Obama’s uphill battle: Must-knows for the Senate debate

Market Realist

GDP and consumption in the United States

The below graph reflects the ongoing decline in real gross domestic product (or GDP) and consumption growth rates in the United States. This data has been arranged by the Presidential Administration in order to chronicle the secular (long-term) trends in the real economy within a political and historical context, providing perspective on what might be reasonable to expect in the future. As the graph reflects, the Obama Administration is facing an uphill battle against deteriorating economic data.

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Explaining the data

  • The yellow line  reflects the ongoing change in real consumption rates (left axis).
  • The blue line reflects the ongoing change in real GDP growth rates (left axis).
  • The red line  reflects the difference between the yellow line and blue line. When this line is greater than zero on the right axis, it means that consumption growth is greater than GDP or overall economic growth (right axis). Data above zero (the thick black line in the middle of the graph) suggests robust consumption data.
  • The large dash line reflects the negative trend in Consumption growth (left axis).
  • The small dash line reflects the negative trend in GDP or economic growth (left axis).

 Interpreting the trend

Based on three-year rolling averages, we see that both consumption and GDP growth rates have been on long-term declines in the United States. It’s important to note that this data has ranged quite widely over the years, as different political administrations with varying monetary and fiscal policies have reversed negative economic trends—though not in a particularly sustainable fashion—post-1964. Plus, as we noted in a prior series, investment has also been on a long-term decline in the United States. The major declines in consumption and GDP growth in the above graph also reflect in investment data, and we explain the economic cycles or crises associated with the above data swings further in Part 5 of this related series.

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The Reagan effect

Perhaps the most notable and sustained growth periods occurred during the Reagan Administration in the 1980s, as the economy bounced back from a period of inflation, oil shocks, and an overvalued dollar. Later, after the Tax Reform Act of 1986, it seems that the US economy also recovered for an extended period. Though perhaps these economic reforms weren’t fully manifested in the economy until the Clinton Administration in the 1990s—with real GDP growth rates above 2.5% (left axis). Since Clinton and the dotcom bubble collapse (a 13-year period), both real GDP and consumption growth rates have been in a sharp downtrend—very similar in magnitude to the trend we saw from 1972 to 1983 (an 11-year period), though starting from a lower high and falling to a slightly lower low this time around.

In other words, the United States has seen decade-long declines in the economy before, though the more recent decline of 2000 to date has been a little more severe than the 1965-to-1983 period of decline—dipping into negative growth rates in both consumption and GDP growth rates for the first time since the Great Depression (left axis). Perhaps you could argue that significant changes to tax policy, such as the Tax Reform Act of 1986, can have a big impact on restoring decade-long expansions in the economy—perhaps even longer. So you could argue that the US economy maintains some fundamental economic strengths, though significant changes are required at times in order to adapt to a changing economic environment.

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What has changed since 2000?

As we noted in Part 4 of a prior series, the Bush Tax Cuts, under EGTRAA (the Economic Growth and Tax Relief Reconciliation Act of 2001) and JGTRAA (the Jobs and Growth Tax Relief Reconciliation Act of 2003), had lowered the capital gains tax rates from 20% to 15%. This temporarily revived the faltering economy. However, prior to the Bush Tax cuts, Clinton had engaged in even larger cuts in capital gains taxes in the budget deal of 1997, lowering rates from 27% to 20%. Both these presidents cut capital gains taxes far below the Reagan era rate of 27% to 33%. Obama recently raised capital gains taxes back to 20%—still significantly below Reagan era levels.

Why this is happening

As the above graph suggests, the Clinton Administration cut capital gains taxes in 1997 because the United States seemed able to afford the cut. Both real GDP and consumption growth rates were over 2.5%—very solid growth—and tax receipts were robust. US gross debt as a percentage of GDP was around 35% when Reagan took office, though it rose to around 65% when Clinton took office, then fell to around 55% by the time Clinton left office. At the time, there was the sense that the United States would be on trend to retire the majority of its debt in the future. Well, things changed. Investment faltered in the United States post-dotcom crisis, and things haven’t been the same since. Financial deregulation, the housing bubble, the subprime meltdown, and the ensuing global financial crisis have conspired to create the perfect storm for President Obama, as US gross debt levels have skyrocketed—approximately doubling since Reagan left office from 50% of GDP to 100% of GDP today. This is a different ballgame altogether.

What Obama can do, and is doing

As we noted above, Obama has raised the capital gains tax rate from the Bush era emergent levels of 15% to 20%. Apparently, the Obama Administration had about as much fun as it could stand with record corporate profits, widespread corporate share buy-back programs, and record-high stock prices, while real unemployment remains largely unchanged, the labor participation rate continues to decline, and investment in future growth continues to decelerate.

