The Myth of Sound Fundamentals
The recent correction in the US stock market is now being characterized as a fleeting aberration – a volatility shock – in what is still deemed to be a very accommodating investment climate. In fact, for a US economy that has a razor-thin cushion of saving, dependence on rising asset prices has never been more obvious.
NEW HAVEN – The spin is all too predictable. With the US stock market clawing its way back from the sharp correction of early February, the mindless mantra of the great bull market has returned. The recent correction is now being characterized as a fleeting aberration – a volatility shock – in what is still deemed to be a very accommodating investment climate. After all, the argument goes, economic fundamentals – not just in the United States, but worldwide – haven’t been this good in a long, long time.
But are the fundamentals really that sound? For a US economy that has a razor-thin cushion of saving, nothing could be further from the truth. America’s net national saving rate – the sum of saving by businesses, households, and the government sector – stood at just 2.1% of national income in the third quarter of 2017. That is only one-third the 6.3% average that prevailed in the final three decades of the twentieth century.
It is important to think about saving in “net” terms, which excludes the depreciation of obsolete or worn-out capacity in order to assess how much the economy is putting aside to fund the expansion of productive capacity. Net saving represents today’s investment in the future, and the bottom line for America is that it is saving next to nothing.
Alas, the story doesn’t end there. To finance consumption and growth, the US borrows surplus saving from abroad to compensate for the domestic shortfall. All that borrowing implies a large balance-of-payments deficit with the rest of the world, which spawns an equally large trade deficit. While President Donald Trump’s administration is hardly responsible for this sad state of affairs, its policies are about to make a tough situation far worse.
Under the guise of tax reform, late last year Trump signed legislation that will increase the federal budget deficit by $1.5 trillion over the next decade. And now the US Congress, in its infinite wisdom, has upped the ante by another $300 billion in the latest deal to avert a government shutdown. Never mind that deficit spending makes no sense when the economy is nearing full employment: this sharp widening of the federal deficit is enough, by itself, to push the already-low net national saving rate toward zero. And it’s not just the government’s red ink that is so troublesome. The personal saving rate fell to 2.4% of disposable (after-tax) income in December 2017, the lowest in 12 years and only about a quarter of the 9.3% average that prevailed over the final three decades of the twentieth century.
As domestic saving plunges, the US has two options – a reduction in investment and the economic growth it supports, or increased borrowing of surplus saving from abroad. Over the past 35 years, America has consistently opted for the latter, running balance-of-payments deficits every year since 1982 (with a minor exception in 1991, reflecting foreign contributions for US military expenses in the Gulf War). With these deficits, of course, come equally chronic trade deficits with a broad cross-section of America’s foreign partners. Astonishingly, in 2017, the US ran trade deficits with 102 countries.
The multilateral foreign-trade deficits of a saving-short US economy set the stage for perhaps the most egregious policy blunder being committed by the Trump administration: a shift toward protectionism. Further compression of an already-weak domestic saving position spells growing current-account and trade deficits – a fundamental axiom of macroeconomics that the US never seems to appreciate.
Attempting to solve a multilateral imbalance with bilateral tariffs directed mainly at China, such as those just imposed on solar panels and washing machines in January, doesn’t add up. And, given the growing likelihood of additional trade barriers – as suggested by the US Commerce Department’s recent recommendations of high tariffs on aluminum and steel – the combination of protectionism and ever-widening trade imbalances becomes all the more problematic for a US economy set to become even more dependent on foreign capital. Far from sound, the fundamentals of a saving-short US economy look shakier than ever.
Lacking a cushion of solid support from income generation, the lack of saving also leaves the US far more beholden to fickle asset markets than might otherwise be the case. That’s especially true of American consumers who have relied on appreciation of equity holdings and home values to support over-extended lifestyles. It is also the case for the US Federal Reserve, which has turned to unconventional monetary policies to support the real economy via so-called wealth effects. And, of course, foreign investors are acutely sensitive to relative returns on assets – the US versus other markets – as well as the translation of those returns into their home currencies.
Driven by the momentum of trends in employment, industrial production, consumer sentiment, and corporate earnings, the case for sound fundamentals plays like a broken record during periods of financial market volatility. But momentum and fundamentals are two very different things. Momentum can be fleeting, especially for a saving-short US economy that is consuming the seed corn of future prosperity. With dysfunctional policies pointing to a further compression of saving in the years ahead, the myth of sound US fundamentals has never rung more hollow.
