GDP Outlook 2011: Momentum is Building

2010 was a year of recovery for the US economy. On a year-over-year basis, nominal GDP grew 4.1%. (I will mostly use nominal GDP because I like to look at relative values. Nominal GDP represent actual cash numbers, while the individual items that make up real GDP can get distorted by quirky inflation adjustments.) Real GDP grew 2.85%, implying an economy-wide inflation rate of only 1.25%. The components of growth are as follows:

Personal Consumption: 2.7%

Private Investment: 1.1%

Government Spending: 0.7%

Net Exports: -0.5%


Within this mix, private investment gained economic share, while the rest of the components lost share. This is not surprising, because private investment is the driver of business cycles.


The preliminary estimate for Q1 GDP growth slipped to 3.7% in nominal terms and 1.8% in real terms implying an inflation rate of 1.9%, a pickup in inflation and a slowdown in growth from the pace of 2010.


I believe that the Q1 slowdown is a blip and that economic momentum is building, driven by a strong and lasting expansion of business investment. I believe that the investment boom will more than offset what I believe will be sustained long term weakness in real estate investment.

Business investment

Source:, author's calculations

Two things stand out in the above chart of private investment as a percent of nominal GDP. First, the recessions of 2008-09, 2001, 1990, 1980-82, 1974, 1970, etc. are all clearly visible. Second, it can be seen just how severe the Great Recession was, with private investment plunging to as low as 10.9% of GDP in Q2 2009, well below its long term average of 15.9%.

Private Investment can be broken down into business investment and real estate investment. The chart below shows the relative share of GDP of both long term business investment (excluding changes in inventories) and real estate. These are the forces that drive the intermediate term (5-10 year) business cycle.

Business investment is starting to recover, while real estate investment (residential and commercial) is not.

Source:, author's calculations

Notice the general 16-18 year infrastructure investment cycle (called a Kuznets cycle for you business cycle buffs). The front side of the cycle generally benefits from a powerful business investment boom, which also coincides with strong job growth. The back side of the cycle has a larger share of real estate investment and is generally associated with weaker job growth. The good news is, we are entering the powerful phase of the investment cycle, meaning the next decade should actually produce strong economic and employment growth.

Business investment reached a low of 7.0% of GDP, below the average of 8.2% since the end of the 1970 recession. This level roughly matches the lows of 7.4% hit during the 1974 and 1990 recessions. In Q1 2011, business investment was 8.2% of GDP, in line with the historical average. It is interesting that business investment is at mid-cycle levels so early in a recovery. Perhaps we really are moving to a new paradigm of more consumer saving and higher business investment, and less focus on consumer spending and real estate investment.

Real estate investment, on the other hand, has been experiencing a series of "lower highs" and "lower lows", hitting 7.2% in the 1974 recession, 6.3% in the 1990 recession and 4.0% in Q4 2010, well after the end of the 2008-09 recession. In normal circumstances, I would expect a snap-back from such a severe drop. Demographic trends are working against the real estate market, however, as Baby Boomers are moving past their peak home buying years and toward retirement while being followed by the much smaller Generation X. I expect only a very gradual recovery in real estate investment, although it's hard for it to go much lower.

Another component of business investment is the change in inventories, which tends to lead the short-term business cycle. In 2010, inventory additions added a full 1.9 percentage points of the 4.1% nominal GDP growth.

Inventory changes are clearly volatile, and have been losing share as a percent of GDP due to the decline in the relative importance of manufacturing and to the improvement in inventory management. There was some alarm with the drop in inventory additions in Q4 2010. Inventory cycles usually last at least 3-5 years, however (as can be seen in the chart above, these cycles are known as Kitchin Cycles). We should therefore expect for inventories to continue their positive trend for at least the next year.

Consumer spending

As I have noted previously, personal savings has risen to a normalized level relative to GDP, so personal consumption should now keep pace with GDP growth, as it has most of this decade.

Even as employment starts to improve, however, we shouldn't expect much of a boost from additional spending as long as savings holds at its current percent of GDP. The reason of this is that aggregate personal income hasn't really declined during the recession.

Source:, author's calculations

Wage and salary income has declined substantially relative to GDP over the past decade, but increases in government transfers and health care benefits have held total income roughly constant at about 85% of GDP. Given the imminent retirement of the baby boomers and the planned increases in government health care spending, there is no reason not to expect a continuation of the trend of a smaller wage base relative to GDP.

One threat to consumer spending is that there is a good chance that taxes will increase.

Income taxes paid as a percent of GDP is at its lowest level since the early 1960s. In addition, consumer spending (and potentially personal savings) is being temporarily goosed in 2011 by a cut in the payroll tax.


Given the budget tussles in Washington and state capitals, and the likely winding down of the wars in Iraq and Afghanistan, we can expect direct federal, state and local government spending to start declining as a percentage of GDP. We should expect the federal transfer payments that support consumption (social security, Medicare/Medicaid, unemployment benefits) to continue at relatively high levels unless some major budget revolution takes over the Federal government.


The economy is underperforming the public's expectations primarily because of the collapse in real estate investment and home values. As a result of the large drop in household net worth (from 470% of GDP in early 2006 to 347% of GDP in early 2009), household savings rapidly rose while real estate and business investment rapidly sank. The government stepped in and offered tax rebates, transfer payments and spending stimulus to prop up demand, while the Fed and the treasury propped up the banks to prevent a deflationary spiral. By mid-2009 the markets started to recover, stabilizing consumer net worth, personal saving and personal consumption. Once businesses saw the economy stabilizing and economies resuming growth abroad, business investment started to recover, first with inventory restocking and now investment in software and equipment.

