Tuesday, August 14, 2018

Small business optimism is huge

Economic growth is a function of two major factors: growth in the number of people working, and growth in the output of those working (i.e., the productivity of labor). For most of the current business cycle expansion, which has been the weakest post-war expansion on record, productivity has been unusually weak, averaging about 1% per year. Prior to the Great Recession, productivity averaged over 2% per year. Productivity and jobs growth are in turn a function of investment, and investment—no surprise—has been unusually weak for the past 9 years, despite the fact that corporate profits have been unusually strong. Investment is the seed corn of future growth, since investment builds new businesses, creates new jobs, and gives workers the advanced tools necessary to increase their productivity. 

Something has been holding back the economy, and it might be as simple as a general unwillingness on the part of business to expand and invest in new plant and equipment. Confidence is key, and confidence has, until fairly recently, been low. Risk aversion, by the same token, has been rather high.

(Note my supply-side bias: Supply-side economists believe that investment, hard work, and risk-taking are what drive the economy, not spending. In our global economy, total spending can never exceed total production. Increased production (supply) is the key to increased spending (demand). Beware of all those economists who say the economy is weak because the consumer is not spending enough; they are not seeing the whole picture.)

If the economy is going to grow by 3% or more, productivity is going to have to increase (and maybe jobs growth, but not necessarily), and that means that investment is going to have to increase. Increased investment is likely to follow from lower corporate tax rates, and from increased confidence and an increased willingness to take risk. Thanks to the bulk of Trump's policies, we have the essential ingredients for a stronger economy: lower tax rates on business and business investment, reduced regulatory burdens, and a more business-friendly climate in Washington. There are early indications that the economy is picking up steam (e.g., business investment is up in the past 18 months, and real yields are up), but it's still premature to declare victory. 

Here are two charts which are particularly impressive in this regard, since they document a pronounced and sustained increase in small business optimism and hiring intentions—an increase that dates to December 2016, just days after Trump was elected. Small businesses generate the vast majority of new jobs, and they are a vital source of innovation and productivity. These charts argue convincingly for a stronger economy in the months and years to come, thanks to increased business optimism and investment. (Both charts reflect survey results as of July '18, released today.)

Chart #1

Chart #2

Unfortunately, things are never so straightforward. While we undoubtedly have the essential ingredients in place for a significant pickup in economic growth, we also have—from the same pro-growth Trump who advocated for lower tax and regulatory burdens—an escalation of tariffs, which suppress growth by making imports more expensive for everyone.

I think Trump's ultimate objective is to reduce tariff barriers. I think he sees higher tariffs as a negotiating tool to eventually arrive at a reduced and even zero-tariff world. But for his negotiations to succeed, he has to convince our trading partners (particularly China) that he is willing to sacrifice some portion of US growth to achieve a result that would eventually be a win-win for all concerned. Suffice to say that this is a delicate balancing act. I'm optimistic he will succeed, but my confidence in that belief is not as strong as I would like it to be.

In short, Trump's tariffs are, for the time being, a headwind to growth, while his other policies are a tailwind.


WealthMony said...

Scott, I do wish I were as optimistic as you regarding President Trump's use of tariffs as a negotiating tool to get lower tariffs, possibly all the way to zero. I suppose I am very cautiously hopeful. Something needed to be done to reach a level global playing field, but I do hope we don't get a global recession instead where no one is happy.

At the same time these tariffs are being imposed, the US Supreme Court has opened the door to states requiring online sales to include sales taxes. The government has estimated this ruling will add somewhere between $8-$13 billion in additional tax revenue. Economists at Morgan Stanley estimate it will add +0.07% to the PCE while $50 billion in tariffs on aluminum and steel will add +0.03%. The PPI for July was released last week at 3.3% y/y. The core CPI is up +2.4% over the past year, and the PCE will be released on August 30.

These numbers all contribute to my main worry: a Federal Reserve that makes a key policy error in raising interest rates too far. It always does. As of today the 10-year Treasury yield was 2.898% and the yield curve got a little flatter. I worry about an eventual yield curve inversion.

There's a global flight to safety coming into US equities and fixed income. This pushes down interest rates while the Fed is raising interest rates and the net result could be an inverted yield curve. Please tell us it won't happen.

I do not see worker productivity overcoming the two headwinds of higher interest rates and higher tariffs. I sure do hope I am wrong, and I sure do hope President Trump's team to quickly successful in resolving trade disputes with China. I'm not hopeful because I just don't know that China will bend. I do not know that President Trump will bend. The net result there is a trade war that may not end well.

Benjamin Cole said...

Maybe Trump is right about tariffs.

For example, China provides free land and capital to export industries.

Ergo, the price signal is meaningless in regard to China exports. Without an accurate price signal, there is no efficient resource allocation. China can obtain market share using less efficient plant and equipment.

In this case, if the US applies a tariff to China imports, and the US obtains domestic substitution from more-efficient plants and industries, then global output remains the same but less resources are consumed. Both US and China living standards should increase.

Actually, tariffs are but a small part of the many and large structural impediments and institutional frictions that characterize global trade.

I must say, US-based multinationals appear able to frame discussions about global trade. Even more surprisingly, US-based multinationals often present the China viewpoint to the US media, and of course have agendas which may be separate from the US national interest.

Trump may be the least likable US president in recent history. But his instincts may be right on global trade.

steve said...

Benjamin, given that you have contributed perspicaciously over the years I find it mind boggling that you can agree with using tariffs to fight tariffs. Allow me to follow my thinking of ZERO tariffs by the US re China specifically.