America’s Tax-Cut Peronists
American populism in the Trump era, though promising great gains for working people, will in fact benefit only those who are already rich. That's quite a twist on anything Argentina's Juan Perón could have imagined pulling off, but, if left unchecked, the result, in terms of economic hardship and national decline, will be the same.
WASHINGTON, DC – Name the country. Its leader rails against foreigners, erects various import barriers, and pushes for low interest rates and lots of cheap credit for favored sectors. Government debt is already high, but the would-be strongman in power decides to pile on even more by increasing the budget deficit, arguing that this will boost prosperity to previously unattainable levels. While the government claims to represent the common people, state contracts are awarded to friends of friends.
The answer, of course, is Argentina under Juan Perón, who was in power from 1946 to 1955 (and again briefly in 1973 and 1974), and many of his successors. One of the richest countries in the world around 1900 was laid low by decades of unsustainable economic policies that made people feel good in the short run but eventually ended in disaster, such as runaway inflation, financial crisis, and periodic debt defaults. (To be clear, Argentina’s economic policies today are quite different; for deep and up-to-date analysis, I recommend the work of my colleague Alberto Cavallo.)
But if your answer was the United States under President Donald Trump, you would not be far off. There is reason to fear that the US is now on the path to what was previously known as Latin American populism.
Consider the remarkable volte-face of the Republican Party on fiscal responsibility. There used to be a national debt clock in the hearing room of the House Financial Services Committee, and Republicans would rant about government profligacy as it ticked upward. When I was in that room recently, the clock was “under repair.”
Self-proclaimed “fiscal conservatives,” such as Mick Mulvaney (a former member of the House of Representatives who now runs government finances as head of the Office of Management and Budget), are close to enacting a massive tax cut, despite knowing that it will drive up the deficit and the national debt. Mulvaney and his colleagues could not care less.
Despite controlling both Houses of Congress and the presidency, the Republicans are beset by internal divisions. As a result, they are finding it hard to “pay for” the tax cuts with any reduction in tax expenditures (incentives for various activities such as corporate borrowing, mortgage financing, or retirement saving). But Republicans are deeply committed to gigantic tax cuts, in large part because their donors are demanding that they enact them. As a result, the US will merely end up with bigger budget deficits.
Facts used to matter in Washington, at least a little bit. But this is no longer the case in the age of Trump, at least not when it comes to taxes. Instead, the strategy has been to state, in a bald-faced manner whatever one wants to believe and heap ill-mannered abuse on anyone who cites evidence to the contrary.
In Chapter 3 of White House Burning, James Kwak and I reviewed what happened after the tax cuts enacted in 2001 under George W. Bush. Great promises were made about the cuts, including that they would help most Americans. But while they did help rich people become richer, there is no evidence that they delivered faster growth or higher incomes for the middle class. Instead, they boosted the budget deficit and contributed significantly to increasing the US national debt (by around $3 trillion through 2010), which weakened the government’s ability to respond to crises, either in terms of national security or financial instability.
I have testified repeatedly before Congress on matters of fiscal policy. During the financial crisis of 2008-2009, Republicans were certainly interested in the facts. But this quickly tapered off, most notably in the House of Representatives. In fact, Kevin Brady, the representative who told me most clearly that he was not interested in looking at even moderately inconvenient facts, is now Chair of the House Ways and Means Committee, which plays a key role in what happens with taxes.
Ron Wyden, the senior Democrat on the Senate Finance Committee, calls the proposed Republican tax cuts “a middle-class con job.” He is being polite.
The cut in corporate taxes that the Republicans are likely to support will not boost wages significantly. As the Congressional Research Service, describing the broader blueprint put forward by House Speaker Paul Ryan, has put it, “the plan’s estimated output effects appear to be limited in size and possibly negative.”
Including all possible positive effects of the Republican proposals, the Tax Policy Center has concluded that federal government “revenue would fall by between $2.4 trillion and $2.5 trillion over the first ten years and by about $3.4 trillion over the second decade.”
The Trump administration has responded to this type of sensible, fact-based analysis in the way one has come to expect: by being rude.
American populism in the Trump era, though promising great gains for working people, will in fact benefit only those who are already rich. To be fair, this is quite a twist on anything Perón could have imagined pulling off. The results of irresponsible populism, however, are always the same.
Cutting US Corporate Tax Is Worth the Cost
One of the main criticisms leveled at congressional Republicans' proposal to cut corporate taxes is that a higher budget deficit would amount to an undesirable fiscal stimulus. But with monetary policy turning contractionary, and most experts predicting a US recession in the next five years, stimulus should be welcomed.
