Volume 57, Number 9 | December 10, 2010
With the impending passage of the two year extension of the Bush tax cuts –which contains roughly $210 billion in fresh stimulus — many economists are boosting their estimates of real GDP growth by 1.0% to over 4% for 2011 and beyond. PIMCO’s Mohamed El Arian has abandoned the “new normal” and is calling for 3.5%-4.0% growth rather than 2.5%-3%. Morgan Stanley has lifted their 2011 target for real GDP to 4.0%+. Moody’s is at 4.0% for 2011 as well. Macroeconomic Advisors, whose model closely mirrors the thinking at the Federal Reserve, has 4.0%+ growth for the next three years. True, many of these forecasters had been at the bullish end of the curve even before the new stimulus package. More conservative estimates add only 0.5% to real GDP in 2011—but, in most cases, that still boosts growth north of 3%. Bottom line, the consensus is moving toward a normal economic recovery on the belief that this latest shot of stimulus will lift growth above potential and generate enough job growth to leave the jobless recovery label behind. We hate to be the curmudgeon at the party, but we do not see this new stimulus being a game changer for US economic growth – particularly when the world economy is being faced by oncoming restrictions in Europe and China.
The deal President Obama has negotiated with the Senate Republicans includes two new elements: it allows all companies to expense 100% of capital spending in 2011; and it provides all workers a 2% cut in the employees’ portion of FICA payments for 2011. The expensing would save businesses roughly $150 billion in 2011, broadening the option from just small businesses in 2010 to all business in 2011. The 2% payroll tax holiday generates $120 billion in savings for wage earners. However, the actual stimulus is only $60 billion as Obama exchanged this program for his Making Work Pay program. The net $210 billion in stimulus amounts to about 1.5% of GDP, a healthy dose of stimulus. Unfortunately, it is badly timed, poorly targeted and very temporary. We estimate the effect on real GDP will be less than 0.5% and that most of that boost to growth is simply stolen out of 2012. This leaves us worried about still sub-potential growth and little improvement in the unemployment rate by the next election. However, the budget deficit will be another couple hundred billion bigger than was expected earlier — and with very little to show for it. Better they had spent the funds on the Drury plan and bought one million houses for $200,000 each and burnt them to the ground. Oh, well.
Another Lost Opportunity
We are bearish because we see most of the expensing option driving purchases of imported goods, rather than creating jobs at home, and most of the payroll tax holiday being saved rather than spent. On the payroll tax, Obama swapped his Making Work Pay $400 a year stimulus for low income households (it phased out over $75,000) for a 2% tax cut to all wage earners up to the 2011 FICA limit of $106,800. For those earning $20,000, who are most likely to spend any tax windfall, there is no real change in income (true they don’t lose the spending power in 2011.) For those at $75,000, the windfall generates a fresh $1,100 and for those at $106,800, a maximum $2,136 in savings. And that is the point. High income families are much more likely to save a one-time windfall in income than to spend it. That was the lesson of the Bush tax rebates in 2001 and in 2003. Moreover, since the program is only for one year, this year’s $60 billion in net stimulus becomes next year’s $120 billion in negative stimulus as the program expires (there would have been a $60 billion negative stimulus in 2011 if Making Work Pay had expired without a replacement.)
On the expensing of capital investments, the biggest problem is that nearly half of US company’s expenditures on capital goods are on imports. Expenditure on construction is obviously largely domestic, but there is unlikely to be any change in nonresidential construction regardless of tax depreciation rates. The program only lasts for one year, so only long term projects that are already underway are likely to get any benefit. The biggest impact by far will be on equipment outlays, and particularly technology outlays, where the refresh cycle demands constant updating. It is these electronics which have the highest degree of import penetration. Finally, the program is really primarily an interest free loan since firms would have eventually used the depreciation allowance anyway. Giving US businesses an interest free loan when they are fat with cash invested at near zero interest rates already is unlikely to generate much new economic activity. Like the 2% payroll program, unless this program is extended it will become a drag on real GDP growth in 2012.
