Stepping on the Gas

The economy is doing well – low unemployment, accelerating growth, rising corporate earnings and even some better wage growth, which has been notably lacking during the ongoing expansion. The equity markets are doing even better – new records fall with increasing frequency, volatility is extremely low, and we have gone two years without a significant pullback. Consumer and small-business confidence hover near generational highs, and we have yet to enjoy most of the stimulative effects of the recently passed tax legislation.

So why am I worried?

Well, part of it is that it is my job to worry. If markets went up forever on unending parabolic curves, no one would ever need investment counsel. More to the point, though, I worry about the great fiscal experiment (which follows a great monetary experiment) that we are embarking upon.

We borrowed the chart below from a recent The Washington Post article entitled “We’re embarking on an unusual fiscal experiment: high deficit spending at low unemployment”, by Jared Bernstein. The chart shows a strikingly high correlation between the unemployment rate (currently at 4.1%) and federal budget deficits as a percentage of GDP (expected to be about 3.6% for 2017, according the CBO). Please note that for the unemployment rate, the series in the chart is inverted. In other words, the further down the red line goes, the higher the rate of unemployment. You will also notice that the budget deficits have displayed a long-term downward trend, which means our federal government debt has been accumulating for quite some time.

Again, unemployment and budget deficits have moved very nearly in lock step since 1948. As unemployment goes down, so have budget deficits. Intuitively, this makes sense. With more people working, more people pay taxes. With fewer people working, as during recessionary times, there is less tax revenue and more of a reliance on government spending to stimulate the economy. So, in essence, fiscal discipline during expansionary economic times has allowed us to use government spending as a lever to support the economy in recessionary times. This is known as Keynesian economics.

Until the past couple of years, the only times that the unemployment rate and the budget deficit diverged meaningfully were during the Vietnam War and, to a lesser extent, the Korean War. Wars tend to create jobs and spark economic growth, while at the same time federal budget deficits increase due to the heavy spending required to prosecute the war. It could be argued, and I would agree, that running large budget deficits during a time of war is perfectly justified. After all, national security takes precedence over almost everything else.
During the Global Financial Crisis, both the unemployment rate and the budget deficit (as a % of GDP) surged, as would be expected. In fact, each metric rose to about 10% – levels not seen in decades. As the economy began to recover and jobs were added, budget deficits fell. This trend is also in line with historical trends. But what happens next is extremely rare. There is expected to be a wide divergence between our budget deficits and the unemployment rate over the coming years. The unemployment rate has plummeted to 4.1% and is still falling, but the budget deficit inflected higher in 2016 and is expected to rise again in 2017. And thanks to the recently passed tax-cut legislation, which is expected to increase our deficits by $1.4-$1.5 trillion over the next 10 years, our budget deficits are likely to continue rising in the years to come.

To be sure, the recent decision to stimulate the economy through tax cuts may be enough to sustain the recent improvement in economic growth – at least for a little while. But at what cost? Reinhart and Rogoff, in research first published in 2009 and later revised, demonstrated that high debt levels can be a serious drag on an economy. In essence, what history shows us is that deficit spending can sometimes stimulate economic activity in the short term, but the accumulation of massive debt over time can meaningfully inhibit longer term growth.

In last year’s Phillips Lecture at the London School of Economics, Professors Christina and David Romer presented a paper that found that the degree of fiscal and monetary policy flexibility – that is, the level of stimulus capacity that is available – prior to periods of financial distress greatly affects the recovery from that crisis. Countries in relatively solid fiscal condition have historically been able to apply expansionary fiscal policy (deficit spending) and monetary policy (lower interest rates) relatively quickly in response to a crisis. And, as Romer & Romer showed, the economies in those countries were generally able to recover in fairly short order. However, countries running high deficits, with already high debt levels and relatively low interest rates, are not as easily able to do so. In fact, their high debt levels could force austerity measures just as an economic slowdown is causing higher deficits (think Greece, Portugal, etc). Based on these findings, I worry about what happens when the next crisis in the US comes – and they always do. If our deficits and our debt continue to rise, and interest rates are still relatively low, how will we be able to respond?

Equity investors are benefiting from the stock market’s positive reaction to the tax cuts. There are plenty of things to like in the tax bill. However, longer-term, we remain concerned that the tax bill was poorly timed and didn’t do much to address economic inequality. Moreover, it would have made more sense to cut taxes for businesses during a recession as opposed to nine years into an economic expansion when the economy stands at full-employment and the Fed is raising rates to slow things down. The Fed has already embarked on its normalization path, in part to ensure that it has enough dry powder when the next downturn comes. It remains to be seen whether the economy can withstand meaningfully higher interest rates. But without sizeable budget cuts or sharply higher economic growth, there is likely to be very little flexibility with regard to fiscal policy.