America: Empire Or Republic? Part I [ANALYSIS] by Bill O’Grady of Confluence Investment Management LLC

N.B. Due to the upcoming Labor Day holiday, the next report will be published September 8, 2014. Last week, we introduced this topic. This week, we will conclude our analysis, including market ramifications.

The Costs of Hegemony

Being a superpower, at a minimum, requires a country to skew its economy toward consumption and to have a large standing military and an extensive intelligence apparatus. At times, the superpower will be drawn into rather pointless wars with no obvious end. The superpower often finds itself stuck policing actions that are essentially endless.

The following charts and subheadings detail the costs to the U.S. for taking on the superpower role.

The U.S. economy has become skewed toward consumption: Because the superpower provides the reserve currency and is the driver of global growth, the U.S. must stand ready to consume all the goods the world wants to sell us. By being open to imports, foreign nations can acquire dollars for reserve purposes. This means the U.S. economy will tend to have more consumption than it would otherwise. This, by design, also means the U.S. will tend to run a persistent trade deficit; when the reserve currency nation runs a trade surplus,  the surplus acts as a contraction of the global money supply. And so, the superpower cannot really be a “normal” economy.

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This chart shows U.S. consumption and net exports as a percentage of GDP. Normal consumption for a developed nation is around 60% to 65% of GDP. That was the position of the U.S. until the early 1980s. Around that time, the U.S. economy’s relative size compared to the rest of the world declined, meaning that a proportionally larger level of consumption was required to keep the world supplied with dollars. In addition, several large economies, including Japan and Germany, had engaged in export-led growth, meaning that much of their exports went to the U.S. As the chart indicates, as U.S. consumption rose, net exports steadily declined, a result of high levels of consumption.

Providing high levels of consumption has created challenges for policymakers:

There were two major consequences shaping the economy to provide high levels of consumption. First, to constantly spur consumption, fiscal spending rose and deficits became commonplace.

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The chart on government spending shows the transition from republic to empire. During the period of 1792-1930, excluding the wars and demobilization, government spending was 2.6% of GDP. Since 1930, excluding WWII, spending has averaged 18.9%. We include the “little wars” simply because, for an empire, small wars are part of the landscape. We use the OMB’s forecast for spending into 2020. Note that the executive branch assumes spending will hold at just above 20% of GDP.

Deficit spending became the norm.

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This chart shows the federal government’s fiscal balance as a percent of GDP, including the Office of Management and Budget (OMB) estimates for 2015-2020. Until the 1930s, the government ran small surpluses or deficits, with large deficits only occurring during wartime. After WWII, deficits became more common and were part of supporting consumption. Policymakers found themselves in a dilemma. The program for supporting consumption from the early 1930s into the late 1970s was designed to fund consumption through incomes. In order to provide enough high-paying jobs, the government built an economy that restricted entrepreneurship. Technological progress was severely restricted and mostly focused on national defense. Unfortunately, by retarding the “creative destruction” element of capitalism, inflation became difficult to control.

To control inflation, the Carter administration embarked on a program of hard money and deregulation. Paul Volcker was appointed to the chair of the FOMC. He began targeting the money supply which caused interest rates to soar. Carter also deregulated financial services and transportation, forcing the economy to become more efficient. At the same time, globalization was allowed to expand. President Reagan furthered this policy direction by slashing marginal tax rates. The cuts in tax rates, coupled with deregulation, led to the unleashing of new technologies from firms of all sizes.

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This chart shows the highest marginal tax rate along with patent issuance. We use the latter figure as a proxy for entrepreneurship. Note that as the highest marginal tax rate declined, patent issuance rose. With high marginal tax rates, there is little incentive to start a business or develop a disruptive technology. The risks of such activities are high and if one is lucky enough to generate a strong reward, the government confiscates the gains. But, when the highest marginal tax rate is cut significantly, the incentive to innovate rises.

Of course, the gains from innovation and globalization also are disruptive. New technologies destroy old industries and foreign competition moves jobs overseas. While these changes were effective in corralling inflation, they cut into incomes. If the U.S. wasn’t a superpower, this shift would have been manageable. However, because of the reserve currency role, the U.S. had to provide consumption for global imports. Unfortunately, that required a new source of funds to provide consumption, which turned out to be household debt.

The next chart shows the amount of consumption funded by wages. In the blue shaded area, when the economy was designed to create jobs that would fund consumption, most of the time, about 90% to 95% of consumption was paid for by wages. As deregulation and globalization policies were implemented, the amount of consumption funded by wages fell and debt levels rose.

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Median income growth also stalled.

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From 1947 to the early 1970s, real median income growth followed a rather steep trajectory. Had we stayed on that course, median household income would be approaching $100k per year. However, deregulation and globalization lowered the pace of growth to the current, lower trajectory. This change led to rising income inequality.

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Currently, the top 10% of income earners are taking the highest share since the introduction of the income tax. There is growing evidence that the deleveraging occurring in the U.S. is slowing global trade.

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This chart shows total U.S. debt as a percentage of GDP compared to world trade scaled to GDP as well. As global trade grew, relative to the size of the U.S. economy, debt also rose. As debt levels have declined, note how global trade growth has mostly stalled.

Defense spending was elevated: During the period of 1792-1940, excluding the wars, U.S. defense spending was a mere 1.2% of GDP. These defense spending levels are consistent with small European nations.

Note that from 1950 to 2012, this spending averaged 7.2% of GDP.

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This high level of defense spending was necessary to confront communism; however, the military-industrial complex also provided millions of high-paying middle class jobs as well. Note the OMB’s forecast for defense spending into 2025; spending is forecast to fall to around

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