Tuesday, November 29, 2016

Closing the Obama Gap

Third quarter GDP growth was revised upwards slightly today, from 3.0% to 3.2%. This is encouraging, of course, but it does little to change the bigger picture, which is one of unusually slow growth. Over the past year, the economy has expanded by a very modest 1.6%, and over the past two years it has risen at a mere 1.9% annualized rate. It's managed annualized growth of only 2.1% since the recovery began in mid-2009. I can think of no better way to emphasize how painful this recovery has been than the following chart, which I have been featuring and updating regularly for many years now:


The chart above uses a semi-log scale on the y-axis to emphasize how, for 40 years, the economy has followed a 3.1% annualized real growth path, bouncing back after every recession except for the last one. Never before has the U.S. economy posted such a weak recovery and such a long period of sub-par growth. Demographics—the retirement of baby boomers—can explain some of the slow growth since late 2008, but not all of it; demographic changes take years to unfold.

What we do know is that business investment has been very weak, especially in recent years, and despite record-setting profits; jobs growth has been modest; and productivity has been miserable. At root, I believe the underlying problem has been a lack of "animal spirits," a shortfall of confidence, and the persistence of risk aversion. People have simply been unwilling to work and invest more. We also know that, beginning in 2009, the economy has been burdened by 1) an unprecedented remaking of the entire healthcare industry (Obamacare) which in turn has impacted the lives and healthcare costs of nearly everyone, 2) sweeping new regulatory burdens on the financial industry (e.g., Dodd-Frank), 3) a massive increase in government spending and transfer payments (the ARRA), 4) higher marginal tax rates on income, dividends, and capital gains, and 5) a huge increase in the federal debt burden. You don't have to have a political bias to believe that these changes could go a long way to explaining why the economy has been so weak during the Obama years.

Let's call this the Obama Gap. It's depressing because it represents a huge amount of lost income and jobs that were never created. But to look on the bright side, it is a measure of the massive amount of untapped potential in the U.S. economy. If my analysis of the economy's current malaise is correct, then if the Trump administration can succeed in rolling back the burdens heaped upon the economy in the past 8 years, the future growth potential of the U.S. economy could be enormous. For example, it would take 5% real growth per year over the next 8 years just to close the Obama Gap.

Here are some recent and encouraging developments that suggest the market is in the very early stages of anticipating the unlocking of the economy's upside potential:


I've been following this chart for a number of years, and the relatively tight relationship between the price of 5-yr TIPS and gold never ceases to amaze me. (I use the inverse of the real yield on 5-yr TIPS as a proxy for their price.) Two completely different asset classes have behaved in a similar fashion for the past 10 years! The one thing that gold and TIPS have in common is that they are both a refuge from uncertainty: gold is the classic "port in a storm," and TIPS are not only government-guaranteed but also promise protection from inflation. Both have declined in price in recent weeks, and I think that is a sign that the market is less desirous of paying for protection, and by inference, somewhat less risk averse.


The Conference Board today released their November estimate for consumer confidence, and it registered a new high for the current business cycle. Confidence is still lower than it has been during previous recoveries, but it is moving a positive direction.


Since November 4th, the Vix index has fallen from 22.5 to 12.7, and the 10-yr Treasury yield has jumped from 1.8% to 2.3%. That adds up to less uncertainty and more confidence in the economy's ability to grow. Not surprisingly, the stock market is up almost 6% over the same period.


The chart above shows that there is a decent correlation between the economy's underlying growth rate and the level of real yields on 5-yr TIPS. Real yields are up some 40 bps since November 4th, which suggests the market is pricing in a modest increase in the economy's underlying growth potential. This might be just the beginning of a significant rise in real yields, however: the chart suggests that if the economy manages to sustain 4-5% annual rates of growth, real yields could rise to 3% or more. That would further imply 5% nominal yields, assuming inflation expectations don't change much from where they are currently. If we manage to close a decent portion of the Obama Gap, then the Fed is still in the very early stages of hiking short-term rates.

Would a huge increase in nominal and real yields kill the economy? No, because yields don't cause growth; yields are driven by inflation, growth, and expectations for the future. Higher yields would be the natural consequence of stronger growth, not the enemy of growth.


