Forces engendering the long-term economic outlook
The growth of entitlements has weighed on domestic saving, and foreign borrowing is now a very large source of funding for domestic investment. If foreign capital flows slow, and domestic saving continues to be crowded out by entitlements, there would be serious consequences for investment and productivity, even though the recent figures on output per hour are a little better. The growth of populist sentiment has hampered the ability of our political system to handle important issues such as tackling entitlements. There is no precedent, in Western civilization, where you can expand the money supply as much as going to be necessary to fund this deficit, without engendering inflation. In the very near term, though, the near-term outlook for capital investment is favorable.
KeywordsLong-term outlook Entitlements Investment Productivity Inflation
I would like to thank Paul Volcker and NABE for this special award. As one of the founding members and an early president, NABE has a special place in my career.
It is fascinating that this organization has done what it did. It’s such a pleasure for me to look around this room and see how an individual’s idea—it wasn’t my idea—can create something of this nature.
What I’d like to do this afternoon is to discuss the forces which are engendering the long-term economic outlook, not only in the United States, but really across the globe.
I will start with a comparison of gross domestic saving and entitlements. When you get into the detail, the data show that mandated entitlements drive out gross domestic saving dollar for dollar. Since 1965, entitlements have grown tremendously. Although in recent years their share of GDP has flattened out, the Congressional Budget Office has a forecast of what’s going to be happening to entitlements, based on the existing structure of the population. This shows that the entitlement share will rise fairly significantly for about ten years. But even at the current level, there is significant crowding out of saving: the sum of gross domestic saving and entitlements as a percent of GDP has been roughly, though not exactly, constant. It has been remarkably stable going all the way back to 1965.
For many years gross domestic investment followed saving very closely. When we ran out of domestic saving, we began to reach abroad for funding for investment. Saving borrowed from abroad mirrors the gap between the investment and saving. We are now materially reaching out abroad for investment resources.
The cumulative effect of that process has been an extraordinary increase in net borrowing from abroad. The figure, most recently, is close to $10 trillion. It was zero in the mid-1980s. It should become fairly obvious that, at some point, no one’s going to lend to us the way they have been. There are no signs of that yet. But $10 trillion is important even in today’s environment.
If foreign capital flows were to slow, and domestic saving continues to be crowded out by entitlements, there would be serious consequences for capital investment and productivity. From the capital investment data, we can derive—obviously after correcting for the depreciation charges—the net change in the capital stock. And then by cumulating the net changes, we get the actual stock of capital invested. When we compare the capital stock data, plus an adjustment for the level of education in the economy, and output per hour, we see an extraordinarily tight relationship. These two variables, are not, in themselves, very unusual or difficult to estimate.
The data that came out this morning, which my staff conveyed to me, suggest that we got a slight pick-up in the rate of growth in output per hour. That in itself is quite important, because we have seen very slow growth in productivity in recent years. In fact, subsequent to the 2009 surge, that occurred as a consequence of the crisis immediately before, we went for a protracted period in which the average annual growth rate of productivity was little more than 1%. Considering the fact that we’ve historically had long-term periods of 2%–3% growth, and since productivity is the most important constituent of economic growth, that is a very sorrowful performance. The data in the last two quarters look a little better. But for reasons I will suggest, I’m hesitant to put too much value in them as suggesting improvement in the long-term economic outlook.
Returning to the issue of entitlements and their crowding out of saving and domestically funded investment, a major issue is that if you’re dealing with the need to finance entitlements or pare their growth, you’re dealing with politics. It’s inconceivable to me that we get to the state of affairs where we have entitlements, grow to, say, 20% of GDP. That is a very huge number. As you know, entitlements have been called the third rail of American politics. If you’re running for office and you touch them, you lose. That is a more important proposition than many others I can think of.
We are dealing with a very tough problem. It would be one thing if we funded entitlements. But we don’t. The biggest part of all this, of course, is Social Security. The Social Secretary trustees have an annual report. The last one came out about nine or 10 months ago, for the year 2017. It went through the usual stuff. They were talking about the trends, while never getting to grip with the difficulties. In the back of the report, I think it’s on page 199, the actuaries of the Social Security trust fund have their say. What they demonstrate mathematically is the fact that under the existing structure, as they put it, in order to get to fiscal solvency or mathematical solvency, as a private insurance company would do, you’d have to cut benefits by 25%. The probability of that occurring in our political system is zero. And that figure may be too high.
