building acquisitions. Corporations should either invest their cash in the US or pay it out as dividends. If a corporation wants to make an acquisition, it should subject itself to the discipline of the financial markets and issue debt or equity. Because this reform encourages actual investment by businesses and would eliminate the double taxation of dividends, there would no longer be a need to give preferential treatment to dividends and capital gains for personal income taxes. In addition, the tax difference between corporations and "flow-through" business entities like LLCs would be dramatically reduced, ending a major distortion in the tax code.

Remove barriers to domestic energy production. The oil and gas industry is running at over 95% of capacity, the most of any domestic industry, so it needs more investment now. We need to remove barriers to offshore and onshore drilling and "fracking" and to encourage nuclear power and wind power, where appropriate. Within the energy complex we can encourage demand for domestic energy by putting a tariff on imported oil, which would also help fight the biggest source of our chronic trade deficit. The long term goal would be to move to a straight carbon tax. We can also raise revenue to offset other measures encouraged herein by eliminating the preferential tax treatment of oil and gas investment, which isn't needed given the tight capacity and proposed tariff. The tariff on oil prices would help encourage a transition to more fuel-efficient automobiles, whether hybrid or electric.

Encourage hiring by permanently cutting the payroll tax. We can increase the return on labor to businesses by permanently eliminating the employer side of the payroll tax (which is 6.2% of wages). It needs to be a permanent cut because businesses are otherwise rational and won't hire based solely on a temporary cut. The long term goal would be to replace the payroll tax (a regressive tax on hiring) with a carbon and/or consumption tax (a regressive tax on consumption). The cut would be partially offset by letting the temporary 2% cut in the employee-side of the payroll tax expire as scheduled.

Stand up to currency manipulators. There is no reason that an innovative, productive economy like the United States has to run a persistent trade deficit. We are being manipulated by the central banks and sovereign wealth funds of East Asian and OPEC nations, plain and simple. The inflow of these excess savings must be matched by an equal trade deficit, artificially suppressing American manufacturing. For example, there is no reason that manufacturing of high tech goods for American companies, which requires relatively little labor, should be done in Asia and not at least mostly in the United States. We are needlessly allowing excess capital formation outside of our borders. While I think the corporate tax reform mentioned above will help in this regard, we should also explore a wider array of "sticks" like currency interventions, tariffs and capital controls in addition to diplomatic "carrots" like trade deals in seeking to promote trade balance. (Our trade deficit is currently 4% of GDP.) I know that such a proposal will spark warnings of "trade wars", but in reality other countries use these types of tools all the time (Switzerland did this week) and if they are used to negotiate an end to market interference by the other country, there should be no long term repercussions.

Stop encouraging inflation. One of the biggest fallacies in all of economics is that you need positive inflation for the economy to work properly. It is absolute hogwash. Prices were basically flat for the hundred years prior to World War I and the US economy grew faster than ever. All inflation does is transfer purchasing power from ordinary people to the elites who know how to profit from inflation in the financial markets. Stopping inflation would also have the benefit of making finance boring again, which would stop the drain of talent and capital from the real economy toward non-productive endeavors like designing the latest hedge fund trading algorithm or speculating in commodities. While targeting zero inflation wouldn't create jobs per se, it would lift the real income of American workers, since prices have been rising faster than wages. I frankly don't understand what the Fed has been trying to accomplish lately. The dollar is already at the bottom of its long term trading range and gold prices are soaring. Asset prices are generally pretty expensive. It's time for a new approach.

All of these ideas are incremental steps toward what I think should also be America's new (or at least modified) long term economic strategy. I also include some revenue offsets designed pay for these programs in a way that would not harm the economy and would also serve our long term goals. I realize that some of these proposals cut strongly against the conventional "wisdom", and I don't care. The long term goals are to get more Americans working, to make sure they get paid more by their employers, to produce more domestic investment and to pay for it with more domestic savings. It can be done. We shouldn't expect miracles, however. The economy is going to be abnormally weak for some time to come. This is the time, however, that we can band together to build a long term foundation for strong growth and general prosperity.

The market does not want austerity (now)

If one looks at both nominal and inflation-adjusted treasury yields for the next five years, the market does not think near term austerity is necessary. In fact, it is pretty clear that the market wants more treasury issuance not less, with negative real yields through at least the next five years. With fiscal stimulus being reined in, the market expects the Fed to be the stimulator of last resort (and all the Fed can do is try to promote inflation through bond purchases), hence the gold price is rising as the market expects an even longer period of negative real interest rates.

Our economic problem is simple, we went from a period of over-stimulated and debt-fuelled real estate investment running at 8.5% of GDP to a collapse in real estate investment down to 4% of GDP. The collapse in real estate prices reduced the collateral value on trillions of dollars of loans and forced austerity among consumers.