Monetary policy only becomes a threat to growth when the real and nominal yield curves become flat or inverted. Flat or inverted yield curves are a sign that the market realizes that the Fed is more likely to cut rates in the future than raise them, and that in turn only happens when high real and nominal rates begin to depress economic activity. The chart above shows the current real short-term rate (red line) and the market's expectation of where real short-term rates will be in five years (blue line); it's positive, and that means the real yield curve is still upward-sloping. I wouldn't start to worry about the Fed unless and until the red line moves above the blue line—which is what happened prior to the last two recessions. We're likely still years away from that point.

20 comments:

AUGUST said...

Mr. Grannis, President Elect Trump needs you on his economic staff. Well done.

Scott Grannis said...

It remains to be seen, of course, whether Trump will make the right moves. I'm hopeful that he has enough good people on his staff to keep him from choosing misguided policies, such as those that would lead to a reduction in international trade. But only time will tell.

The Cliff Claven of Finance said...

If borrowing and spending is the road to prosperity, then Trump is just what we need.

But I don't believe that's true.

He has no plan to control baby boomer entitlement and government pension spending.

Wants to expand the military.

Wants $1 trillion infrastructure spending.

I don't recall any promised spending cuts except the usual blathering about fraud and abuse.

Based on his campaign Trump wants to spend more than Obama !

And perhaps with more deficit spending than Obama too!

Maybe he'll add free college at some time in the future!

Trump campaigned on making the government bigger, with lower taxes = more debt.


The Reagan tax cuts worked because marginal rates were very high, so could be significantly reduced.

Currently marginal tax rates are not that high.

So another huge reduction of marginal rates is not possible.


Will Congress stop Trump's reckless spending and debt expansion?

Trump once said he was 'the king of debt'

If you think smaller government is the key to a stronger private sector,
nothing Trump said during the campaign should make you happy.

The actual corporate tax rate, based on what American corporations actually pay, is 25%,
not the official 35% rate. There will be riots if he lowers the official rate to 15%.

The Cliff Claven of Finance said...

If borrowing and spending is the road to prosperity, then Trump is just what we need.

But I don't believe that's true.

He has no plan to control baby boomer entitlement and government pension spending.

Wants to expand the military.

Wants $1 trillion infrastructure spending.

I don't recall any promised spending cuts except the usual blathering about fraud and abuse.

Based on his campaign Trump wants to spend more than Obama !

And perhaps with more deficit spending than Obama too!

Maybe he'll add free college at some time in the future!

Trump campaigned on making the government bigger, with lower taxes = more debt.


The Reagan tax cuts worked because marginal rates were very high, so could be significantly reduced.

Currently marginal tax rates are not that high.

So another huge reduction of marginal rates is not possible.


Will Congress stop Trump's reckless spending and debt expansion?

Trump once said he was 'the king of debt'

If you think smaller government is the key to a stronger private sector,
nothing Trump said during the campaign should make you happy.

The actual corporate tax rate, based on what American corporations actually pay, is 25%,
not the official 35% rate. There will be riots if he lowers the official rate to 15%.

The Cliff Claven of Finance said...

If borrowing and spending is the road to prosperity, then Trump is just what we need.

But I don't believe that's true.

He has no plan to control baby boomer entitlement and government pension spending.

Wants to expand the military.

Wants $1 trillion infrastructure spending.

I don't recall any promised spending cuts except the usual blathering about fraud and abuse.

Based on his campaign Trump wants to spend more than Obama !

And perhaps with more deficit spending than Obama too!

Maybe he'll add free college at some time in the future!

Trump campaigned on making the government bigger, with lower taxes = more debt.


The Reagan tax cuts worked because marginal rates were very high, so could be significantly reduced.

Currently marginal tax rates are not that high.

So another huge reduction of marginal rates is not possible.


Will Congress stop Trump's reckless spending and debt expansion?

Trump once said he was 'the king of debt'

If you think smaller government is the key to a stronger private sector,
nothing Trump said during the campaign should make you happy.

The actual corporate tax rate, based on what American corporations actually pay, is 25%,
not the official 35% rate. There will be riots if he lowers the official rate to 15%.

Scott Grannis said...