Real estate investment has not recovered for obvious reasons, and this leaves a big hole in the nation's productive capacity, which is also holding back employment. The Fed continues to ease and the economy makes a gradual transition away from the real estate fuelled economy of the 2000s and employment is slow to recover. The weak dollar is helping US exporters but is causing a rise in the nominal value of imports, particularly in petroleum products, which now account for nearly our entire trade deficit. I am not quite sure what the Fed now expects to accomplish with its current course of action.

All that said, momentum is building. The American economy is very resilient and is merely in a transitional phase where the tired consumption and real estate driven economy is handing the baton to one focused on productivity and business investment. Which is a good thing.

The Return of the US Consumer

The following post is the second in my "United States of Debt" series that analyzes how the different sectors of the US economy will handle their high debt loads. The first installment can be found here.

During the housing bubble, American consumers loaded up on debt. Since the bursting of the bubble, Americans have adjusted by increasing their savings and paying down debt. This adjustment resulted in a slight decrease in consumer spending and a large decrease in residential investment. My analysis shows that the bulk of the adjustment in consumer spending is complete. The level of personal savings is driven by household net worth. As a percent of GDP, both household net worth and savings have returned to normal levels. Therefore if asset values can remain elevated, consumer spending can at least keep pace with normal levels of GDP growth for the foreseeable future.

As has been discussed previously in the Dynamist, a big secular trend over the past forty years has been the rise in consumer spending and residential investment as a percent of GDP.

Figure 1


As has also been discussed previously (namely here), virtually all of the long term increase in consumer spending can be attributed to the rise in (mostly non-voluntary) medical expenses and housing investment. Virtually all of the decline in household spending as a percent of GDP since 2005 can be attributed to the decline in residential investment from 6% of GDP to less than 2.5% of GDP.

Not surprisingly, consumer indebtedness climbed to support the increase in spending (particularly since personal income has not risen as a percent of GDP…to be discussed in a later post).

Figure 2


Also not surprisingly, the amount of consumer debt has started to decline with residential investment, albeit with a lag.

The increase in consumer debt shown in Figure 2 seems kind of scary until you compare that consumer debt with the amount of consumer assets.

Figure 3


From 1994 to 2005, household assets as a percent of GDP rose from under 425% of GDP to over 550%. With asset values surging, household net worth (assets minus liabilities) also surged, even with the large increase in liabilities. Figure 4 below illustrates the effects of the twin bubbles in stocks (in the 1990s) and real estate (in the 2000s) on household assets.

Figure 4


Looking at Figure 3, it appears that the preferred level of household net worth is about 350% of GDP, although it would make sense for this number to rise somewhat over the next decade as the baby boomers prepare for retirement. If we look at the long term levels of personal savings in Figure 5 and compare it to the long term levels of net worth in Figure 3, a pattern emerges.

Figure 5


When household net worth is around its long term trend of 350%, personal savings averages 4-6% of GDP. In the high inflation, high interest rate 1970s, when asset values were depressed, net worth dipped down toward 300% of GDP and savings rose above 6%. During the asset bubbles of the late 1990s and early 2000s, net worth rose well above 350% of GDP and savings fell below 4%. After the housing bubble burst, net worth fell back to 350% and savings promptly popped to above 4% of GDP.

Now that savings is at a normal level, consumer spending has the ability to keep pace with GDP growth. That does not mean that consumers won't choose to keep increasing their saving rates over the next decade, particularly the baby boomers as they prepare for retirement. As long as the savings rate as a percent of GDP exceeds the nominal growth rate of GDP, consumer indebtedness as a percent of GDP will decline.

Thus we see the importance of keeping interest rates low and preventing asset deflation. Financial assets like stocks and bonds fall in value when interest rates spike. Assets geared to inflation like stocks and real estate fall when you have deflation. The Fed will see propping up asset values to prevent another major spike in the consumer savings rate as a high priority for the foreseeable future. A spike in the savings rate would reduce final demand, which in turn would force the federal government to spend more money to prop up demand.

The United States of Debt – Part I

The economy of the United States is highly leveraged. Through the boom times of the 1980s through the 2000s, total US private and public debt to GDP has risen sharply. Since the 2008-2009 recession, private debt has started to fall while public debt has risen, while the country's total indebtedness has remained relatively stable. Most US citizens have the nagging feeling that our debt burden has gotten too high. If we know that debt to GDP needs to come down, however, we don't know to what level it should come. I have decided to analyze this issue in a series of posts called "The United States of Debt".

In this the first installment, I will run through the big picture. The first section discusses how the recent run-up is not surprising in the context of the long cycle, and that we have seen these financial booms before, during the Gilded Age following the Civil War and during the Roaring Twenties. The second section dissects the recent debt buildup between the private, public and financial sectors. The last section discusses why the recent financial boom has been so long lasting and powerful relative to the Gilded Age and Roaring Twenties.

The next three installments will analyze the financial health of the Household, Business and Government sectors and to make policy recommendations on how to promote the financial health of those sectors.

The long wave debt cycle

It's no secret that the United States has a debt problem. This long term chart of total, economy-wide debt to GDP demonstrates it pretty well.

Chart 1

The long term pattern of debt peaks corresponds with the long wave, or Kondratiev Cycle (for a more detailed description of this concept, see here). During the "autumn" phase of the "financial bull", inflation is falling, thus interest rates are falling and asset values are rising. While asset values are rising, the cost of borrowing is falling, which creates a perfect environment for using leverage for investment, whether in the financial markets, real estate markets or for corporate investment.

Eventually, the asset bubble pops, marking the transition to the "winter" phase, or the "real bear". It is at the bottom of the first winter recession that the debt-to-GDP ratio peaks (previously in 1875 and 1933). Why? Because as asset values start to fall, the high level of underlying debt results in a deflationary spiral of forced asset sales and financial failures. Nominal GDP falls while the level of debt remains roughly the same (or rises).

Eventually, the economy bottoms and debt-to-GDP turns down. The decline in debt-to-GDP comes from a combination of rising real GDP, rising inflation (which reduces debt in real terms) and debt destruction trough defaults.

Chart 2

At the beginning of the Great Depression in 1929, the bulk of US debt was corporate debt tied to the investment bubble in auto manufacturing, electric utilities, houshold appliances, radio and other sectors that made up the "new economy" of the Roaring Twenties. Corporate debt to GDP collapsed from over 100% in 1933 to under 30% by the mid-1940s. Household debt fell from 50% of GDP in 1933 to roughly 15% in the same time period. Much of the drop in total debt to GDP came during the 1933-1936 period, when the dollar was devalued by 50% and economic growth was very high (albeit from an extremely low base). The ratio rose again when the economy relapsed in 1937-38, but resumed its decline when the economy recovered modestly in the pre-war years. The end of the long depression years came when government debt to GDP began to expand during World War II in the early 1940s. Government debt to GDP balooned from under 50% to about 100% of GDP during World War II, while private debt to GDP declined.

Total non-financial debt to GDP remained between 125% and 140% from the end of World War II to the early 1980s. During that time, government debt to GDP fell from about 100% to 40%, while private non-financial debt rose from 40% to 100% by 1980. During the same time, financial debt to GDP rose from under 5% to about 20% by 1980, returning to roughly the same level that prevailed in the late 1920s.

The consumer and financial debt explosion since 1980

Table 1

Table 1 above walks us through how our debt load has evolved since the early 1980s. For the sake of cyclical consistency, I show the recession years of 1982, 1990, 2001 and the recent recession trough of Q2 2009. There has been a steady increase in private sector debt, particularly among households and the financial sector. During each business cycle, the private sector tacked on 50-60 percentage points of indebtedness. The government sector, on the other hand, has see-sawed in a one-cycle-up, one-cycle-down pattern.

The largest increase in indebtedness has come from the financial sector, having increased by 93 percentage points between 1982 and 2009. As can been seen in Chart 2, about half of that increase came from the Government Sponsored Entities ("GSEs"), namely Fannie Mae and Freddie Mac. That debt has from a practical standpoint become government debt as well.

Since the 2009 recession has ended, total debt to GDP is has declined by three percentage points. Private sector debt has dropped by 14 percentage points while government debt has risen by 11 percentage points. So far the government has been filling the classic Keynesian deflation-fighting role by borrowing and spending to offset a decline in private borrowing and spending.

The problem with this analysis so far is that while interesting, it doesn't mean a lot without knowing what the optimal debt to GDP level is. Just because debt to GDP used to be 150%, doesn't mean that was the right level. In fact, for all we know, 150% was way too conservative and presented a great opportunity to lever up to the optimal level north of 300%. My gut tells me that the truth lies somewhere in between these two extremes.

The Second Gilded Age

So what happened in the period from 1980 to 2009 that led to an explosion of US indebtedness? We have had a confluence of factors that created the ideal environment for the greatest bull market in the history of the world:

  1. A roughly 90% devaluation of the dollar in nominal terms against gold;
  2. A general policy mix of tight monetary policy and loose fiscal policy;
  3. A decline in long-term interest rates from nearly 15% to 4%;
  4. Tax policies that reward borrowing and equity capital gains; and
  5. Financial deregulation and the expansion of the GSEs.

With the devaluation of the dollar (also known as "inflation"), the denominator in which the S&P 500 is quoted has declined, providing a lift to the nominal value of the S&P. That said, however, over the past 50 years, the price of gold and the S&P have merely kept pace with each other (see Chart 3). Since 1955, 100% of the excess return of the S&P 500 over gold is attributable to dividends.

Chart 3

Source:, Standard and Poors,


Or looking at it another way, Chart 4 shows the S&P 500 expressed in terms of ounces of gold.

Chart 4

Source:, Standard and Poors,

If you ignore the outlying years of 1997 to 2001, the pattern is pretty clear: a steady buildup to about 3 ounces of gold before the plunge to below 1. The only question now is how low the ratio goes. The previous bottom was 0.22 in 1980. That would imply the S&P falling to 265 at today's price of gold, or conversely, gold rising to 4,881 at today's level of S&P.

Nevertheless, since 1955, the price of gold has risen from $35 to $1,205 and the S&P 500 has risen from $35 to $1074. The ratio of S&P 500 to gold seems to spend 15-18 years above 1 and 15-18 years below.

The other factor that drove the bull market in stocks and bonds has been the relentless decline of interest rates from 1980 to 2000. As can be seen in Chart 5 below, since the early 1960s, the earnings yield (the inverse of the price-to-earnings valuation multiple) of the S&P 500 has pretty closely followed the yield of the 10-year treasury bond. Prior to the 1960s, when inflation was very low or even negative, earnings yields were far higher than treasury yields.