CAMBRIDGE – The United States Congress is close to enacting a major tax reform. The plan’s most important provision reduces the corporate tax rate from 35% to 20% – from the highest among all OECD countries to one of the lowest – and allows US companies to repatriate the profits of their foreign subsidiaries without paying additional US taxes. Opponents of the legislation point to the resulting increase in the federal budget deficit, which will add $1.5 trillion to the government debt over the next ten years.
I dislike budget deficits, and I have long warned about their dangerous effects. Nonetheless, I believe that the economic benefits resulting from the corporate tax changes will outweigh the adverse effects of the increased debt.
The lower rate will attract capital to the US corporate sector. American corporations will invest more in the US, because foreign countries will no longer offer lower tax rates, and will repatriate profits earned by their foreign subsidiaries rather than leaving them abroad. They will also bring back some of the previously earned foreign profits that have been left outside the US, estimated by the Treasury to be worth $2.5 trillion. Foreign companies will expand their investments in the US – or even shift their operations there – to take advantage of the lower tax rate. And within the US, capital will flow from agriculture and housing to higher productivity uses in the corporate sector.
Although it is difficult to estimate the total increase in capital in the corporate sector, I think it is reasonable to assume that over the next ten years it will reach at least $5 trillion. The increased flow of capital to the corporate sector will raise productivity and real wages. If that happens, it will raise annual real GDP in 2027 by about $500 billion, equivalent to 1.7% of total 2027 GDP, implying a gain of $4,000 per household in today’s dollars.
These favorable effects are directly relevant to balancing the primary adverse effects usually associated with a fiscal deficit: that government borrowing crowds out private capital formation; that higher interest payments generally require higher taxes or reductions in spending on defense and nondefense programs; that a budget deficit implies an unwanted increase in aggregate demand when the economy is at full employment; and that a higher debt ratio leaves less capacity for increased emergency government spending.
I believe that none of these problems will materialize during the coming decade. Let’s consider them in turn.
Although the $1.5 trillion of government borrowing caused by the tax bill during the next decade could crowd out an equal amount of private borrowing, the capital stock will grow by an even larger amount. The $1.5 trillion corporate tax cut will go directly to US companies, and the stock of corporate capital will grow further because of the inflow of funds from the rest of the world. Even with increased government borrowing, the proposed tax reform can therefore still raise the corporate capital stock by some $5 trillion over the next decade.
Moreover, the $500 billion increase in total annual income by 2027 would increase tax revenue by $100-150 billion a year. That is enough to cover the $60 billion in interest payments on the $1.5 trillion of extra debt, with money left over to increase government spending or reduce personal taxes.
Likewise, concern that an increase in the fiscal deficit would undesirably stimulate aggregate demand is misplaced. In fact, the stimulative effects of the fiscal deficit and increased corporate investment should be welcomed, for two reasons. First, they will offset the contractionary effects of the expected increase in the federal funds rate and the shrinking size of the Federal Reserve’s balance sheet. And, second, after nine years of economic expansion, most experts expect the US to enter recession sometime in the next five years.
Similarly, concern about the ratio of government debt to GDP, which has doubled in the past decade and is now 77%, is exaggerated. The Congressional Budget Office projects that even with no further legislation, the debt ratio will rise to 91.2% by 2027. The direct effect of the $1.5 trillion deficit implied by the tax reform would be to raise that to 97%. A military emergency or an economic downturn would call for additional debt-financed spending or tax reductions. But even a massive spending program like the $900 billion American Recovery and Reinvestment Act of 2009 would add only an additional three percentage points to the debt ratio. It is hard to believe that a debt ratio of 97% would make that more difficult to achieve than a debt ratio of 92%.
So, for all four of these reasons, I believe that the benefits of cutting the corporate tax rate more than offset the adverse effects normally attributed to budget deficits. But, looking ahead, I believe that reducing the fiscal deficit should be a high priority after the 2018 congressional election. A tax on carbon dioxide emissions or a slowdown of spending growth for federal entitlement programs can start to bring the debt ratio back down toward the 50% level that prevailed before the 2008-2009 downturn. But first it is important to enact the proposed tax reform.
Making America’s Deficits Great Again
The new tax legislation pushed through by Donald Trump and congressional Republicans is virtually certain to raise the budget deficit and, in turn, the current-account deficit. Whatever the resemblance to the Reagan-era tax cuts of 1981-1983, it's not morning in America.
FRANKFURT – US President Donald Trump and congressional Republican allies have succeeded in passing their big tax legislation. While it lacks many of the desirable attributes of true tax reform, it amounts to a success for Trump, who failed to deliver any other major piece of legislation during the first year of his administration. But what will it mean for Trump’s other major promise, to cut the US trade deficit?
