Friday, April 28, 2017

Weak Q1 growth, but stronger growth to come

First quarter GDP statistics were disappointing, with real growth of only 0.7% annualized (real GDP increased by a mere $29 billion in the quarter, almost a rounding error). However, real growth for the 12 months ended March was 1.9%, only modestly less than the 2.1% annualized growth rate for the current business cycle expansion. More interesting, perhaps, was the rate of inflation as measured by the GDP deflator (the broadest measure of inflation available): 2.3% annualized for the first quarter and 2.0% for the past 12 months. By this measure, the Fed has achieved its target inflation goal, and is fully justified in raising short-term interest rates. The brightest spot in the quarter was a 12% annualized jump in gross private fixed investment, since weak business investment has been the root cause of the current recovery's dismal, 2.1% annualized pace of growth. This may mark the beginnings of a pickup in growth in the years ahead, especially if Trump is able to slash the corporate tax rate as he proposes.

As the chart above shows, real GDP growth has essentially been on a 2% growth path since the middle of 2009. That's about one percentage point below its long-term growth path, and the "gap" between the two is now a bit over $3 trillion. That's a disappointing result, to be sure, but it also implies that the economy has tremendous upside potential, and that is extremely encouraging. As long-time readers will  know, I consider that the current recovery has been weak primarily due to rising tax and regulatory burdens and a dearth of business investment (and the two are most likely closely entwined). Rebuilding confidence, reducing the barriers to business investment and risk taking, and increasing the after-tax rewards to investment will thus be critical to closing the GDP gap. The potential rewards to successful growth-oriented policies are hard to overestimate.

Real gross private domestic investment (shown in the graph above) grew at a 3.7% annualized rate from 1966 through 2007, over which time real GDP growth grew at a 3.1% annualized rate. From the peak of the last business cycle in 2007 until March of this year, private investment has managed to post only 1% annualized growth. It's no wonder then that growth in the current expansion has been only 2.1%. Without more investment, there will be a scarcity of jobs, and a scarcity of the tools (machines, computers, software) necessary to boost the productivity of those who are employed. Investment is the key to prosperity, and so far, in the current business cycle expansion, it has been in scarce supply.

A subset of real gross private investment is gross private fixed investment, shown in the chart above. Largely driven by strong residential investment, it jumped at a 12% annualized rate in the first quarter.

As the chart above shows, inflation as measured by the GDP deflator (the broadest possible measure of inflation) was 2% in the 12 months ended March 2017. Forget deflation. The issue now is whether inflation is likely to accelerate from its current 2% pace. It's also significant that despite the sluggish growth of the past 6 ¾ years, inflation has on balance remained well above zero, a result that runs counter to the Phillips Curve theory of inflation, which holds that weak growth and lots of unused capacity tend to depress inflation. Inflation is a monetary phenomenon, not a function of growth.

The key to the future prosperity of the US economy is business investment. Only the private sector can create prosperity; the proper role of the public sector is to uphold the rule of law, ensure personal freedom, protect private property, and maintain the peace—not to create jobs. Prosperity is the result of people working smarter and harder—and taking on risk in the process. In order to get more prosperity we need more investment, and Trump's tax proposals—while far from ideal—go a long way to incentivizing private sector investment.

Lowering the tax rate on big and small businesses to 15% would significantly increase the after-tax rewards to business investment. One simplistic example: currently a business gets to keep 65 cents on every dollar of profit; under Trump's proposal a business would get to keep 85 cents on every dollar of profit. That works out to a 30% increase in the after-tax rewards to running, starting, and expanding a business. (It also suggests that reducing the corporate tax rate to 15% could boost the stock market—which is the present value of future after-tax profits—by 30%.) When rewards increase to such a significant degree it is only reasonable to expect to see a big increase in business investment, which in turn would result in more jobs, more income, and an expanding tax base. Cutting tax rates needn't result in reduced tax revenues, and cutting the corporate tax rate is the most logical place to start if you want to stimulate the economy. And by the way, we need to continue to cut regulatory burdens and simplify the tax code; shrink the government, and give the private sector the room and freedom to grow.

UPDATE: John Steele Gordon yesterday wrote forcefully (and in much greater depth than I do here) about why Trump's tax proposals would be very good for the economy. Trigger warning: he criticizes those who oppose the proposals.


Benjamin Cole said...

I might prefer different set of tax cuts, but hey, any tax cuts on productive behavior are good. Anybody in business is productive by free-market definition, whether working or investing. I think such people should not be taxed at all.

An interesting thought: So the Trump tax cuts balloon deficits. Left-wingers, but also quite a number of right-wing deficit hawks, say so.

For sake of argument, let's grant that Trump tax cuts increase federal debt.

That last time the Fed paid down the national debt (buying about $3 trillion in U.S. Treasuries) nothing happened. No inflation. Gold prices actually cracked, and never recovered.

The Bank of Japan now owns about 43% of JGBs, and will own them all in perhaps 10 years. They have near deflation. Japan soon will have no real national debt. They will owe themselves money. I call it Mobius-strip economics.

So the Trump tax cuts add $2 trillion to national debt in next 10 years. That seems to be the rough estimate. And so the Fed buys back $3 trillion in US Treasuries in the next 10 years.

Does anyone really believe the Fed would incur inflation doing so?

Mark said...

Scott, curious if you have ever found value in the commercial and industrial loan dollar value and delinquency rates data on the FRED website?

Scott Grannis said...

Mark: you must have missed this post from last month:

Scroll down to the bottom half of the past and you will find charts of C&I Loans and delinquency rates.

Rich said...

I'm all for cutting taxes but I hate the anti-libertarian social policy that this crowd pushes along with it.

Frozen in the North said...

Don't want to come across as a Troll, but there really is no correlation between lower taxes and greater economic activity. As of now corporate America, as a whole has a real tax rate of about 28% -- the difference between what is taxable income and real deduction. Now if Trump was proposing to remove all the deductions and loopholes then YES a very good idea.

But lets be serious here he has neither the attention span or the interest in getting that done (nor does Corporate America -- how about removing the deduction for interest paid).

Trump's one pager tax plan (if you want to call it that) is on the same level of Herman Cain's 9/9/9 tax rate. Nice idea as long as no on things of the consequences.

BTW, and this is the most important, there is no correlation between lower taxes and greater economic activity -- and please don't use the example if Ireland (its not because its based there that any meaningful economic activity actually occurred there)

Scott Grannis said...

I think there is a very strong argument in favor of cutting corporate tax rates as Trump has proposed. That argument is based on the fact that US corporations hold almost $3 trillion in overseas profits that they have chosen to not repatriate, and on the fact that there has been a significant increase in the number of US corporations choosing to relocate to other tax jurisdictions (aka corporate inversions). These two facts prove that the US corporate tax rate is not only too high relative to other countries' tax rates, but that our tax system is resulting in a serious distortion of economic activity.

Trump's proposal would lead to a massive repatriation of foreign profits, which in turn would almost certainly result in greater domestic investment by US corporations. It would also lead to a reversal of corporate inversions, and create a powerful incentive for foreign firms to relocate to the US. The fact that the Chinese worry about this is proof enough that lower corporate tax rates would be good for the US economy: