Seeking American Renewal

We are flailing economically. No question about that. Sadly, no one has any good answers for what to do about it.

Sometimes, there's just not that much to do. We just have to ride it out.

The immediate economic problem is quite simple. There is a gigantic hole in the economy where real estate investment used to be. The chart below pretty much sums it up.

Source:, calculations by

As a percent of GDP, business investment has snapped back nicely and has returned to a relatively normal level. As I mentioned in my previous post "Momentum is Building", I think we are likely on the front end of a powerful investment cycle for business investment.

Real estate investment, on the other hand, has cratered to by far the lowest level recorded since World War II.

Enter John Maynard Keynes

The Keynesian economic solution would be for the government to step in and fill the hole in demand (1) by supporting consumption with lower taxes and transfer payments and by (2) directly investing in infrastructure and other public works. The government has done plenty of number (1), which is why our deficit is so large, and not enough of number (2).

What people forget about Keynes was that he advocated withdrawing stimulus and running surpluses when the economy is strong. Instead, the "Keynesians" that have been running our economy since World War II (and that includes both political parties) have made stimulus a permanent feature of our economic policy. Overall it worked great…until 2008.

As a result, we have run up huge debts in all sectors of the economy (government, financial, consumer, business).

Source:, calculations by

And have gotten to the point that government transfer payments and health benefits are equal to about 20% of GDP.

Source:, calculations by

Even more disturbing, if we total transfer payments and investment income (dividends, interest and rental income), non-work income equals 35% of GDP, while work-related income (wages, salaries and proprietor's income) equals only 50% of GDP. This is a classic sign of potential national decline, when more and more income flows to the upper "rentier" class and the government mollifies the masses with transfer payments.

This trend can also be seen as fewer people of working age are even participating in the labor force (working or looking for work).

Source:, calculations by

Generational imbalance

It gets worse as time goes on. As the baby boomers retire, transfer payments will take up more and more of GDP, particularly health care payments, but also Social Security and unfunded pension benefits.

Source: "Where's Your Budget Mr. President?" by Paul Ryan, Wall Street Journal, 8/3/11

As can be seen above, if left unchecked government health care spending will continue to gobble up more and more of GDP. The chart above assumes that the rest of the government actually shrinks as a percent of GDP.

So while in the short term today's Keynesians are right, in the long term they are wrong. Our budget deficit is hovering around 10% of GDP, and we still can't stimulate growth. In addition, even though we supposedly have insufficient demand, we are running a trade deficit of 4% of GDP. In other words, even with 9% unemployment and only 76% industrial capacity utilization we consume 4% more than we produce.

We can no longer have a smaller and smaller portion of the population earning a smaller and smaller proportion of income and expect the country to thrive. The welfare state needs to be scaled back to make room for more productive activity.

Seeking American Renewal

While the Republicans are right to focus on scaling back the welfare state, they do not have a good plan for fostering future growth. Scaling back government spending will cut back demand, and the coincidence of super-low interest rates with deficits of 10% of GDP and strong money printing prove there is extremely weak demand for investment capital. It is therefore unlikely that private investment has been crowded out by government deficits.

In the big picture, Obama actually articulates a more credible vision than the Republicans for long term growth…less focus on consumption, imports and residential real estate, more focus on savings, exports and investment, focus on infrastructure investment, technology, education, health care and reducing our reliance on imported oil. His execution, on the other hand, has left a lot to be desired. He was elected to help rebuild the economy and instead dissipated his political capital on his health care bill. Only time will tell if that was the right call or not.

While our political culture is raucous and messy, they are slowly getting it right. Cut back the welfare state, allow private investment to grow and eventually throw the government behind a new growth plan. The focus should neither be on further increasing the returns to investment (the Republican plan) nor on increasing transfer payments (the Democratic plan). We need a plan that gets more people working and making more money. (More on that in a later post.)

In the meantime, all we can do is wait for the real estate downturn to play out before we fire on all economic cylinders again. Until that time, the "Rounded Bottom" scenario holds.

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.