Chart 5

Source:, Standard and Poors,

As can be seen in Chart 3, in the 1970s, when the value of the dollar plunged and the price of gold rose, stocks did not follow because of the rise in interest rates which provided stiff competition to stocks. As treasury yields rise, the required return from stocks' earnings yield goes up as well. That pattern reversed in 1980. Tighter monetary policy gradually brought down interest rates, but loose fiscal policy kept inflation positive. The combination of falling interest rates and moderately positive inflation is the ideal combination for stock returns.

Now that we are likely shifting to a deflationary environment of falling debt to GDP, we may be seeing a shift to rising earning yields while interest rates remain low. This was the combination that prevailed in the 1930s and 1940s. We are already at a spread between earnings yields and 10-year treasuries not seen since the mid-1950s. If inflation stays as low as it is currently (around 1%), goes lower or even consistently negative, we will very likely see earnings yields back to the level of the early 1950s by the middle to end of this decade.

Rising Asset Values lead to Higher Indebtedness

As asset valuations rose from 1980 to 2008, investors had the opportunity to use financial leverage to supercharge returns. Just witness all the people who made a fortune in real estate over the past thirty years: inflation made the value of rents and real estate rise while financing costs fell. Leveraged buyout practitioners could borrow money and benefit from the combination of rising cash flows and valuation multiples while benefitting from falling interest rates. It's pretty simple. In a thirty-year bull market in asset values for stocks, bonds and real estate, the use of leverage to "get-rich-quicker" is a natural outcome.

The Government has encouraged leveraged speculation

Many of the "supply side" tax policies of the past thirty years have encouraged the use leverage as well. Ostensibly, policies like cuts in upper-end income tax rates, dividend tax rates and capital gains tax rates are meant to encourage savings and investment. In reality, they don't directly encourage savings or investment, they encourage the reward from investment profits. Businesses are the ones that actually invest. If you wanted to directly encourage investment, you would allow for the full deduction of capital expenditures in the year incurred and make the R&D tax credit permanent. If you wanted to directly encourage savings, you would impose consumption taxes or large deductions for money put into investment accounts.

We do, however, directly encourage the use of debt by making interest tax-deductible for businesses and real estate investors, while dividends, on the other hand, are double-taxed at the business and individual level. The government even further subsidized residential real estate interest rates through their "implicit" (now explicit) guarantee on securities issued by the government sponsored entities ("GSEs") Fannie Mae and Freddie Mac.

Private equity and real estate investors had this figured out. Take the subsidy for borrowing money and use it to generate subsidized capital gains profits. Benefit from rising asset values as interest rates fell. And benefit from rising cash flows driven by government-generated inflation. In such an environment, it's frankly a wonder we have as little debt as we do.

I bet this makes you wish you had this all figured out in 1982.

Reform the Tax Code Now

The United States has a tax code that encourages borrowing and consumption at the expense of savings and investment. I believe this concept is pretty well understood. What is less understood is that the rest of the world does not. The much-derided (in the United States at least) European-style welfare states actually have less progressive tax systems than the US, as do the developed Asian countries of Japan and South Korea. This means they are more apt to discourage consumption and to promote exports with value-added taxes. Most of these countries have found a policy balance that produces neutral trade deficits. Countries like China and Germany, on the other hand, take it even further and use their tax code to actively promote massive trade surpluses, a key source of the "global imbalances" that are threaten the world economy. Even worse, within the US tax code we discourage domestic investment in general, yet we lavish subsidies on specific old-economy industries like real estate, agriculture and energy extraction and even encourage US multinationals to invest overseas instead of in the United States. Our distorted tax policy is a bipartisan failure that must be addressed soon or our country will begin to lose ground economically while struggling under a mountain of foreign-owned debt.

How we got here

Much of The Dynamist blog is devoted to analyzing long term trends in economic policy, market valuations and political cycles. One of the consistent themes (for examples see here and here) is that the United States needs to focus on reducing its structural trade deficit. When we run a trade deficit, we are importing capital (i.e. borrowing) from abroad. Importing capital is not inherently bad. If the US had a surplus of investment opportunities relative to its pool of savings, investment capital may come in from abroad to make up the difference. In such an event, the investments would presumably increase the long run growth rate of the US economy.

The trade deficits that the US has run since the mid-1990s, and in the 1980s before that can generally be attributed to policy distortion by the Federal Government or by the Federal Reserve. The Fed's policy of high real interest rates in the early 1980s and late 1990s drew in a great deal of capital from abroad. In the 1980s, it funded Reagan's tax cuts and military buildup. In the 1990s, it funded the investment in a large increase in US manufacturing production capacity. In the Dynamist's view, neither of these investments were bad things and they generally made the US stronger.

The problem came when the disinflationary high interest rate policy was unwound. In both the late 1990s and 2000s, the combination of falling real interest rates, a weakening dollar, a surge in liquidity and an upturn in inflation create a ripe environment for a junk bond and real estate boom. Finance-fuelled booms like these tend to leave behind banking crises, overleveraged LBOs and real estate overcapacity. In the 1980s, the S&L deregulation led to a commercial real estate bubble. In the 2000s, the flow of Chinese money into the agency debt of Fannie Mae and Freddie Mac, combined with the policy innovation of "securitizations" and credit derivatives created the housing bubble. While such investments aren't useless, they don't have much of an impact on future US productivity.