To deal with the problem we needed only three steps:

1. Recapitalize the banks to prevent an uncontrolled unwinding of leveraged positions (done);
2. Increase temporary transfer payments to individuals to prop up consumer spending while savings levels are increased (done, but in danger of being unwound); and
3. Increased government investment in infrastructure to put the millions of unemployed construction workers to work (not done, we focused on health care instead).

Business investment, exports and consumer spending have been doing fine since we came out of the recession, but the markets are fearing that a pullback in government spending worldwide, combined with continued weakness in real estate investment will tip the scales to recession.

I personally think the odds favor us muddling through for the next year or so and avoiding recession, and that the recent market correction is probably overdone. That does not mean I am calling a bottom, because the momentum could overwhelm the facts on the ground. I do, however, feel ok nibbling at stocks at this level.

With US banks in far better shape than in 2008, I don’t see a mini-replay of that crisis as the major threat to the economy. Europe has major issues, but they are also solvable in due course as long as Germany steps up to the plate. The next crisis may come from exactly where we don’t expect it today: a crash in emerging markets leading to global deflation.

 

Seeking American Renewal

We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source: Economy.com, calculations by tylernewton.com

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source: Economy.com, calculations by tylernewton.com

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source: Economy.com, calculations by tylernewton.com

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source: Economy.com, calculations by tylernewton.com

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.

GDP Outlook 2011: Momentum is Building

2010 was a year of recovery for the US economy. On a year-over-year basis, nominal GDP grew 4.1%. (I will mostly use nominal GDP because I like to look at relative values. Nominal GDP represent actual cash numbers, while the individual items that make up real GDP can get distorted by quirky inflation adjustments.) Real GDP grew 2.85%, implying an economy-wide inflation rate of only 1.25%. The components of growth are as follows:

Personal Consumption: 2.7%

Private Investment: 1.1%

Government Spending: 0.7%

Net Exports: -0.5%

 

Within this mix, private investment gained economic share, while the rest of the components lost share. This is not surprising, because private investment is the driver of business cycles.

 

The preliminary estimate for Q1 GDP growth slipped to 3.7% in nominal terms and 1.8% in real terms implying an inflation rate of 1.9%, a pickup in inflation and a slowdown in growth from the pace of 2010.

 

I believe that the Q1 slowdown is a blip and that economic momentum is building, driven by a strong and lasting expansion of business investment. I believe that the investment boom will more than offset what I believe will be sustained long term weakness in real estate investment.

Business investment

Source: Economy.com, author's calculations

Two things stand out in the above chart of private investment as a percent of nominal GDP. First, the recessions of 2008-09, 2001, 1990, 1980-82, 1974, 1970, etc. are all clearly visible. Second, it can be seen just how severe the Great Recession was, with private investment plunging to as low as 10.9% of GDP in Q2 2009, well below its long term average of 15.9%.

Private Investment can be broken down into business investment and real estate investment. The chart below shows the relative share of GDP of both long term business investment (excluding changes in inventories) and real estate. These are the forces that drive the intermediate term (5-10 year) business cycle.

Business investment is starting to recover, while real estate investment (residential and commercial) is not.

Source: economy.com, author's calculations

Notice the general 16-18 year infrastructure investment cycle (called a Kuznets cycle for you business cycle buffs). The front side of the cycle generally benefits from a powerful business investment boom, which also coincides with strong job growth. The back side of the cycle has a larger share of real estate investment and is generally associated with weaker job growth. The good news is, we are entering the powerful phase of the investment cycle, meaning the next decade should actually produce strong economic and employment growth.

Business investment reached a low of 7.0% of GDP, below the average of 8.2% since the end of the 1970 recession. This level roughly matches the lows of 7.4% hit during the 1974 and 1990 recessions. In Q1 2011, business investment was 8.2% of GDP, in line with the historical average. It is interesting that business investment is at mid-cycle levels so early in a recovery. Perhaps we really are moving to a new paradigm of more consumer saving and higher business investment, and less focus on consumer spending and real estate investment.

Real estate investment, on the other hand, has been experiencing a series of "lower highs" and "lower lows", hitting 7.2% in the 1974 recession, 6.3% in the 1990 recession and 4.0% in Q4 2010, well after the end of the 2008-09 recession. In normal circumstances, I would expect a snap-back from such a severe drop. Demographic trends are working against the real estate market, however, as Baby Boomers are moving past their peak home buying years and toward retirement while being followed by the much smaller Generation X. I expect only a very gradual recovery in real estate investment, although it's hard for it to go much lower.

