Patrick Watson argues that much like the War on Drugs gave the US more drugs, the country's 'War on Slow Growth' might give it even slower economic growth

By Patrick Watson*

According to the more cynical pundits, government programs usually achieve the opposite of their intended goal. And sometimes they do.

For example, Richard Nixon’s “War on Drugs” is still in progress, but the drugs are definitely winning.

Some government programs, however, are more effective. Firefighters are doing a pretty good job extinguishing fires. The US Coast Guard saves lives every day. Public school teachers educate students who would rather be elsewhere.

And then there’s our increasingly dysfunctional Congress. Where to begin?

I’ve written recently how Congress’s new tax plan misses a chance to boost economic growth. Now I think it may be even worse. Instead of merely failing to stimulate growth, the tax changes could actually launch a recession.


Image: Renegade98 via Flickr

Long & weak expansion

I explained two weeks ago why tax cuts won’t stimulate the economy as much as Republican lawmakers think. Most CEOs say they will use any tax savings for stock buybacks or dividends, not new hiring or expansion.

Since then, the Joint Committee on Taxation, Congress’s nonpartisan scorekeeper, found the Senate tax bill would spur only 0.8% of economic growth, split over 10 years, and add a net $1 trillion to the national debt.

But let’s set aside debt for now. What if, instead of little or no growth, this tax bill sets off an outright contraction?

The current economic expansion is now the third-longest since World War II. It’s also the weakest. Here’s a chart I showed last [Northern Hemisphere] summer.


Source: BCA Research

The yellow line is the current recovery that began in 2009. Only the 1960s and 1990s growth periods went on longer - and both had much higher growth.

So, just by length of time, we’re already due or overdue for recession. Yes, the economy could improve further from here… but probably not for long.

Potential achieved

Last week, the Commerce Department revised its third-quarter inflation-adjusted GDP estimate to a 3.3% annualized pace. While that was good news, it also marked something ominous.

In addition to actual gross domestic product, economists track “Potential GDP.” That’s how fast the economy is capable of growing, considering the number of available workers, productivity, and other factors.

If subsequent data confirms last quarter’s 3.3% growth, it will mark the first time since 2007 the US economy achieved “maximum sustainable output.”


Image: Washington Post

The gap between the gray line (potential GDP) and the red line (actual GDP) represents unused capacity. You can see we had a lot of it at the recession’s 2009 depth. The gap slowly shrank since then. Now it’s closed.

Great news, right? Yes, it is - but don’t celebrate just yet.

The end is near

Actual GDP can’t stay above potential GDP for long before bad things start happening. This chart proves it:


Image: Washington Post

We see here how GDP moved above and below its potential since the 1970s. Notice that each time the green line went above zero, a recession (the gray bars) began soon after.

“Soon” can vary, of course. GDP ran above potential for extended periods in the late 1990s and 2006–2007, but in both cases, intense downturns followed. Plus, the Fed wasn’t tightening as it is now - which suggests the current expansion is at least approaching its endpoint.

The Trump administration and congressional Republicans disagree, saying their tax changes will stimulate years of economic growth and more than pay for themselves.

President Trump himself said last month he thought growth could reach 4% and even “quite a bit higher.”

I agree we may get a quarter or two of 4% real annualized growth. But will it continue for years? Probably not, unless potential GDP takes a big leap.

Here is the potential GDP chart above, extrapolating the future as it would look with 3% to 4% growth over the next decade.


Image: Washington Post

I’m sorry this chart is so tall, but that red triangle is necessary to project as much growth as the president anticipates and that Congress says will pay for the tax cuts. The smaller yellow fan below it is the less thrilling estimate of nonpartisan economists.

In either case, to do what the Republicans predict, GDP must grow above potential for years, unless potential GDP rises in a similarly spectacular fashion.

That’s not impossible: a major technology breakthrough might do it, say, a cure for cancer that frees up more workers, or wearable supercomputers to make workers more productive.

But just as likely, a recession, natural disaster, war, or other shock could sharply reduce GDP. The projections above don’t account for that possibility.

Booms going “boom”

Actual GDP can outpace potential GDP at the end of a cycle, but by definition, such growth is unsustainable. The inputs to higher production - available workers, productivity - can’t grow fast enough, so those booms end up going “boom.”

Now consider what else is happening.

The Federal Reserve is in tightening mode, both raising short-term interest rates and reducing its massive balance sheet assets. Fed officials think the economy is close to full employment, and they want to control inflation pressure before it gets out of hand.

If this tax cut finally passes - and I’m still dubious that it will - I don’t think it will create anything like 3% to 4% GDP growth. I think it will do the opposite, as the US Treasury borrows hundreds of billions more dollars to cover deficit spending. That will drive rates higher; not good for real estate or consumer spending.

Much like the War on Drugs gave us more drugs, the “War on Slow Growth” might give us even slower growth.