Cliff: If Trump does all the things you worry he might do, then I would agree we're in for a world of hurt. But I'm one of those who think that what he says is not to be taken literally. I note that Congress is controlled by conservatives who have received a mandate to shape up, not squander resources.

The infrastructure spending Trump has talked about will not necessarily be financed by raising taxes. Most of the talk centers around incentivizing the private sector to undertake the investments. That is much better than what happened with the ARRA.

Cutting marginal tax rates will not necessarily result in reduced revenue or a bigger deficit, if lower rates result in stronger economic growth. We saw this happen with the Reagan tax cuts.

As for the corporate tax rate, cutting it to 15% would unleash a wave of prosperity for everyone. Studies have shown, and logic dictates, that cutting the corporate tax rate would likely result in rising incomes for the middle class. Corporations would have a strong incentive to expand, individuals would have a strong incentive invest more, and capital would become abundant. Companies would begin competing with each other to hire talent and able-bodied workers. Investment can't rise without employment also rising.

Labor and capital are the two main ingredients to any economy. When capital is scarce, labor becomes abundant, and wages fall. When capital is abundant, labor becomes scare, and wages rise. Look at all the countries where there is an abundance of capital, and you will find that wages and living standards are very high, especially when compared to countries with a scarcity of capital. Compare Switzerland to Venezuela in the extreme if you need an example.

Cutting corporate taxes would boost the value of stocks (which are the discounted value of future expected after-tax earnings), and that would have an enormously powerful impact on pension funds and the average household.

It doesn't matter what the "average" corporate tax rate is. It only matters what the marginal rate is, and that is 35% currently. Corporations make decisions based on marginal changes to after-tax profits. Everything that is important happens on the margin.

Scott Grannis said...

I vow to be among the first to condemn any stupid policy that the Trump administration tries to pass. As the Cato Institute always says, I am an equal-opportunity critic of both Republican and Democratic parties. Both parties can claim the honor of doing very good and very stupid things. I'm looking and hoping for more good things than stupid things from Trump. I hope I'm not wrong.

Scott Grannis said...

Cliff: you are correct that industrial production is at all-time highs, even though industrial employment has been declining for decades. We are exporting lots of stuff. Unfortunately international trade is Trump's major weakness. That's why I'm encouraged that he has people like David Malpass and Steve Moore advising him on economic policy, because they understand how things work.

You are correct that the trillions in corporate profits held overseas are not lost to the U.S. economy. Those dollars are most likely invested here already, via a number of different avenues. But as I've pointed out, the increase in federal borrowing has effectively absorbed all of corporate profits in the past 8 years. If taxes are cut on profits that are repatriated, that has the potential to generate a significant increase in federal revenues. Right now the government is collecting 35% on nothing. 15% of a few trillion dollars would be a huge improvement from the perspective of the federal budget.

Furthermore, the knowledge that profits are no longer going to be taxed at onerous rates would almost certainly result in increased investment, higher profits, higher employment, and higher wages, and all of that would boost federal revenues.

Benjamin Cole said...

Trump is the most interesting player on the US political scene in decades and decades.

Remember, the GOP-Fox-National Review-neocon crowd tried to gut Trump before the Donks tried.

My guess is Trump will be a low-brow version of Reagan, and for the economy that will be roughly good.

Forgotten today is that the Reaganauts were protectionists, ran big deficits and wanted easier monetary policy. The US economy did well, although it did even better in the 1990s.

Interesting times ahead.



Benjamin Cole said...

Trump is the most interesting player on the US political scene in decades and decades.

Remember, the GOP-Fox-National Review-neocon crowd tried to gut Trump before the Donks tried.

My guess is Trump will be a low-brow version of Reagan, and for the economy that will be roughly good.

Forgotten today is that the Reaganauts were protectionists, ran big deficits and wanted easier monetary policy. The US economy did well, although it did even better in the 1990s.

Interesting times ahead.



Mike Kruger said...

"Great minds discuss ideas; average minds discuss events; small minds discuss people."

Scott-
As an investor, I tend to do my research "bottom-up" and limit my macro reading to a few carefully selected voices, including yours. I've been impressed at how you've limited your discussion to ideas and events. Why lower your standards now?

The unmentioned factor driving the explosion in the national debt and sluggish growth is the ~30 year increase in debt which began in the early '80s and culminated in the financial crisis. No doubt some of Obama's policies have been a drag on the economy, but please don't blame one person for every ill that happens to coincide with his term as President.