Another component of business investment is the change in inventories, which tends to lead the short-term business cycle. In 2010, inventory additions added a full 1.9 percentage points of the 4.1% nominal GDP growth.

Inventory changes are clearly volatile, and have been losing share as a percent of GDP due to the decline in the relative importance of manufacturing and to the improvement in inventory management. There was some alarm with the drop in inventory additions in Q4 2010. Inventory cycles usually last at least 3-5 years, however (as can be seen in the chart above, these cycles are known as Kitchin Cycles). We should therefore expect for inventories to continue their positive trend for at least the next year.

Consumer spending

As I have noted previously, personal savings has risen to a normalized level relative to GDP, so personal consumption should now keep pace with GDP growth, as it has most of this decade.

Even as employment starts to improve, however, we shouldn't expect much of a boost from additional spending as long as savings holds at its current percent of GDP. The reason of this is that aggregate personal income hasn't really declined during the recession.

Source: economy.com, author's calculations

Wage and salary income has declined substantially relative to GDP over the past decade, but increases in government transfers and health care benefits have held total income roughly constant at about 85% of GDP. Given the imminent retirement of the baby boomers and the planned increases in government health care spending, there is no reason not to expect a continuation of the trend of a smaller wage base relative to GDP.

One threat to consumer spending is that there is a good chance that taxes will increase.

Income taxes paid as a percent of GDP is at its lowest level since the early 1960s. In addition, consumer spending (and potentially personal savings) is being temporarily goosed in 2011 by a cut in the payroll tax.

Government

Given the budget tussles in Washington and state capitals, and the likely winding down of the wars in Iraq and Afghanistan, we can expect direct federal, state and local government spending to start declining as a percentage of GDP. We should expect the federal transfer payments that support consumption (social security, Medicare/Medicaid, unemployment benefits) to continue at relatively high levels unless some major budget revolution takes over the Federal government.

Conclusion

The economy is underperforming the public's expectations primarily because of the collapse in real estate investment and home values. As a result of the large drop in household net worth (from 470% of GDP in early 2006 to 347% of GDP in early 2009), household savings rapidly rose while real estate and business investment rapidly sank. The government stepped in and offered tax rebates, transfer payments and spending stimulus to prop up demand, while the Fed and the treasury propped up the banks to prevent a deflationary spiral. By mid-2009 the markets started to recover, stabilizing consumer net worth, personal saving and personal consumption. Once businesses saw the economy stabilizing and economies resuming growth abroad, business investment started to recover, first with inventory restocking and now investment in software and equipment.

Real estate investment has not recovered for obvious reasons, and this leaves a big hole in the nation's productive capacity, which is also holding back employment. The Fed continues to ease and the economy makes a gradual transition away from the real estate fuelled economy of the 2000s and employment is slow to recover. The weak dollar is helping US exporters but is causing a rise in the nominal value of imports, particularly in petroleum products, which now account for nearly our entire trade deficit. I am not quite sure what the Fed now expects to accomplish with its current course of action.

All that said, momentum is building. The American economy is very resilient and is merely in a transitional phase where the tired consumption and real estate driven economy is handing the baton to one focused on productivity and business investment. Which is a good thing.

The Return of the US Consumer

The following post is the second in my "United States of Debt" series that analyzes how the different sectors of the US economy will handle their high debt loads. The first installment can be found here.

During the housing bubble, American consumers loaded up on debt. Since the bursting of the bubble, Americans have adjusted by increasing their savings and paying down debt. This adjustment resulted in a slight decrease in consumer spending and a large decrease in residential investment. My analysis shows that the bulk of the adjustment in consumer spending is complete. The level of personal savings is driven by household net worth. As a percent of GDP, both household net worth and savings have returned to normal levels. Therefore if asset values can remain elevated, consumer spending can at least keep pace with normal levels of GDP growth for the foreseeable future.

As has been discussed previously in the Dynamist, a big secular trend over the past forty years has been the rise in consumer spending and residential investment as a percent of GDP.

Figure 1

Source: Economy.com, tylernewton.com

As has also been discussed previously (namely here), virtually all of the long term increase in consumer spending can be attributed to the rise in (mostly non-voluntary) medical expenses and housing investment. Virtually all of the decline in household spending as a percent of GDP since 2005 can be attributed to the decline in residential investment from 6% of GDP to less than 2.5% of GDP.

Not surprisingly, consumer indebtedness climbed to support the increase in spending (particularly since personal income has not risen as a percent of GDP…to be discussed in a later post).

Figure 2

Source: Economy.com, tylernewton.com

Also not surprisingly, the amount of consumer debt has started to decline with residential investment, albeit with a lag.

The increase in consumer debt shown in Figure 2 seems kind of scary until you compare that consumer debt with the amount of consumer assets.