The growth of populist sentiment has hampered the ability of our political system to handle important issues such as entitlements. Much the same thing that has been occurring in the United States has been replicated in Britain. They got Brexit. We got Trump. The relationship between the two is really remarkable. My view is Brexit was a terrible idea for Britain. Nonetheless, it passed. It passed largely because of deep-seated prejudice. I read something about a little hubbub in the United Kingdom, where a number of Bulgarians were seen roaming around Piccadilly Circus. You could see in the content of the report that deep-seated prejudice. The Brits in Piccadilly Circus didn’t want Bulgarians there. But they didn’t want them anywhere else, either.
The EU structure led to essentially the same type of problem that we have with populist attitudes damaging policy. There are two parts to the European Union. There’s the fundamental central, Ricardian-based evaluation where the more trade that goes on and is funded, the more rapid the growth rate, because the division of labor is put together in the most practical way. If the EU were only the trade portion, Brexit would never have occurred. The politics of Britain is they can’t disassociate freedom of movement of goods and services from freedom of movement of people. Whereas they are really two fundamentally different issues.
I would submit that if we get into a referendum on trade agreements, like the Brits had, and we had only an EU-like goods and services portion to vote on, the so-called remaining percent would be 60%. A separate portion dealing with immigration would be significantly voted down.
I’ve raised this question with a number of my British friends. They’re reluctant to hold that view of Brexit because it doesn’t go very well with them. But this is what the issue is. This is the reason why Brexit created what is effectively a populist movement. The same thing is occurring in the United States. We’re confronting the same issue when, unfortunately, we are about to run into a trillion-dollar deficit. I shouldn’t say about to. We are facing a trillion-dollar deficit. A trillion-dollar deficit should be scaring everybody who is in the political system into panic to do something. It hasn’t happened. The political system does not react to the data on the size of the deficit. The politicians talk about it, but they never act. Action will occur only if and when that very extraordinary increase in the federal debt begins to create inflation.
There is no precedent, in Western civilization, where you can expand the money supply as much as is going to be necessary to fund this deficit, without engendering inflation. When inflation occurs, the politics change. Just remember that Richard Nixon imposed price controls on the United States when the inflation rate was 4%, which was considered to be an utter disaster.
We don’t have an inflation rate of 4%. We have half of that, or less. However, within a few years, we will have, if nothing is done, a federal debt as a percent of GDP that will resemble levels close to what existed during World War II, the previous high point. Unless you believe in fairies, that is not an economy which can function without inflationary instability. We’re in a very difficult period now where the political pressures are such, that despite the very huge increase that we see in the debt, nothing is happening. People are behaving as though it’s a terrible thing, but I want a little more occurring on the policy side.
The reason the debt increase threatens inflationary instability is that the best indicator I have on the rate of inflation in an economy is unit money supply, which is M2 divided by real GDP. What is quite remarkable is how very successful an indicator it’s been, especially in the last 100 years or more.
That raises the question as to what’s going on recently, since unit money supply has been rising much faster than the GDP deflator. However, past history says those two lines are going to converge. The best bet, in our political system, is that inflation rises. If we think that we’re doing reasonably well, we are not.
Returning to the near term, the data which came out this morning were actually not bad. GDP, at a 2.6% annual rate of growth, rose a bit more than some were expecting. One very famous brokerage firm was projecting 1%. The figures suggest that the productivity numbers were not all that bad. I do have some reason for near-term optimism on that score, reflecting the relationship between productivity and investment earlier noted.
When we look at capital investment, we always look at expenditures. But back when NABE was just beginning, McGraw Hill and Company compiled capital appropriations for the private sector. What the data showed is that it takes about 6 months between an initiation of capital investment taking place at the corporate board level and when the expenditures actually happen. Econometric evidence confirms the six-month lag between developments that trigger the decision to invest and outlays. Having been on as many boards as I have, that’s exactly how long it takes. People in a particular department or corporation come up to the executive committee or the board. They present their proposal. They get shouted at and all sorts of things. But then the board makes a decision. It takes six months before that decision is implemented and shows up in capital investment on the company’s books, and in GDP. It shows up very specifically in the econometrics that you can explain capital investment with a two-quarter lag on the major explanatory factors.
If one were to take the fitted values from a regression explaining corporate capital investment, and lag them two quarters, we would have a series that essentially shows capital appropriations. It leads the business cycle in virtually every case and it is still rising, relative to corporate cash flow. If we look at the current environment, the data also show that the corporate sector is still de-leveraging. I’ve never heard of a recession that began from a state of de-leveraging. The analysis indicates that the tax cut is still functioning to generate capital investment.
In conclusion, the long-term outlook is terrible. We are not taking actions to address the rapid growth of entitlements, which will ultimately weigh on capital formation, productivity, and inflation. However, the short-term outlook is not too bad: capital investment and productivity are improving, and corporations continue to de-leverage.