I think that this has not been a normal recovery as we are dealing with a deleveraging cycle. It seems we go through these every few generations - e.g. the Great Depression, the Great Recession, etc.

I welcome your comments.

Frozen in the North said...

Now that a Republican is in the WH I am sure that the government taps will re-open. Budget concerns only occur when the WH occupant is a Democrat, the missing GDP pie has been government spending, which has been on a downward spiral for virtually the entire Obama administration (which is correct).

The end of Obamacare is certain to lead to much higher medical costs in the US -- that's a given since a large percentage of the population will no longer have primary care and will rely on emergency care. Don't give me the BS that Trump will keep bits of the ACA, its not possible, the insurance companies will walk away (righlty so) if they cannot recover their costs from part of the healthy population -- that's the concept of insurance.

As far as I can see Wall Street is back in charge of regulation (so expect a bailout sooner or later) -- more money, as for the privatisation of Social security that will be neutral in the short run, as is the creation of vouchers for medicare, although that should over time cut costs, since I am relatively certain that the value of vouchers will grow at the rate of general inflation whereas medical care costs will grow at their usual 8/10% p.a -- so that within 10/15 years medicare will be dead.

The last bit is defense, and I am confident that Trump will increase these budgets, I am certain that there are lovely planes and guns to buy, maybe Trump will do something about the VA administation -- but then maybe not. Its more fun to blow stuff up!

Honestly, the rest of the government spending is about 3/5% of the total, so its somewhat irrelevant.

There is no history of America having real GDP growth in excess of 3% for any period of time.

Scott Grannis said...

Re GDP growth: for seven and one quarter years, from the end of December 1982 through the end of march 1990, real GDP growth posted an annualized rate of growth of 4.5%. Robert Bartley wrote a book about this: "The Seven Fat Years."

Scott Grannis said...

Mike: I appreciate your comment, and I agree that ideas are extremely important. But policies are also extremely important, and sometimes there are people who manage to implement ideas that result in sweeping changes in policies. Obama was one of those people, and just about everything he did was wrong. I hated Bill Clinton as a person, but I recognized that the policies he ended up adopting were positive for the economy. I liked GWBush as a person, but he made some unfortunate and significant policy mistakes; growth was not very impressive as a result, and in effect he paved the way for Obama.

I think Trump is one of those people who don't have strong policy ideas (he's not an ideologue), except maybe when it comes to trade (where he is totally wrong). His success is not going to be a function of his ideas. If he succeeds it will be because the people he chooses implement the right policies. But for now, I'm focused on whether and by how much the policies implemented in the past 8-10 years (yes, even some of Bush's policies) are reversed, as I think that could have a tremendous impact on future growth.

Scott Grannis said...

Frozen: What happens to non-discretionary spending is going to be critical, no question. I'm hopeful that the Republican Congress is going to deliver at least something in the way of entitlement reform, but I'll admit they have racked up a lousy record in that regard over the past decade. If we don't get some entitlement reform in the next few years it is going to be very disappointing, even if the economy enjoys stronger growth. The best strategy, in my view, would be to start off with a focus on growth-oriented policies, then use the resulting strong growth to help offset the pain of entitlement reform.

egp said...

"... and productivity has been miserable ..."
Scott: This we are told by statisticians all over the western world and we feel some sort of uneasyness when we read these statements. Is that true? Really? This made me look for this topic and I found a hint for the picture behind this problem at very tiny Swiss website from a tiny St. Gallen think tank: http://www.m1ag.ch.

After a look around thre my conclusion is that it is you who is responsible for the productivity gap, yes YOU.

I got to know you (but you don't know me :-)) ~ the year 2000 at the Shindig Meeting in L.A. organised by David Gordon. Since then I follow you, your comments, your blog. That is 16 years of valuable ideas, perspectives, advice! I did not even thank you, let alone pay a dime. Your generosity seems to be endless. But your undoubtedly economic activity does not appear in the data sets the GDP-number is relying on.