Figure 3

Source: Economy.com, tylernewton.com

From 1994 to 2005, household assets as a percent of GDP rose from under 425% of GDP to over 550%. With asset values surging, household net worth (assets minus liabilities) also surged, even with the large increase in liabilities. Figure 4 below illustrates the effects of the twin bubbles in stocks (in the 1990s) and real estate (in the 2000s) on household assets.

Figure 4

Source: Economy.com, tylernewton.com

Looking at Figure 3, it appears that the preferred level of household net worth is about 350% of GDP, although it would make sense for this number to rise somewhat over the next decade as the baby boomers prepare for retirement. If we look at the long term levels of personal savings in Figure 5 and compare it to the long term levels of net worth in Figure 3, a pattern emerges.

Figure 5

Source: Economy.com, tylernewton.com

When household net worth is around its long term trend of 350%, personal savings averages 4-6% of GDP. In the high inflation, high interest rate 1970s, when asset values were depressed, net worth dipped down toward 300% of GDP and savings rose above 6%. During the asset bubbles of the late 1990s and early 2000s, net worth rose well above 350% of GDP and savings fell below 4%. After the housing bubble burst, net worth fell back to 350% and savings promptly popped to above 4% of GDP.

Now that savings is at a normal level, consumer spending has the ability to keep pace with GDP growth. That does not mean that consumers won't choose to keep increasing their saving rates over the next decade, particularly the baby boomers as they prepare for retirement. As long as the savings rate as a percent of GDP exceeds the nominal growth rate of GDP, consumer indebtedness as a percent of GDP will decline.

Thus we see the importance of keeping interest rates low and preventing asset deflation. Financial assets like stocks and bonds fall in value when interest rates spike. Assets geared to inflation like stocks and real estate fall when you have deflation. The Fed will see propping up asset values to prevent another major spike in the consumer savings rate as a high priority for the foreseeable future. A spike in the savings rate would reduce final demand, which in turn would force the federal government to spend more money to prop up demand.

The United States of Debt – Part I

The economy of the United States is highly leveraged. Through the boom times of the 1980s through the 2000s, total US private and public debt to GDP has risen sharply. Since the 2008-2009 recession, private debt has started to fall while public debt has risen, while the country's total indebtedness has remained relatively stable. Most US citizens have the nagging feeling that our debt burden has gotten too high. If we know that debt to GDP needs to come down, however, we don't know to what level it should come. I have decided to analyze this issue in a series of posts called "The United States of Debt".

In this the first installment, I will run through the big picture. The first section discusses how the recent run-up is not surprising in the context of the long cycle, and that we have seen these financial booms before, during the Gilded Age following the Civil War and during the Roaring Twenties. The second section dissects the recent debt buildup between the private, public and financial sectors. The last section discusses why the recent financial boom has been so long lasting and powerful relative to the Gilded Age and Roaring Twenties.

The next three installments will analyze the financial health of the Household, Business and Government sectors and to make policy recommendations on how to promote the financial health of those sectors.

The long wave debt cycle

It's no secret that the United States has a debt problem. This long term chart of total, economy-wide debt to GDP demonstrates it pretty well.

Chart 1

The long term pattern of debt peaks corresponds with the long wave, or Kondratiev Cycle (for a more detailed description of this concept, see here). During the "autumn" phase of the "financial bull", inflation is falling, thus interest rates are falling and asset values are rising. While asset values are rising, the cost of borrowing is falling, which creates a perfect environment for using leverage for investment, whether in the financial markets, real estate markets or for corporate investment.

Eventually, the asset bubble pops, marking the transition to the "winter" phase, or the "real bear". It is at the bottom of the first winter recession that the debt-to-GDP ratio peaks (previously in 1875 and 1933). Why? Because as asset values start to fall, the high level of underlying debt results in a deflationary spiral of forced asset sales and financial failures. Nominal GDP falls while the level of debt remains roughly the same (or rises).

Eventually, the economy bottoms and debt-to-GDP turns down. The decline in debt-to-GDP comes from a combination of rising real GDP, rising inflation (which reduces debt in real terms) and debt destruction trough defaults.

Chart 2

At the beginning of the Great Depression in 1929, the bulk of US debt was corporate debt tied to the investment bubble in auto manufacturing, electric utilities, houshold appliances, radio and other sectors that made up the "new economy" of the Roaring Twenties. Corporate debt to GDP collapsed from over 100% in 1933 to under 30% by the mid-1940s. Household debt fell from 50% of GDP in 1933 to roughly 15% in the same time period. Much of the drop in total debt to GDP came during the 1933-1936 period, when the dollar was devalued by 50% and economic growth was very high (albeit from an extremely low base). The ratio rose again when the economy relapsed in 1937-38, but resumed its decline when the economy recovered modestly in the pre-war years. The end of the long depression years came when government debt to GDP began to expand during World War II in the early 1940s. Government debt to GDP balooned from under 50% to about 100% of GDP during World War II, while private debt to GDP declined.