Image: Danlele Pesaresi via Flickr

Recession triggers

Here’s where we are:

  • The current expansion is long in the tooth, suggesting a recession could start anytime
  • GDP growth is running above potential, which also points to recession in the near future
  • The Fed is tightening, soon to be joined by other central banks
  • Treasury borrowing will likely increase in the next few years as deficits rise
  • Bitcoin and other cryptocurrencies look increasingly bubble-like

All that is happening even if we get no surprises. War with North Korea, a NAFTA breakup, Chinese banking crisis, a hard Brexit - any of those could extinguish global growth.  

My main fear as we entered 2017 was that the Fed would tighten too much and too fast, pushing the economy into a deflationary recession. I still think that’s the most likely scenario.

If this tax bill passes in its current form, the recession may happen sooner and go deeper. The combined fiscal and monetary tightening could be the triggers.

However, first we might get a sugar-high inflationary rally, which could last a while. GDP ran above potential for four years in the late 1990s, and for over a year in the housing craze.

Those were fun times while they lasted. Then the fun stopped.

One thing I’m positive won’t happen is another 10 years of uninterrupted 3% or 4% real GDP growth, as politicians so glibly promise. That’s pure fantasy.

Gravity still applies, no matter how many people wish it didn’t. We may get a demonstration soon.

See you at the top.

------------------------------------------------

*Patrick Watson is senior economic analyst at Mauldin Economics. This article is from a regular Mauldin Economics series called Connecting the Dots. It first appeared here and is used by interest.co.nz with permission.

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8 Comments

We need to be brutally honest with ourselves , and recognize that some economic fundamentals have reached critical points .

Asset prices have now reached levels where the underlying value no longer bears any relationship to the price , there are numerous examples from Auckland property , Bitcoins, Nasdaq stocks to stocks in Hong Kong and Shanghai in particular .............. Has anyone followed the share price of the Hong Kong listed Tencent ? .

The value of a critical factor of production , namely money or capital has been reduced to close to ZERO through the biggest monetary experiment in humankind .......... Quantitative Easing , a fancy name for Central bankers losing their marbles .

The only other example of such a destruction of a factor of production is where land values collapse when a communist government takes over in a revolution

Now more cash is going to be pumped into an oversupplied cash market by way of tax cuts.

Where pray -tell does one expect that money going to end up ?

When this all goes pear -shaped , we cannot say that we were not warned

Re: Tencent. They just picked up the IP rights to Player Unknowns Battle Grounds which is a popular online game which has exploded from nothing to titanic proportions in the past 6 months. They will have the market cornered in China and its a bigger cash cow than you would ever imagine.

You say: the price of Auckland property doesn't bear any relationship to its underlying value. I will agree with you the day when I can buy a piece of land and build a house for a lower cost than the purchase price of a similar house in the same area

"Most CEOs say they will use any tax savings for stock buybacks or dividends".
Actually, they don't. They say that they will do the opposite, and invest any tax savings in jobs and expansion, but they won't of course. Who would?! The pattern of success in a post QE World has been established, and stock buy-back is it.....

The 15% tax rate reduction to 20% corporate tax rate is aimed at the multi-nationals who, over the years, have squirrelled $trillions of foreign earned profits in offshore tax-havens at tax rates of 1% - Trump thinks they will be encouraged to bring those profits home to the US at the lower rate of 20%

One thing we know it won't do from all the previous times it's been tried, is trickle down to everyone other than the rich to any large extent.
Even though that sad and tired old sales pitch gets rolled out for this kind of thing every time.
Rich people with more money will probably just take longer holidays abroad from their own countries, and buy more luxury items, which are generally made somewhere else than their own country.

A tax cut in any Economy can not be a bad thing. Its great to see a President pushing this.
The roman empire expanded with no income tax ( the govt made their own money to fund govt ) The economy grew and outpaced that money supply. In a nut shell it was the introduction of income taxes and theft of private lands etc (along with outsourcing the military ) that drove it all in to the ground.
Zero income tax = watch that economy take off like a rocket.

Funny thing about the Trump tax cuts is they are exactly what was needed in the US in 2009.

Tax cuts leave money in people's pockets. To some extent, you can choose whose pockets they get left in. So, in a downturn they are a really, really good idea.

Each individual gets to choose how best to spend them, depending on their circumstances. So, people who find themselves over-indebted can use them to keep up the payments on their loans (which helps them and the lenders, reducing the amount of government support needed to "save" the financial sector). People who are struggling can buy necessities, people who are comfortable can save a bit more, big spenders can keep on spending.

The downside to the tax cuts is of course, increased government indebtedness, which needs addressing over the following years. My contention, though, is that tax cuts are a far more effective and far fairer response to a downturn than any other. You also get maximum bang for the government buck.

Why is it that those on the left hate tax cuts with a vengeance at all times? I can see why those on the right like them at all times, as the better off you are the more you can save. Those on the right also tend to talk a lot about government debt when the left are in power but happily increase it when they are running things. This also makes a lot of sense as they stand to be first in line for the money.

If the US had cut taxes significantly in 2009, then surely they would have needed far less QE and the economy would have sorted itself out faster.