I've written before about how US economic policy since the Great Depression has basically promoted consumption and real estate investment at the expense of saving and business investment. Domestic tax policy is skewed toward taxing high earners and lenders and supporting lower earners, borrowers and leveraged equity owners, particularly in real estate and farming (this even after the income tax rate reductions of the Reagan and Bush eras). When examining how domestic policy leads to distortions to the external trade and capital accounts, it is worth comparing how our policies compare to those of our largest competitors.

Global tax rates

A couple of months ago, The Economist had an interesting table outlining the tax policies of various countries (it can be found here, by those with a subscription). I worked with the numbers a bit so we could compare the state's take (including state and local taxes) relative to GDP across various types of taxes. I don't have the underlying data, nor do I know the policy details behind how various countries collect taxes, but in rough terms the data give one a good idea about the thrust of tax policy.

I took the average of five European-style welfare states (Britain, Canada, France, Germany and Italy), two developed Asia industrial powerhouses (South Korea and Japan), the US, China and Germany stand-alone. Their sources of tax revenue relative to GDP are shown below:

Source: The Economist, author's calculations

Unsurprisingly, governments in the United States collect a smaller amount of taxes as a percent of the economy than the four European countries and Canada. To compare apples-to-apples, however, the 6-8% of GDP that flows to privately-funded health care in the US should be added to the relatively regressive "social contributions" line item, for health insurance costs are deducted directly from our compensation just like Social Security and Medicare taxes. That would move US taxes to within 4-6% of European levels.

Surprisingly, the total tax take from "progressive" sources like income, capital and property in the United States is almost identical to that of Europe. The big difference between the two systems is in the "regressive" taxation of consumption. The European-style welfare states use value-added taxes that collect consumption taxes to the tune of 10.4% of GDP. The US taxes consumption, mostly in the form of state sales taxes, at only 4.4% of GDP. In other words, the US has a more progressive tax code than the European-style welfare states. The result is Europe as a whole runs a trade balance and the consumption-driven US runs a trade deficit.

The developed Asia countries of South Korea and Japan tax their economies by a similar percent as the US and have similar percentages for social contributions. The difference is that developed Asia taxes income less and consumption more than the US, with a difference of about 3 percentage points in each category.

Now look at China. It has a weak social safety net, and collects nothing in terms of "social contributions". It then gets nearly two-thirds of its tax base from consumption taxes, with most of the rest coming from taxes on companies. No wonder China has huge levels of savings and investment and low consumption levels. Combine that with a policy to suppress currency values and you have the ideal recipe for large trade deficits.

Germany is another great promoter of global imbalances, particularly within Europe, as has come to light with the recent Greek debt crisis. It collects a huge portion of its tax base from regressive consumption taxes and social contributions, while collecting less than the US in progressive income, capital and property taxes. Additionally, of the developed countries it takes the lowest percentage from companies. By taxing employment so highly via social contributions, and taxing companies at such a low level, Germany is encouraging "capital deepening", or investment in its great export machine. Germany's high consumption taxes have also encouraged the lowest level of consumption of the major developed economies.

Domestic distortions

Even within the US tax code, the US discourages domestic business investment relative to encouraging US multinationals to invest abroad; punishes businesses in general with the second-highest corporate tax rate in the world while it lavishes massive subsidies on individual sectors like agriculture, energy extraction, and real estate; forces companies to write off investments in productive capacity over long periods of time while other countries offer massive incentives for multinationals to invest. In the past 30 years, the US has gotten away with its disincentives to business investment funded by domestic savings by replacing domestic savings with foreign savings flowing through its levered-up capital markets casino.

Reform the Tax Code

It was nice while it lasted. We got lots of investment, bigger houses, a beefed-up military, technological innovation, and debt-fuelled consumption with low domestic savings. Now that the bill has come due, we either need to encourage more saving or live with less investment. Opting for the latter is not the path to long run prosperity. The tax code needs to be reformed to tax more consumption (which could include a carbon tax, an export-promoting value added tax and/or larger deductions for saving), not to increase income taxes and to reform the corporate tax code to replace the subsidies for specific old-economy industries with incentives for investment in domestic manufacturing capacity and R&D.

For corporate taxes, I would propose a general reform that would lower the statutory rate by eliminating special-interest subsidies and the deferral of international income, while also allowing the full, immediate expensing of business investment and R&D. I would also support the deductibility of dividends, while returning the tax rate on individual dividends back to the income tax rate. This reform would discourage corporate cash-hoarding for buybacks and ill-conceived acquisitions. (If you can't convince the capital markets to fund an acquisition, you probably shouldn't do it.)

In a globalized economy, large differences in tax policy cause trade and capital flow distortions. The US can no longer pretend it is an island unto itself. Our tax code is harmful enough to our national interests as it is, it gets even worse when allows the rest of the world to take advantage of us.

Q4 Economic Growth – Be Happy, but Worry

There is alot to like in the recently announced 5.7% rate of US GDP growth in the fourth quarter of 2009. 

While many commentators are brushing it off as a fluke tied to the vagaries of inventory trends, it is actually very normal for inventory swings to account for a good portion of GDP growth when the cycle is first turning.  The question is always whether growth can then get handed off to sustained consumption and private investment after a few quarters.  I think it can, but extreme swings in public policy could theoretically jeapordize the expansion.

The personal consumption number is encouraging, particularly given that consumer credit has been declining.  This implies that we are moving to a sustainable level of spending, complemented by a positive savings rate.  Government transfer payments tied to unemployment insurance and the stimulus package are supporting spending, of course, and my advice would be to withdraw this support only gradually in 2010, if at all.