Total non-financial debt to GDP remained between 125% and 140% from the end of World War II to the early 1980s. During that time, government debt to GDP fell from about 100% to 40%, while private non-financial debt rose from 40% to 100% by 1980. During the same time, financial debt to GDP rose from under 5% to about 20% by 1980, returning to roughly the same level that prevailed in the late 1920s.

The consumer and financial debt explosion since 1980

Table 1

Table 1 above walks us through how our debt load has evolved since the early 1980s. For the sake of cyclical consistency, I show the recession years of 1982, 1990, 2001 and the recent recession trough of Q2 2009. There has been a steady increase in private sector debt, particularly among households and the financial sector. During each business cycle, the private sector tacked on 50-60 percentage points of indebtedness. The government sector, on the other hand, has see-sawed in a one-cycle-up, one-cycle-down pattern.

The largest increase in indebtedness has come from the financial sector, having increased by 93 percentage points between 1982 and 2009. As can been seen in Chart 2, about half of that increase came from the Government Sponsored Entities ("GSEs"), namely Fannie Mae and Freddie Mac. That debt has from a practical standpoint become government debt as well.

Since the 2009 recession has ended, total debt to GDP is has declined by three percentage points. Private sector debt has dropped by 14 percentage points while government debt has risen by 11 percentage points. So far the government has been filling the classic Keynesian deflation-fighting role by borrowing and spending to offset a decline in private borrowing and spending.

The problem with this analysis so far is that while interesting, it doesn't mean a lot without knowing what the optimal debt to GDP level is. Just because debt to GDP used to be 150%, doesn't mean that was the right level. In fact, for all we know, 150% was way too conservative and presented a great opportunity to lever up to the optimal level north of 300%. My gut tells me that the truth lies somewhere in between these two extremes.

The Second Gilded Age

So what happened in the period from 1980 to 2009 that led to an explosion of US indebtedness? We have had a confluence of factors that created the ideal environment for the greatest bull market in the history of the world:

1. A roughly 90% devaluation of the dollar in nominal terms against gold;
2. A general policy mix of tight monetary policy and loose fiscal policy;
3. A decline in long-term interest rates from nearly 15% to 4%;
4. Tax policies that reward borrowing and equity capital gains; and
5. Financial deregulation and the expansion of the GSEs.

With the devaluation of the dollar (also known as "inflation"), the denominator in which the S&P 500 is quoted has declined, providing a lift to the nominal value of the S&P. That said, however, over the past 50 years, the price of gold and the S&P have merely kept pace with each other (see Chart 3). Since 1955, 100% of the excess return of the S&P 500 over gold is attributable to dividends.

Chart 3

Source: economy.com, Standard and Poors, tylernewton.com

 

Or looking at it another way, Chart 4 shows the S&P 500 expressed in terms of ounces of gold.

Chart 4

Source: economy.com, Standard and Poors, tylernewton.com

If you ignore the outlying years of 1997 to 2001, the pattern is pretty clear: a steady buildup to about 3 ounces of gold before the plunge to below 1. The only question now is how low the ratio goes. The previous bottom was 0.22 in 1980. That would imply the S&P falling to 265 at today's price of gold, or conversely, gold rising to 4,881 at today's level of S&P.

Nevertheless, since 1955, the price of gold has risen from $35 to $1,205 and the S&P 500 has risen from $35 to $1074. The ratio of S&P 500 to gold seems to spend 15-18 years above 1 and 15-18 years below.

The other factor that drove the bull market in stocks and bonds has been the relentless decline of interest rates from 1980 to 2000. As can be seen in Chart 5 below, since the early 1960s, the earnings yield (the inverse of the price-to-earnings valuation multiple) of the S&P 500 has pretty closely followed the yield of the 10-year treasury bond. Prior to the 1960s, when inflation was very low or even negative, earnings yields were far higher than treasury yields.

Chart 5

Source: economy.com, Standard and Poors, tylernewton.com

As can be seen in Chart 3, in the 1970s, when the value of the dollar plunged and the price of gold rose, stocks did not follow because of the rise in interest rates which provided stiff competition to stocks. As treasury yields rise, the required return from stocks' earnings yield goes up as well. That pattern reversed in 1980. Tighter monetary policy gradually brought down interest rates, but loose fiscal policy kept inflation positive. The combination of falling interest rates and moderately positive inflation is the ideal combination for stock returns.