There are millions of private persons, companies, institutions, newspapers, blogs, data storage acounts, offering services for free. Sharing Economy (the modern barter), IKEA Economy, Internet of Things, Information and Entertainment Economy, "likes" instead of money (some sort of Big Data), .... and at the end commercial providers (who contribute to GDP-aggregates) are displaced.

Free beer vs free storage. Is there a difference concerning GDP-numbers? Are the macroeconomic aggregates the GOP-numbers are relying on still resembling reality? Can they - at all?

Now I want to thank you very much for your generosity,
Bob P
Germany
writing from my outlook account - free of charge - of course



Bergsicht (Mountain View)
Secular stagnation... #21
Secular stagnation - or surge of the century?, bergsicht edition 21, 11. october 2016
( https://shop.m1ag.ch/en/A~2000.21/Bergsicht-Secular-stagnation...-%2321#collapsed )
Gnawing questions, no answers

"I recently booked a flight in just five minutes!" "Oh, really?" responded the gentleman seated opposite me, a professor of economics at an American university. " A year or two ago, this operation would have taken me at least half an hour, and the application would no doubt have crashed, at which point I would have had to start the whole laborious process again from square one." "So what?" he retorted. "25 years ago, purchasing a flight ticket would have meant trooping off to a travel agency, and my booking would likely have involved a whole string of people - in the shop, at the travel agent's head office, perhaps even at the International Air Transport Association. And flights were considerably more expensive back then as well." Somewhat dispassionately, my learned companion conceded that technological progress had indeed brought some advantages - and he admitted that he himself had recently downloaded a redesigned app from his preferred US airline that was unambiguously better than the old one. I tried a new tack: "And how much did you have to pay for it?" "Nothing, of course."
STOP - Paywall

The Cliff Claven of Finance said...

Mr. Grannis wrote:
"GDP growth: for seven and one quarter years, from the end of December 1982 through the end of march 1990, real GDP growth posted an annualized rate of growth of 4.5%. Robert Bartley wrote a book about this: "The Seven Fat Years." "


The Cliff Claven of Finance responds:

- The July 1981 Recession officially ended November 1982.

- he next recession was the July 1990 Recession.

- The period you selected to highlight started with the first month of an economic recovery.

- It ended a few months before the next recession started.

This is data mining for several reasons:
- Only one relatively short period of US economic history is shown,
- By choosing only one, the period is implied to be unusual, which it is not,
- Start and end points were chosen to make the GDP growth rate (and Reagan?) look better, and
- You could have made a similar point with much less data mining.

A fair comparison starts and ends at roughly the same point in the business cycle.

Starting just after a recession ends, and ending a few months before the next recession starts, is biased to make GDP growth appear high.

I believe if you had selected ALL non-recession months from after World War II, through 2000 (after which growth rates slowed down), the average annual Real GDP growth rate for non-recession months would have been about 4% -- not that much different than the one short period you highlighted.

The current Real GDP growth rate is hindered by slower productivity growth and slower population / work force growth compared to growth rates before the year 2000.


This issue reminds me of Obama, who took office during a steep recession.

With such a low starting point, Obama will always claim how much better the economy got under his leadership.

As if the recession would not have ended without his "brilliant" leadership.

Obama will never mention, and probably doesn't even know, the rebound from the December 2007 Recession was the weakest rebound from a recession since the Great Depression ended.

If you look at only the first four years of rebounds from recessions, the first four years of the Obama rebound were the weakest since GDP data were first compiled in 1929.

The Cliff Claven of Finance said...
This comment has been removed by a blog administrator.
The Cliff Claven of Finance said...
This comment has been removed by a blog administrator.
Scott Grannis said...

ego: Thanks for the comment. You remind me that we owe David Gordon a huge debt of gratitude for bringing us and keeping us together for so many years. It's unquestionably the case that there is more "free stuff" out there with the internet than we've ever had before, and the value of that free stuff is probably not captured in the GDP stats. But can it explain all of the huge underperformance of GDP growth in this cycle? Did it all start in early 2009? Can we rule out the impact of rising tax and regulatory burdens? Of the anti-business sentiment that has radiated from Washington these past 8 years? And Obama wasn't the only one: Bush is guilty of making a lot of stupid mistakes, and the housing crisis has its roots in decades of legislation.

My best guess is that "free stuff" can account for, at best, a significant fraction (1/8th?) of the Obama Gap.