Simply put, the Republicans’ tax law – which emphasizes big cuts, especially for corporations and the highest-income earners – is virtually certain to widen the budget deficit and, in turn, increase the current-account deficit. Trump’s legislative victory implies the return of the infamous twin deficits that followed George W. Bush’s tax cuts of 2001 and 2003, and Ronald Reagan’s cuts of 1981-1983.
There are different ways to measure the balance of payments, each appropriate for different purposes. The narrowest – and probably the least informative – measure includes only merchandise trade. Yet Trump likes to focus on bilateral merchandise balances, rather than a broader and more useful indicator, such as the overall balance of goods and services.
The current-account balance is broader still, including such other transactions as net investment earnings from abroad, expatriates’ remittances, and foreign aid. It is useful, because it shows whether the United States is spending beyond its means and therefore going into debt to the rest of the world. And, whichever approach an economist takes, the result is clear: Trump’s tax cuts will have a negative effect on the current-account balance.
Start with the simple Keynesian model. A tax cut boosts income and spending. True, Trump’s tax cut focuses heavily on corporate taxes, rather than personal income taxes. But, as Republicans like to point out, corporations are people, too, in the sense that people own and run them.
Most of the corporate windfall that Trump’s tax cut will deliver will be passed through to shareholders in the form of dividends and share buy-backs, and given to managers as higher pay. The recipients will spend some of that additional income on foreign goods, boosting imports and worsening the trade balance.
The simple Keynesian model is less relevant when the economy is at full employment, as the US now is, and output is constrained by capacity. But, under such circumstances, the result is also problematic: the increase in spending afforded by tax cuts goes entirely, rather than only partly, into the current-account deficit.
Moreover, when output is constrained, the increased demand tends to lead to inflation. Higher prices for US products will reinforce domestic consumers’ incentive to buy foreign products, while reducing external demand for US exports. The result, again, will be a larger trade deficit.
What about the burst of investment and eventual rise in productivity that is supposed to result from the Republican tax reform?
In the short run, higher investment is another form of spending: yet again, imports rise, and the trade deficit widens. This effect is likely to be compounded by the expectation that a lower corporate tax rate will attract foreign investment, resulting in a net capital inflow. According to the so-called intertemporal approach, a policy change that people believe augurs higher productivity in the future causes a current-account deficit today. And, in fact, the model that White House economists use to claim that the corporate tax cut will raise wages assumes a large capital inflow and current account deficit.
The net capital inflow will be even larger if the US Federal Reserve continues to respond to increases in demand by raising interest rates. This policy would probably also drive up the value of the US dollar, which would undermine the international price competitiveness of US exports and worsen the trade balance further.
So, whichever approach one takes, it is hard to escape the conclusion that the Republican tax cut will widen the trade and current-account deficits, achieving the opposite of what Trump has promised. But that doesn’t mean that Trump skeptics can just sit back and wait for him to be proven wrong, because it is possible that, in the first year, the reported trade deficit will narrow, even as the true trade deficit widens.
It all comes down to “transfer pricing” – the prices multinational corporations use to put a value on cross-border trade in inputs among their subsidiaries. Consider an American pharmaceutical company that establishes a plant in Ireland. The Irish affiliate imports some inputs (most notably, the intellectual property represented by the drug patent), assembles the product in Ireland, and exports it back to the US. In terms of value-added, the patent makes the biggest contribution. But, because the corporate tax rate is lower in Ireland than in the US, the company has an incentive to assign a low value to the patent, thereby maximizing the profits in Ireland and minimizing them in the US, where the patent was developed.
This sort of profit-shifting – or, put another way, “creative accounting” – is widespread, and has long made the US trade balance appear worse than it really is (while making US primary income look better than it really is). George Saravelos and his colleagues at Deutsche Bank argue that eliminating the measurement error that arises from inaccurate transfer pricing could give a one-time boost to the reported trade balance – particularly in the form of reported service exports – as large as $250 billion. The trade deficit would ostensibly be halved.
But there is a difference between the reported trade balance and the true one; whatever narrowing of the trade deficit arises from the adjustment of transfer prices would be illusory. Moreover, the current-account balance, reported or true, would not improve at all, because the apparent improvement in service exports would be offset by an apparent worsening of profits earned abroad. On the contrary, that balance would deteriorate, for all the reasons stated above.
No matter how you look at it, the Republican tax cut, by widening the budget deficit, will fuel growth in the US current-account deficit. It’s the early 1980s all over again. But it’s not morning in America.