So China imposes a tariff on steel coming into their country and we do not reciprocate in kind. The result The Chinese must buy more expensive steel or make it themselves thus hurting their consumers and economy while the US consumer enjoys "stuff" that they CHOOSE to by at a lower price. Obviously US steel biz suffers to the extent that they don't have a level playing field. But so the F what? US consumers win and Chinese consumers lose! More US citizens win than if we impose tariffs on China. How anyone misses this salient point literally makes me cringe. Moreover, is the US going to impose tariffs on every Tom, Dick and Harry that the Almighty DT thinks is not playing fair?

Does anyone seriously think that the POTUS should be encouraging consumers to boycott a great American company like HD because they have the audacity to want to build some product overseas? By that logic, I guess we should be boycotting Apple and other Iconic American brands. This tariff nonsense is a slippery slope. America would be made "greater" by allowing FREE trade and if other countries like China who make stuff way less expensive than we could ever want to sell it to us, BUY IT!

Walmart and now Amazon are practically single handily keeping inflation down by offering products that US consumers want to by-much of which is bought from China. Imposing tariffs will NOT make America great again but will make America more expensive again! Until of course this admin is voting out of office and everything good about what DT has accomplished (tax, regs, justices) is reversed. THEN we'll get a dose of SOCIALISM.

Am I the only one who gets this?

Houston Advisor said...

The bond market is signaling less-than-stellar outcomes from these economic policies. Real Growth looks anemic, but the Faux Press will praise the Nominal Growth to the ignorant electorate.

minnesota nice said...

Steve, My guess is that everyone reading this blog agrees that DT's bluster against good corporate business decisions (i.e. Harley) is misguided, damaging and embarrassing.
The tariff question is more subtle (and opaque). We are told that the goal of the current tariffs is to ultimately reduce and eliminate tariff. So the question is not about the goal, but the tactics. I cringe at what is happening and have less optimism than Scott, but I have the hope that there is a team around DT that know the stakes and issues much better than I.
A bigger question, however, could be: How do we deal with a world economic and military power that might not have the same interests that we do? And some day may be hostile toward us? Is there a bigger issue than economics that we have to be concerned about?

John said...

DT’s approach reminds me of the old saying “the floggings will continue until morale improves.”

Scott Grannis said...

Houston Advisor: I don't agree that "The bond market is signaling less-than-stellar outcomes from these economic policies." Since Trump was elected, real yields on 5-yr TIPS have risen by about 110 bps. That's a clear sign that the bond market is pricing in stronger growth expectations. Moreover, real GDP growth has picked up in the past six quarters. However, as I've pointed out many times, the current level of real yields is still consistent with sub-par growth of 2.5% or a bit more. That's not stellar, to be sure, but it is certainly better than anemic. As for the press, I would agree that the pickup in growth has been somewhat over-hyped by some members of the press. But the electorate, I would argue, is more in sync with the rising confidence reflected in the Small Business Optimism survey, than is the mainstream media.

Benjamin Cole said...

Steve- for sure, I am out of step with orthodox macroeconomists who insist that no US tariffs are the pathway to economic nirvana.

It is interesting to ponder the David Ricardian graph of comparative advantage and optimized output within the context of heavy export subsidies.

U.S. tariffs on goods from China and Europe will propel those regions to reallocate resources to more-efficient industries, thus boosting world output and living standards.

steve said...

Tariffs (taxes) raise prices on consumers. The LACK of tariffs lower prices. Period and end of story.

Tutors in USA said...
This comment has been removed by a blog administrator.
Charlie said...

I think you should take Trump at face value rather than trying to glean a strategy or objective or rational thought. Trump acts to attack his perceived enemies: Obama, elites, liberal media, blacks, etc. Sometimes the resulting outcome or policy aligns with your preference. Sometimes not. In the case of trade, I suspect that trump considers most but not all foreign leaders part of the "elite."

Scott Grannis said...

Big news flash today: China and US will hold trade talks next week, with the objective of resolving their trade issue prior to a November meeting between Trump and Xi. The US delegation will be headed by David Malpass, a long-time friend and excellent economist with plenty of international experience. This is very auspicious.

I'm seeing lots of news to the effect that Xi is getting lots of pressure from everywhere over his failure to do a deal with Trump. The Chinese economy is much more vulnerable to a trade dispute than the US, and it is hurting. I think this is tipping the balance in the negotiations in Trump's favor. Trump wants a resolution prior to the November elections.

It pays to remain optimistic.

Benjamin Cole said...

Well, I am the oddball here. I see US tariffs on European and Chinese imports as a reasonable counter balance to export subsidies.

Free markets do not work if price signals are bogus, which they are on exports from Europe, China and even Singapore and other Far East nations. The prices do not reflect the amount of resources consumed to make the products and services.

China and Europe will not reorient their economies to our free-market beliefs, or eliminate the VAT. Indeed, in the Far East commerce is often regarded as a marriage between state and enterprise.

The Trump administration has done a poor job on public relations, in allowing the imposition of tariffs to be characterized as a "trade war" rather than an adjustment to the facts on the ground.

steve said...

The Nov elections will be super interesting. Barring some exogenous affect, the economy is smoking and despite the trade nonsense as Scott points out almost all US business is benefiting and therefore almost all US citizens are too. I heard on CNBC yesterday that workers in the LOWEST quintile of earning have seen the largest increase over the past 12 mos.
BUT will that convert to a GOP win? I also heard that voters care less about the economy than a candidates "personality". Easy to say when things are rosy. IF the GOP loses substantially in NOV that will not harbinger well for DT in 2020. Hard for me to believe that voters will prefer socialism over what we have but never underestimate the stupidity of the American voter.

Scott Grannis said...

steve: Was the American voter stupid to elect Trump? I wouldn't underestimate Joe just yet.

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