Net Exports were actually weaker than the real GDP figures reported.  In nominal terms, the trade deficit actually widened as a percent of GDP in Q4.  Petroleum imports increased in nominal terms, but because of rising prices, fell in real terms.  On the flip side, exports grew 25% in nominal terms, meaning world trade is on the rebound and the US can benefit from a strong rebound in the manufacturing and service sectors if it can borrow excess demand from abroad.  Because both the domestic demand and supply of credit is limited, there is reason to be optomistic that exports should expand faster than imports if the dollar stabilizes at current levels.  From a purely economic point of view, it would make sense for the US tom implement policies to reduce its demand for imported oil (to go along with the environmental and security reasons to do so.)  In fact, virtually the entire trade deficit can be traced to the petroleum and auto sectors.

An increase in business investment, on the other hand, was limited purely to high tech equipment.  Traditional industrial and transportation equipment investment remains in the cellar.  There is good reason to expect investment in transportation equipment to rebound from the currently depressed levels not seen since the 1970s in real terms.  Industry, however, suffers from huge levels of excess capacity.  Many sectors of manufacturing got hammered as a whole in the downturn, and had only been skating sideways at best during the expansion of the 2000s.  The most successful manufacturing sectors in the 2000s were high tech, med tech and defense / aerospace which should all continue to thrive, in addition to housing related sectors like wood products, non-metallic minerals, furniture, appliances and fabricated metal products which are highly unlikely to thrive in the intermediate term.  Much of the rebound in manufacturing to date (again, outside of high tech) has been limited to cars, chemicals and steel bouncing from extremely depressed levels to just merely depressed.

Residential real estate investment has clearly bottomed and has added modestly to GDP in the last two quarters.  As a percent of GDP, however, it is at the lowest level since World War II.  Commercial real estate investment continues to plunge, which can be expected for another couple of quarters before bottoming out at record low levels of GDP as well.  Credit conditions, slowing demographics and recent over-investment will all conspire to keep real estate investment at record low levels for at least the intermediate term.

The huge excess capacity in construction workers and construction-related manufacturing leads me to continue to stress how beneficial it would be to focus additional stimulus on infrastructure spending.  These workers can not easily be retrained for health care, education and high tech office jobs.  The country has been behind on such spending anyway, so it would not be Japan-style "bridge-to-nowhere" investment as long as Congress can be reined in.  For this reason I like the "infrastructure bank" idea that takes some of the planning out of the hands of Congressional pork-meisters.

US Indebtedness as a percentage of GDP actually declined in Q3 from 359% to 355%, due primarily to a decline in financial sector debt.  Household and business debt each declined in Q3 as well, but were offset by an increase in US government debt, which increased to 53%, up from 36% at the start of the recession.  In general, I expect this trend continued in Q4 as well, as the US offsets private deleveraging with public borrowing.

In conclusion, the strong parts of the economy (high tech, aerospace, health care and education) are now in expansion mode, and the extractive industries (farming, mining, energy) are likely to join soon.  Those manufacturing sectors exposed to export markets like industrial equipment (think Caterpillar) should resume growth as well unless there is a major economic crisis in the emerging markets.   "Old economy" manufacturing and real estate investment remain a problem and are likely to remain so without increased infrastructure investment.  The trick for policy makers is to transition from a period of broad stimulus to one of consumer and government belt-tightening while letting business investment, infrastructure spending and exports become the primary economic growth drivers.  It would be a neat trick, indeed.

Invest in infrastructure to stimulate jobs

Clearly, today most Americans would identify the weak job market as the biggest problem facing the country today. While the job market will recover on its own eventually, there is a desire in many quarters to roll out a second stimulus package to promote job growth. As Paul Krugman noted in a recent NYT opinion piece, the standard American approach to stimulus is to focus on expanding the economy as a whole with the assumption that jobs will follow. The traditional approach makes a great deal of sense during a run-of-the-mill recession. The problem today is that some of the dislocations in the economy and job market are so large, it could take many years to retrain and relocate the unemployed, particularly among the large pool of unemployed manufacturing and construction workers. In addition, the downturn in employment in construction and manufacturing are the result of long term or secular trends, not purely cyclical unemployment. To stimulate jobs among this large pool of unemployed workers, we should increase our investment in infrastructure on a sustained, multi-year basis.

"Blue collar" job losses

Of the 6.7 million jobs lost in the United States since 2007, nearly 58% were lost in construction and manufacturing. These largely male, "blue collar" occupations have seen such large losses that women now make up more than 50% of the workforce for the first time in history. Over 2.2 million jobs have been lost in manufacturing, but as can be seen in the chart below, the decline of manufacturing (dark green line) as a share of employment is in line with the historical trend. Manufacturing employment as a percent of total non-farm employment has fallen pretty much in a straight line from about a third at the end of World War II to under 10% today. As I have written previously (see here), this decline is due primarily to the consistent increase in manufacturing productivity. Manufacturing production has continued to grow and has largely maintained its share of GDP, even while employment has plunged. In other words, even if there was a large rebound in manufacturing, the vast majority of manufacturing jobs that have been lost in the last decade are never coming back.

Chart 1: Employment by Sector as a % of total Non-Farm Employment

                    Source:, author's calculations

Construction employment (the maroon line) has consistently run at around 5% of the total workforce since World War II. The 5% number makes sense, and is in line with the long term trend in real estate investment, which has run at about 5% of GDP as well.