Raising the capital gains tax rates was Obama’s first protest vote to recognize the apparent fact that the supply-side party had gone out of bounds. The post-Reagan era of collapsing capital gains tax rates had led to the wealthiest 1% of Americans getting richer, while the middle class was hollowing out and long-term fixed investment declined. It might appear that the low capital gains tax served to create a bonanza for private equity and hedge fund managers, as well as homeowners—a bonanza for asset owners and traders across the board. Yet productivity-enhancing long-term fixed investment as a percentage of GDP declined. As a result, after 2008, the average homeowner experienced a much more dramatic decline in net worth. Without strong investment to grow the economy, it will be hard for the average American to recover the decline in purchasing power without growth in productivity—the fruit borne of long-term fixed investment. Financial deregulation takeaway number one: “Heads, I win. Tails, you lose.”

In short, the United States can’t create prosperity through low capital gains taxes alone. If productivity-increasing investments don’t accompany the increases in low-tax cash flows, the United States ends up with declining growth, slowing productivity gains, and zero interest rates. Yes, this is a real pickle. Waving the capital gains tax cut magic wand seems to have run its economic and political course. Obama has drawn a line in the sand. Now it’s time for the standoff with Republicans. It’s an epic battle and a critical debate based equally in the economic and political considerations of social justice upon which American society rests. Simply put, at this point, it isn’t just about numbers. That’s when things get interesting.

Showdown at the Hill

The Senate starts debating a bill today—Wednesday, September 25—in which Senate Majority Leader Democrat Harry Reid is expected to strip Republican Senator Cruz’s provisions in the bill that would defund Obamacare. Cruz has threatened to filibuster into a government shutdown, though Senate Minority Leader Mitch McConnell doesn’t support the Cruz measures, as he wishes to avoid a government shutdown. He would rather pursue other more politically feasible ways of defunding Obamacare, as the government shutdown would likely keep Obamacare funded anyway.

Krugman’s two cents: A monument to the power of truly bad ideas

As Paul Krugman pointed out earlier in the year, it would appear that “the Republicans want to take everything that’s bad about the sequester and make it worse: canceling cuts in the defense budget, which actually does contain a lot of waste and fraud, and replacing them with severe cuts in aid to America’s neediest. That would hit the nation with a double whammy: reducing growth while increasing injustice.” As Krugman suggests, it’s hard to shrink your way into growth.

Exhuming Reaganomics and the Laffer curve

As the above graph notes, Reagan managed a dollar-neutral tax reform package that initially led to rapid growth in US gross debt—practically doubling to 65% of GDP before trending downward. The Reagan Administration, like the Obama Administration today, also faced significant outlays in the area of defence. Cutting defence at this point is politically challenging. However, as the above graphs shows, despite the Reagan era build in national debt, the US economy did in fact seem to find a fairly stable recovery—even with capital gains at 27%. While Reaganomics involved lowering tax rates, the rates under Reagan were higher than under Obama. Also, Reagan was noted for running large deficits of 4% of GDP—roughly right where the Obama Administration is today (bouncing back from 10% during the worst of the crisis).

One of the justifications for the Reagan era supply-side tax cuts was the theoretical model of the economist Arthur Laffer. His analysis suggested that both excessive as well as insufficient tax rates would result in suboptimal tax revenue generation. Apparently, Obama has a ways to go in terms of returning capital gains tax to Reagan era levels. Perhaps this would shrink the budget deficit in the near term. However, the critical issue lies in what will likely be the ongoing growth of the US debt as a result of entitlements and defence spending. Entitlements are scheduled to grow rapidly relative to tax receipts.

Should the debt ceiling be lifted?

As Krugman notes, “It’s not that we as a Nation have overspent and need to spend less; it’s that some people are being forced to spend less, and we have a depression because other people won’t (NOT can’t) spend more. This is how you need to think about debt; it’s not a burden on the Nation’s resources, because its mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt, but because debt is currently leading to spending that’s less than we need to maintain full employment.”

Krugman’s analysis suggests that the debt ceiling isn’t as critical as the media might once have believed. While the current debt level is high by historical standards, at least interest rates remain low, suggesting that the US economy is suffering from a lack of demand. This requires growth in investment rather than simply further declines in spending. If Federal budget deficits didn’t scare Reagan, perhaps they also don’t scare President Obama. Maybe the parties can reach a compromise that optimizes the balance between fiscal prudence and social objectives.

Outlook

Should sequester fears persist and economic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the sequester issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment.

However, if investors are confident in the United States’ ability to sustain the current economic recovery as a result of a positive sequester outcome and improving economic data, they may be willing to take a longer-term view and invest in US equities at their current prices. With the S&P 500 price-to-earnings ratio standing at 19.34 versus the historical average of around 15.50, the S&P is slightly rich in price. But with so much wealth sitting in risk-free and short-term financial assets, you could imagine that a large reallocation into long-term fixed investments of the capital that’s “on strike” (including corporate profits) could lead to greater economic growth rates. This could support both higher equity and housing prices in the future as well.

For related analysis, please see the following articles.

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