Now that we are likely shifting to a deflationary environment of falling debt to GDP, we may be seeing a shift to rising earning yields while interest rates remain low. This was the combination that prevailed in the 1930s and 1940s. We are already at a spread between earnings yields and 10-year treasuries not seen since the mid-1950s. If inflation stays as low as it is currently (around 1%), goes lower or even consistently negative, we will very likely see earnings yields back to the level of the early 1950s by the middle to end of this decade.

Rising Asset Values lead to Higher Indebtedness

As asset valuations rose from 1980 to 2008, investors had the opportunity to use financial leverage to supercharge returns. Just witness all the people who made a fortune in real estate over the past thirty years: inflation made the value of rents and real estate rise while financing costs fell. Leveraged buyout practitioners could borrow money and benefit from the combination of rising cash flows and valuation multiples while benefitting from falling interest rates. It's pretty simple. In a thirty-year bull market in asset values for stocks, bonds and real estate, the use of leverage to "get-rich-quicker" is a natural outcome.

The Government has encouraged leveraged speculation

Many of the "supply side" tax policies of the past thirty years have encouraged the use leverage as well. Ostensibly, policies like cuts in upper-end income tax rates, dividend tax rates and capital gains tax rates are meant to encourage savings and investment. In reality, they don't directly encourage savings or investment, they encourage the reward from investment profits. Businesses are the ones that actually invest. If you wanted to directly encourage investment, you would allow for the full deduction of capital expenditures in the year incurred and make the R&D tax credit permanent. If you wanted to directly encourage savings, you would impose consumption taxes or large deductions for money put into investment accounts.

We do, however, directly encourage the use of debt by making interest tax-deductible for businesses and real estate investors, while dividends, on the other hand, are double-taxed at the business and individual level. The government even further subsidized residential real estate interest rates through their "implicit" (now explicit) guarantee on securities issued by the government sponsored entities ("GSEs") Fannie Mae and Freddie Mac.

Private equity and real estate investors had this figured out. Take the subsidy for borrowing money and use it to generate subsidized capital gains profits. Benefit from rising asset values as interest rates fell. And benefit from rising cash flows driven by government-generated inflation. In such an environment, it's frankly a wonder we have as little debt as we do.

I bet this makes you wish you had this all figured out in 1982.

Reform the Tax Code Now

The United States has a tax code that encourages borrowing and consumption at the expense of savings and investment. I believe this concept is pretty well understood. What is less understood is that the rest of the world does not. The much-derided (in the United States at least) European-style welfare states actually have less progressive tax systems than the US, as do the developed Asian countries of Japan and South Korea. This means they are more apt to discourage consumption and to promote exports with value-added taxes. Most of these countries have found a policy balance that produces neutral trade deficits. Countries like China and Germany, on the other hand, take it even further and use their tax code to actively promote massive trade surpluses, a key source of the "global imbalances" that are threaten the world economy. Even worse, within the US tax code we discourage domestic investment in general, yet we lavish subsidies on specific old-economy industries like real estate, agriculture and energy extraction and even encourage US multinationals to invest overseas instead of in the United States. Our distorted tax policy is a bipartisan failure that must be addressed soon or our country will begin to lose ground economically while struggling under a mountain of foreign-owned debt.

How we got here

Much of The Dynamist blog is devoted to analyzing long term trends in economic policy, market valuations and political cycles. One of the consistent themes (for examples see here and here) is that the United States needs to focus on reducing its structural trade deficit. When we run a trade deficit, we are importing capital (i.e. borrowing) from abroad. Importing capital is not inherently bad. If the US had a surplus of investment opportunities relative to its pool of savings, investment capital may come in from abroad to make up the difference. In such an event, the investments would presumably increase the long run growth rate of the US economy.

The trade deficits that the US has run since the mid-1990s, and in the 1980s before that can generally be attributed to policy distortion by the Federal Government or by the Federal Reserve. The Fed's policy of high real interest rates in the early 1980s and late 1990s drew in a great deal of capital from abroad. In the 1980s, it funded Reagan's tax cuts and military buildup. In the 1990s, it funded the investment in a large increase in US manufacturing production capacity. In the Dynamist's view, neither of these investments were bad things and they generally made the US stronger.

The problem came when the disinflationary high interest rate policy was unwound. In both the late 1990s and 2000s, the combination of falling real interest rates, a weakening dollar, a surge in liquidity and an upturn in inflation create a ripe environment for a junk bond and real estate boom. Finance-fuelled booms like these tend to leave behind banking crises, overleveraged LBOs and real estate overcapacity. In the 1980s, the S&L deregulation led to a commercial real estate bubble. In the 2000s, the flow of Chinese money into the agency debt of Fannie Mae and Freddie Mac, combined with the policy innovation of "securitizations" and credit derivatives created the housing bubble. While such investments aren't useless, they don't have much of an impact on future US productivity.