Chart 2: Private Investment to Nominal GDP


                   Source:, author's calculations

Chart 2 shows the annual numbers through 2008, and 2009 will show a further plunge in private investment in both business equipment and real estate. In addition, given slower demographic growth and the large overhang of unsold homes, potential foreclosures and homeowners in negative equity situations, there is no reason to expect a strong rebound in real estate investment anytime in the next five years.

Where will new jobs come from?

On Chart 1 we can see that there has been a secular increase in the share of jobs going toward "white collar" occupations like health & education (orange line), business & professional services (office & tech jobs, pink line) and leisure & hospitality (light purple line). Of these careers, health, education and non-administrative office jobs tend to require time-consuming and expensive training, and it's hard to envision the government laying out a vision of promoting employment in leisure & hospitality jobs as the route to a strong America.

Having a large pool of angry, unemployed men does not for pleasant politics make. The traditional US government approach of using tax cuts and interest rate cuts to stimulate private spending and investment will not work in the near term (for reasons I outline here). For reasons I won't get into in this article, it also appears that the world economic system is not quite ready to be geared toward stimulating US export growth and trade surpluses. That leaves the US government directly stimulating demand.

Invest in infrastructure

In normal circumstances, I am not one to argue for more government intervention in the economy. However, these are certainly not normal circumstances. I am advocating the government committing to a sustained, multi-year program of increased investment in the nation's infrastructure as a way of both directly creating demand and stimulating private investment. I am not advocating a boondoggle like the stimulus bill from early this year. The US needs to target infrastructure investments that directly improve the long-term productivity of the US workforce by laying out a long-term plan and set of priorities. The investment should have the following goals:

  1. Reduce the amount of time and energy Americans spend commuting (investment in commuter rail, highways and bridges)
  2. Increase the efficiency of moving people and goods around the country (investment in rail, a new air traffic control system, highways, bridges)
  3. Reduce our reliance on imported energy (investment in wind, solar, nuclear, transmission grid, battery technology)
  4. Increase broadband capacity and penetration (invest in rural and wireless broadband)

If carried out in a thoughtful way (i.e. not driven by parochial real estate interests), such a program would make America stronger in the long term while creating near term construction jobs and stimulating domestic manufacturing.

Government Deficits are Necessary (for now)

Read this excellent article by Martin Wolf in the Financial Times, and be sure to click on the chart, which I have also pasted below:

FT chart

The private financial balance (net borrowing or net saving by households and businesses) plus the government financial balance must equal the net capital inflow from abroad.  In the 2000s, the US was running a deficit in both the private and government accounts, which had to be offset by a positive net capital inflow from abroad.  A net capital inflow for abroad must be offset by an equal current account deficit, which for the most part means a trade deficit.

Of the high-income countries, notice that in 2006 nearly all were running trade deficits, except Japan and Germany who were running trade surpluses.  Also notice that Japan and Germany have been running a high positive private balance (i.e. businesses and households are high net savers).  Japan and Germany have essentially been deflationary countries since the early 1990s, when the Japanese debt bubble burst and when Germany reunified.  Both have been borrowing demand from abroad to partially offset their shortage of private demand.

The US, Spain, Ireland and the UK have been running private deficits.  The US and the UK have been running private and government deficits.  The twin deficits were therefore offset by large trade deficits.

Since the Great Recession, all of the countries listed have become high net private savers and all are running large government deficits.  The large government deficits are necessary to offset the collapse in private demand.  With all countries turning down at once, there would be no one to make up for domestic demand shortfalls.  While international imbalances have become smaller, Japan and Germany remain net exporters and and the rest remain net importers. 

As I have been saying over and over, for the US (and Spain, and Ireland and the UK) to dig out of the financial hole, we need to start running a trade surplus.  Ideally that would come from an increase in foreign demand for US goods and services, and not by a deflationary bust in the US.  For this to occur, a structural change will need to occur in the global economy that promotes balanced international capital flows.  For a period we need countries like China, Japan and Germany to run trade deficits.  Such a structural change does not seem at hand.  Until that time, the US's only escape valve is for a weak dollar to support exports and to drive dollar investment abroad.  The investment abroad will flow into emerging market financial bubbles, which will increase foreign demand and reduce the trade deficits in developed markets.

Without structural change, the likely outcome is continued high government deficits, low US interest rates, a weak dollar and financial bubbles in emerging markets.  This is the trend to ride for this business cycle…just be sure to get off before it blows up.

The Nature of the Economic Recovery

Over the past several weeks I've started several posts with titles like "Time for the Fed to Raise Rates", "Where are the adults?", "Time to cut the Deficit" and "Time to Stand up to the Chinese". Each time, however, I've thought about the facts and stopped. As I've stated many times before, the Dynamist tries to be a neutral observer of how the world actually is, not a prescriber of how the world should be. In a perfect world, I would like to see a more stable set of economic policies that promote balance and equilibrium. In the real world we have something very different: a volatile set of economic policies that try to promote long term equilibrium by shifts in short term disequilibrium. The US government adopts aggressive new policy imbalances to deal with old economic imbalances. The first step in developing an economic outlook is to assess the imbalances in the economy and to prioritize how and when they will get dealt with. As I have done so, I have come to the conclusion that our government is actually doing pretty well under the circumstances.

How we got here

The last 40 years or so have been a period of transition between the "old economy" and the "new economy". The new economy is the R&D-centric, globalized economy driven by technology, biotech and health care, financed by equity, based in the Northeast, parts of the Upper Midwest and the Pacific Coast. The old economy is the consumption-centric economy driven by automobiles, residential investment, petroleum, mass agriculture, mass media and retail, financed by debt, based everywhere but prominent in the Sunbelt and Rust Belt.

