September 20, 2016

The Structural Weakness of the U.S. Economy

Yesterday, Monday Sept 23, the Wall Street Journal noted:
[Donald Trump] wants to raise spending for the Pentagon and triple the number of immigration and customs officials; double the amount rival Hillary Clinton proposes for infrastructure; allocate $20 billion to expand school choice and $2.5 billion for guaranteed paid maternity leave. And more. He is proposing more than $4 trillion in tax cuts, and vowing not to cut fas-growing entitlement programs like Medicare and Social Security. ... Mrs. Clinton is proposing a far bigger expansion of government spending than Mr. Trump, with tax increases to pay for it. She wants to spend more to lower or fully eliminate college cost for many young Americans, for example, and has proposed a big boost in spending for early childhood education. The result is a presidential campaign where neither of the two major party candidates is making a serious push to reduce the size and scope of government.
Clinton's tax-and-spending plans are well within the realm of what the modern Democrat party represents: a steady advancement of the American welfare state right up to the point where it equals, even surpasses, its Scandinavian brethren. 

Trump, on the other hand, is basically promising to continue the kind of fiscal policy that has become a Republican trademark since the Reagan days: cut taxes to generate growth and see a surge in new revenue; then, instead of using the revenue to transition from the welfare state to limited government, use the new tax revenue to fund and even expand entitlements.

From that perspective, not much is different in this election. What is different, as the Wall Street Journal points out, is that there is not even a whisper from either candidate about the budget. This is notable especially given the fiscal policies that Clinton's husband pursued while in office: thanks to his productive cooperation with then-chairman of the House Appropriations Committee John Kasich (R-OH), President Clinton could hold back government spending and sign four federal budgets with surpluses. 

The problem is that even such a moderate kind of fiscal conservatism is unknown or uninteresting to the 2016 candidates. This is worrisome, especially if we look at the long-term trend of a steady decline in the macroeconomic base of the American welfare state. Figure 1 explains:

An Image of the Structural Base for the American Welfare State
Sources: Bureau of Economic Analysis; Bureau of Labor Statistics: Office of Management and Budget

Figure 1 compares two trends. The red trend line represents the balance of the federal budget as percent of GDP. (If the budget deficit is $1 and GDP is $100, the deficit is one percent of GDP.) The downward trend is chilling: since the mid-20th century the federal budget has consistently been in deficit (something we already knew) and the deficit is getting deeper as share of GDP (something that is not often reported). Even more troublesome is that the Clinton surpluses stand out as a historical anomaly in view of what the budget balance looked like both before and after his 1996-2000 surplus years. 

The blue trend line compares two variables that are usually not put together in a ratio: GDP growth and unemployment. However, the ratio makes a lot of sense: the growth rate represents the expansion of economic activity in terms of production value, income and spending. It also represents the growth in the tax base over time. Unemployment, by contrast, represents the idling of the workforce - the share of able-bodied and able-minded workers who can make a contribution to the economy but are involuntarily left out. 

A high ratio means the economy is doing well and can, so to speak, carry its unemployment. A low ratio means the negative effects of the idling share of the workforce dominate the positive contributions from growth. There is no magic, static number where this ratio "should be"; what matters is instead how this ratio performs over time. 

Measured through the first of Obama's two terms, the growth-unemployment ratio has fallen almost as steadily as the budget-growth ratio. 

There are two important lessons to be learned from Figure 1.

a) Over time, the U.S. economy is carrying a bigger government burden than it can pay for, as the red function shows. More and more of today's government spending is deferred to future generations. This has bad long-term effects that we will not explore here (though you can check out this ebook for some innovative discussions of those effects). Short term, the U.S. government is setting the country up for a major fiscal crisis of the likes Europeans have grown painfully accustomed to. So far we have dodged that bullet merely because other countries have, relatively speaking, had even bigger problems with their government deficits and debts, but as we continue to expand government in line with what both Hillary Clinton and Donald Trump want to do, we continue steadfastly down the path to a point where there are no longer any discernible differences between our welfare state and theirs. At that point, we will be judged by the same yardstick as Europe. And face the same consequences.

b) The growth-unemployment ratio tells us that our economy is increasingly unable to put our workforce to productive work. Our businesses, while hiring at acceptable rates (especially in light of the massive unemployment problems in Europe), do not turn the work they pay for into high-growth output. This in turn feeds back to the labor market and leaves more people idling. In fact, if we expand the ratio to include those who have left the workforce for good, the ratio is likely to slope downward more steeply than it does here. 

When our workforce is not producing high-growth value to the same extent as it used to, the inevitable consequence is that the tax base shrinks and government suffers a slowly growing structural deficit. The promises that government has made in the form of entitlement programs were, to a large degree, made in the mid-20th century (and some even earlier, such as Social Security) when the growth-unemployment ratio was higher and the federal budget in good shape. Now, when both the ratios of Figure 1 have declined markedly since the major entitlement promises were made, the ability of the federal government to pay for its entitlement promises is considerably - and structurally - much weaker. 

In other words, we consume entitlements and send the bill into the future for our kids and grandkids to pick up. We expect them to pay both for their own entitlements and for ours. Neither Trump nor Clinton seems to be willing to break that trend.

Let me qualify that: for now, Trump does not seem willing to break that trend. It is not out of the real that once he gets the economy growing again he will use the surge in tax revenue to restructure the half-trillion dollar package of entitlements that the federal government runs jointly with the states. If he does that, he will put us on a path to a contained welfare state. That is a small step in the right direction. 

So far we have no other reason to believe that than some statements he has made about decentralized control over the education system (hand it back to the states). A good idea in itself, no doubt, but in order to break the destructive deficit trend in the federal budget we need much more of the same kind. 

Of equal importance is that a President Trump addresses the problems that keep businesses from putting our workforce to high-growth use. Deregulation and tax cuts are standard references here, for a good reason: they work. Regulations cost our private sector approximately half as much as taxes, but they tend to have a stronger deterring effect on business entries than taxes do. This raises the bar for new, competitive businesses to enter markets and industries. It also reduces technological competition which in turn slows down productivity - and eventually GDP growth. 

In a nutshell, our next president needs to work hard on two fronts to stop the weakening of the U.S. macroeconomic base: entitlement reform, and tax-regulations reform. A daunting assignment. It is a safe bet that a new President Clinton will do none of this. Can we trust a President Trump to do the job?

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