I've written before about how US economic policy since the Great Depression has basically promoted consumption and real estate investment at the expense of saving and business investment. Domestic tax policy is skewed toward taxing high earners and lenders and supporting lower earners, borrowers and leveraged equity owners, particularly in real estate and farming (this even after the income tax rate reductions of the Reagan and Bush eras). When examining how domestic policy leads to distortions to the external trade and capital accounts, it is worth comparing how our policies compare to those of our largest competitors.

Global tax rates

A couple of months ago, The Economist had an interesting table outlining the tax policies of various countries (it can be found here, by those with a subscription). I worked with the numbers a bit so we could compare the state's take (including state and local taxes) relative to GDP across various types of taxes. I don't have the underlying data, nor do I know the policy details behind how various countries collect taxes, but in rough terms the data give one a good idea about the thrust of tax policy.

I took the average of five European-style welfare states (Britain, Canada, France, Germany and Italy), two developed Asia industrial powerhouses (South Korea and Japan), the US, China and Germany stand-alone. Their sources of tax revenue relative to GDP are shown below:

Source: The Economist, author's calculations

Unsurprisingly, governments in the United States collect a smaller amount of taxes as a percent of the economy than the four European countries and Canada. To compare apples-to-apples, however, the 6-8% of GDP that flows to privately-funded health care in the US should be added to the relatively regressive "social contributions" line item, for health insurance costs are deducted directly from our compensation just like Social Security and Medicare taxes. That would move US taxes to within 4-6% of European levels.

Surprisingly, the total tax take from "progressive" sources like income, capital and property in the United States is almost identical to that of Europe. The big difference between the two systems is in the "regressive" taxation of consumption. The European-style welfare states use value-added taxes that collect consumption taxes to the tune of 10.4% of GDP. The US taxes consumption, mostly in the form of state sales taxes, at only 4.4% of GDP. In other words, the US has a more progressive tax code than the European-style welfare states. The result is Europe as a whole runs a trade balance and the consumption-driven US runs a trade deficit.

The developed Asia countries of South Korea and Japan tax their economies by a similar percent as the US and have similar percentages for social contributions. The difference is that developed Asia taxes income less and consumption more than the US, with a difference of about 3 percentage points in each category.

Now look at China. It has a weak social safety net, and collects nothing in terms of "social contributions". It then gets nearly two-thirds of its tax base from consumption taxes, with most of the rest coming from taxes on companies. No wonder China has huge levels of savings and investment and low consumption levels. Combine that with a policy to suppress currency values and you have the ideal recipe for large trade deficits.

Germany is another great promoter of global imbalances, particularly within Europe, as has come to light with the recent Greek debt crisis. It collects a huge portion of its tax base from regressive consumption taxes and social contributions, while collecting less than the US in progressive income, capital and property taxes. Additionally, of the developed countries it takes the lowest percentage from companies. By taxing employment so highly via social contributions, and taxing companies at such a low level, Germany is encouraging "capital deepening", or investment in its great export machine. Germany's high consumption taxes have also encouraged the lowest level of consumption of the major developed economies.

Domestic distortions

Even within the US tax code, the US discourages domestic business investment relative to encouraging US multinationals to invest abroad; punishes businesses in general with the second-highest corporate tax rate in the world while it lavishes massive subsidies on individual sectors like agriculture, energy extraction, and real estate; forces companies to write off investments in productive capacity over long periods of time while other countries offer massive incentives for multinationals to invest. In the past 30 years, the US has gotten away with its disincentives to business investment funded by domestic savings by replacing domestic savings with foreign savings flowing through its levered-up capital markets casino.

Reform the Tax Code

It was nice while it lasted. We got lots of investment, bigger houses, a beefed-up military, technological innovation, and debt-fuelled consumption with low domestic savings. Now that the bill has come due, we either need to encourage more saving or live with less investment. Opting for the latter is not the path to long run prosperity. The tax code needs to be reformed to tax more consumption (which could include a carbon tax, an export-promoting value added tax and/or larger deductions for saving), not to increase income taxes and to reform the corporate tax code to replace the subsidies for specific old-economy industries with incentives for investment in domestic manufacturing capacity and R&D.

For corporate taxes, I would propose a general reform that would lower the statutory rate by eliminating special-interest subsidies and the deferral of international income, while also allowing the full, immediate expensing of business investment and R&D. I would also support the deductibility of dividends, while returning the tax rate on individual dividends back to the income tax rate. This reform would discourage corporate cash-hoarding for buybacks and ill-conceived acquisitions. (If you can't convince the capital markets to fund an acquisition, you probably shouldn't do it.)