Government policy in the time of transition has been a hodge-podge that has favored both economies, allowing the new economy to thrive and supporting globalization, while continuing to heavily subsidize housing, petroleum, mass agriculture and cheap imports (with an overvalued dollar) and encouraging the over-production of automobiles. The US military subsidizes both economies, investing in new technologies and protecting the flow of oil from the Middle East.

So while some of the new economy innovations like derivatives and hedge funds helped us get into the mess we're in, the real problem has come in the collapse of the old economy. Securitized housing and consumer loans are what blew up the balance sheets of US banks. The other, lesser culprits for banking problems are the LBO loans made to buy old economy companies.

The way forward

The way forward is for the Obama administration to complete the transition. Policies meant to prop up the old economy, like "cash for clunkers", the homebuyer tax credit the use of now-nationalized Fannie Mae to effectively dominate the market for housing loans, will only offer short-term salves and cannot lead to sustainable recovery. There is no going back to the old housing, consumer credit and retail bubble.

Other Obama policies have encouraged the transition. The reduction of auto capacity makes sense, as does encouraging the move to hybrid and electric cars. The proposed consumer protection agency, the proposed reining in of financial system leverage and other financial market reforms should discourage consumer borrowing. Long term I would expect to see Fannie Mae dismantled and perhaps an end to the favorable treatment received by corporate borrowing over equity financing. The proposed cap-and-trade scheme, for all its flaws, would also encourage the move away from imported petroleum, the biggest source of our structural trade deficit. Even health reform, if it is structured in a way that doesn't stifle innovation, will be a benefit if it levels the health care playing field between small businesses and large corporations.

One of the core tenets of Dynamism is that the American people tend to elect the right government for the times. They will shift around control of the presidency and congress to adjust for imbalances that build up. The US system also leaves the opposition in a powerful enough position that they can help prevent excessive imbalances from building up. The American people were right to favor conservative economic policies over the past 30 years. They were also right to support Obama last year. At some point, when deficits become the most important problem, they will elect a Republican congress. That time is not likely 2010, however.

GDP Outlook

Thanks to the TARP, the Fed's "unconventional measures" and some deft maneuvering by Treasury, the financial system has been stabilized, although many of its underlying problems remain. Now that the financial system is stabilized, GDP can grow. GDP always wants to grow. GDP growth is driven by business competition, which leads to innovation, which leads to investment and hiring, and so on. Business competition gets interrupted when there are financial sector problems. In business competition, there are always businesses on the rise and businesses in decline. In good times, the declining businesses are shielded a bit from their core problems. In bad times those problems are magnified. Recessions accelerate the trends that are already in place. Thus the continued shift of employment from manufacturing to health care. After a bubble, however, a recession can also mark a major turning point. I would argue that we are witnessing a major turning point in housing, energy and retail.

Residential investment has been declining as a percent of GDP since 2005, while personal consumption expenditures as a percent of GDP have been flat. Because personal consumption is less volatile than business investment, it usually rises as a percent of GDP in a recession. As an aside, also notice that the big surge in consumption as a percent of GDP came during periods of supposedly "supply-side" tax cuts in the early 1980s and early 2000s (and late 1990s, with the cuts in capital gains taxes on equities and housing).

Clearly a key pillar of demand during the recession has been the government.

While residential investment as a percent of GDP has fallen by 2 percentage points since 2005, government spending has risen by the same amount. Government spending is now back up to the levels of the 1980s and still below the levels of the 1950s and 1960s. Going forward, increased infrastructure and health care spending will likely be offset by decreases in spending on the wars in Iraq and Afghanistan and by state and local governments, meaning that government spending will likely remain in the 21% of GDP range for the intermediate term.

Where I'd like to see the next wave of demand come from would be exports.

The drag of net imports has been reduced by more than 3 percentage points of GDP since 2005, but this has been driven more by the collapse of imports than by an increase in exports.

The key will be to see if exports start increasing as a percent of GDP while imports are stable or declining. As I've said many times before, a sustained reduction in our trade deficit or the creation of a trade surplus driven by export gains would be the most effective and least painful way to reduce US public and private indebtedness.

Once the recovery has clear traction, business investment should recover.

Business investment as a percentage of GDP is at the lowest level since recessions in the 1950s, a period when business investment was effectively suppressed by government policies. The recovery in investment is likely to be "U" shaped, like in the early 1990s. I expect stabilization by the fourth quarter of 2009, but no real sustained increases until late 2010 at the earliest.


In summary, when examining GDP during the upcoming expansion, look for the following:

  1. An increase in the share of GDP by exports and government near term and exports and business investment long term.
  2. A decrease in the share of personal consumption and imports short term.
  3. If the short term pillars of economic growth are going to be exports and government spending, then expect to continue to see budget deficits, low interest rates and a weak dollar.
  4. Interest rates won't really need to rise until business investment gains traction. When it does, inflation and interest rates will rise, and the American people force the government to focus on cutting the budget deficit.
  5. The likely policy mix to both fight the budget deficit and discourage trade deficits while encouraging domestic business investment will be to raise taxes on the rich, but increasing the amount that can be saved tax-free, effectively creating a progressive consumption tax.

We should also expect to see a reformation of the corporate tax code, lowering rates across the board while eliminating some of the subsidies for old economy industries.