That the US deficit will be $210 billion larger in 2011 than earlier expected is not the worst thing in the world since the government’s current borrowing costs are near zero. Our concern is that if another $200 billion is already tied up in ineffective policy it will limit the government’s ability to pass legislation that would stimulate growth. Even worse, if the money that is going offshore to purchase foreign equipment comes back as investments in US companies rather than to buy US short term Treasury debt (earning near zero), the US is mortgaging its future to foreign investors. That is precisely how the US gained dominance in the post-war period – by investing in the best and brightest overseas and earning returns that exceed the cost of foreign borrowing even today.
Structural Imbalances Remain
The underlying economic problem for the United States – and indeed for most of the world that remains in economic trouble – is from too much debt relative to income. The cause in the US is two-fold: thirty years of strong productivity growth and thirty years of ever growing trade deficits. Both result in the supply of goods and services growing much faster than the demand for those goods generated by wage earners income.
Productivity growth, by definition, means that output is rising faster than hours worked, so unless wage rates are rising much faster than general inflation, wages cannot pay for the goods and services they produce. Rapid productivity growth boosts profits as a share of income, resulting in both a shift in production toward the luxury goods profit-earning households prefer (like financial services, healthcare and education) and a growing use of debt by wage earners as they try to maintain their living standards.
Similarly, a trade deficit means that foreigners are earning more for the goods they sell than they are spending on those they buy and are investing the difference in US equities or lending it back increasing indebtedness. Bottom line, these two structural imbalances mean either US entrepreneurs or foreign ones are winning an increasing share of the economic pie. However, because neither their consumption nor their direct investment in their own businesses rise as fast as their income, they end up lending it to wage earners – either through banks as mortgages and consumer loans or through governments as transfers.
Unless either productivity growth slows significantly or the trade deficit narrows, it seems likely that debt will continue to accumulate relative to income. It is possible that wealthier households could increase their consumption, creating more jobs in the luxury sector. Or, an increase in high income households’ direct investment – as hoped for in the new stimulus package – could increase future productivity (or at least limit is decline.) Higher relative US productivity could help shift the ownership of the growing future debt from foreign to domestic hands by limiting the widening of the trade gap. However, it seems likely that the indebtedness problem itself will be hard to resolve. More than half of the recent decrease in household debt has come from write-offs. The limited reduction in household spending has been concentrated in durable goods, as households reduce their holdings of physical assets (via depreciation) in order to free up money to pay down their financial liabilities. Households are unlikely to reduce durables purchases further – indeed car sales are beginning to revive. So, the bulk of debt reduction is likely to come through forgiveness – or very slowly as mortgages are paid down.
A continued high level of debt paradoxically suggests that interest rates – and inflation — will remain low and relatively stable. When debt as a percentage of GDP is high, an economy is very sensitive to interest rates moves and even a modest increase leads to disruptions a la Lehman or Anglo-Irish Bank. The roughly eighty basis point rise in long term rates over the past several weeks is likely to present a problem for the spring housing market – undermining the stability of the banking system again. Conversely, when leverage is low – as in China or Brazil – high or rapidly rising interest rates are less of a problem. In China, many small and medium sized companies have no debt, but occasionally need funds for a short period of time to get over funding shortfalls. They borrow almost regardless of the rate (often 25% to 100% annualized) because, despite the stratospheric rates, interest represents a small part of total expenditures. Tightening access to credit via the rising reserve requirement is a more effective policy for China than interest rate hikes – and it avoids attracting hot money, which has been a problem in Brazil.
China will announce a new debt target for 2011 next week. It is widely expected to be 7 trillion yuan, down slightly from 7.5 trillion yuan in 2010. While that doesn’t sound like much, it is critical to note that China’s nominal GDP grew roughly 17% in 2010, so a target of 8.8 trillion yuan would represent a steady level of new lending relative to GDP. A 7 trillion yuan target is effectively tightening loan growth by $265 billion in 2011. The shortfall in credit to primarily state owned enterprises is likely to have a very direct effect on their investment in real estate – and consequently on the industrial commodities markets. We suspect the impact of China’s $265 billion in monetary tightening will trump the US’s $210 billion in fiscal ease with regards to the world economy – and maybe even the US economy – in 2011.