In a globalized economy, large differences in tax policy cause trade and capital flow distortions. The US can no longer pretend it is an island unto itself. Our tax code is harmful enough to our national interests as it is, it gets even worse when allows the rest of the world to take advantage of us.

Q4 Economic Growth - Be Happy, but Worry

There is alot to like in the recently announced 5.7% rate of US GDP growth in the fourth quarter of 2009. 

While many commentators are brushing it off as a fluke tied to the vagaries of inventory trends, it is actually very normal for inventory swings to account for a good portion of GDP growth when the cycle is first turning.  The question is always whether growth can then get handed off to sustained consumption and private investment after a few quarters.  I think it can, but extreme swings in public policy could theoretically jeapordize the expansion.

The personal consumption number is encouraging, particularly given that consumer credit has been declining.  This implies that we are moving to a sustainable level of spending, complemented by a positive savings rate.  Government transfer payments tied to unemployment insurance and the stimulus package are supporting spending, of course, and my advice would be to withdraw this support only gradually in 2010, if at all.

Net Exports were actually weaker than the real GDP figures reported.  In nominal terms, the trade deficit actually widened as a percent of GDP in Q4.  Petroleum imports increased in nominal terms, but because of rising prices, fell in real terms.  On the flip side, exports grew 25% in nominal terms, meaning world trade is on the rebound and the US can benefit from a strong rebound in the manufacturing and service sectors if it can borrow excess demand from abroad.  Because both the domestic demand and supply of credit is limited, there is reason to be optomistic that exports should expand faster than imports if the dollar stabilizes at current levels.  From a purely economic point of view, it would make sense for the US tom implement policies to reduce its demand for imported oil (to go along with the environmental and security reasons to do so.)  In fact, virtually the entire trade deficit can be traced to the petroleum and auto sectors.

An increase in business investment, on the other hand, was limited purely to high tech equipment.  Traditional industrial and transportation equipment investment remains in the cellar.  There is good reason to expect investment in transportation equipment to rebound from the currently depressed levels not seen since the 1970s in real terms.  Industry, however, suffers from huge levels of excess capacity.  Many sectors of manufacturing got hammered as a whole in the downturn, and had only been skating sideways at best during the expansion of the 2000s.  The most successful manufacturing sectors in the 2000s were high tech, med tech and defense / aerospace which should all continue to thrive, in addition to housing related sectors like wood products, non-metallic minerals, furniture, appliances and fabricated metal products which are highly unlikely to thrive in the intermediate term.  Much of the rebound in manufacturing to date (again, outside of high tech) has been limited to cars, chemicals and steel bouncing from extremely depressed levels to just merely depressed.

Residential real estate investment has clearly bottomed and has added modestly to GDP in the last two quarters.  As a percent of GDP, however, it is at the lowest level since World War II.  Commercial real estate investment continues to plunge, which can be expected for another couple of quarters before bottoming out at record low levels of GDP as well.  Credit conditions, slowing demographics and recent over-investment will all conspire to keep real estate investment at record low levels for at least the intermediate term.

The huge excess capacity in construction workers and construction-related manufacturing leads me to continue to stress how beneficial it would be to focus additional stimulus on infrastructure spending.  These workers can not easily be retrained for health care, education and high tech office jobs.  The country has been behind on such spending anyway, so it would not be Japan-style "bridge-to-nowhere" investment as long as Congress can be reined in.  For this reason I like the "infrastructure bank" idea that takes some of the planning out of the hands of Congressional pork-meisters.

US Indebtedness as a percentage of GDP actually declined in Q3 from 359% to 355%, due primarily to a decline in financial sector debt.  Household and business debt each declined in Q3 as well, but were offset by an increase in US government debt, which increased to 53%, up from 36% at the start of the recession.  In general, I expect this trend continued in Q4 as well, as the US offsets private deleveraging with public borrowing.

In conclusion, the strong parts of the economy (high tech, aerospace, health care and education) are now in expansion mode, and the extractive industries (farming, mining, energy) are likely to join soon.  Those manufacturing sectors exposed to export markets like industrial equipment (think Caterpillar) should resume growth as well unless there is a major economic crisis in the emerging markets.   "Old economy" manufacturing and real estate investment remain a problem and are likely to remain so without increased infrastructure investment.  The trick for policy makers is to transition from a period of broad stimulus to one of consumer and government belt-tightening while letting business investment, infrastructure spending and exports become the primary economic growth drivers.  It would be a neat trick, indeed.

GDP of US, Japan, Germany and China

For all you "USA is in decline" and "China is eating our lunch" adherents, I present the following chart.  I'm not beating my American chest, for the future can certainly head off in many different directions.  Just offering a little perspective.