Hoisington Investment Management commentary for the second quarter ended June 30, 2016.
Hoisington Investment Management – The Separate Constraints of Deficit Spending and Debt
Real per capita GDP has risen by a paltry 1.3% annualized since the current expansion began in 2009. This is less than half of the 2.7% average expansion since the records began in 1790. One of the most persistent impediments to growth has been the drag from fiscal policy, a constraint that is likely to become even more severe in the next decade. The standard of living, or real median household income, has only declined in the 2009-2016 expansion and stands at the same level reached in 1996.
Six considerations indicate federal finance will produce slower growth: (1) the government expenditure multiplier is negative; (2) the composition of spending suggests the multiplier is likely to trend even more negative; (3) the federal debt-to-GDP ratio moved above the deleterious 90% level in 2010 and has stayed above it for more than five years, a time span in which research shows the constriction of economic growth to be particularly severe. It will continue to move substantially further above the 90% threshold as debt suppresses the growth rate; (4) debt is likely to restrain economic growth in an increasingly nonlinear fashion; (5) the first four problems produce negative feedback loops from federal finance to the economy through the allocation of saving, real investment, productivity growth and eventually to demographics; and (6) the policy makers force the economy into a downward spiral when they rely on more debt in order to address poor economic performance. More of the same does not produce better results. It produces worse results, a situation we term a policy trap.
Deficit spending is a separate matter from debt. If the starting point were a situation of no federal debt, a discussion of expenditure multipliers would be sufficient. However, that is not the case. Federal debt levels are already extremely elevated, and the trend is escalating steadily higher.
When deficits and debt impair growth, a sequence of events impacting other critical barometers of economic performance takes place. Saving is increasingly misallocated, shifting income that generates public and private investment into investments that are either unproductive or counterproductive. Real investment in plant and equipment falters, which in turn pulls productivity, employment and economic growth down. When the policy response to poor economic performance is ever-higher levels of debt, the economy’s growth becomes more feeble, which over time causes demographics to erode, a common pattern in highly indebted countries. Then the deterioration in real investment, productivity and demographics reverberate to the broader economy through negative feedback loops that suggest that as debt moves ever higher, the restraining effect on economic growth turns nonlinear. While some economists have called these headwinds, they should be more appropriately viewed as symptoms that originated with the deficits and the debt. And these symptoms will persist as long as the debt problems continue.
These indirect influences of debt on economic growth, as well as how this process has proceeded in Japan, illustrates these points. Japan, burdened by a massive debt overhang for almost three decades and a 25-year policy trap, provides a road map for the United States, which is in a much earlier stage of debt overhang.
Deficit Spending Restrains Economic Growth
Negative multiplier. The government expenditure multiplier is negative. Based on academic research, the best evidence suggests the multiplier is -0.01, which means that an additional dollar of deficit spending will reduce private GDP by $1.01, resulting in a one-cent decline in real GDP. The deficit spending provides a transitory boost to economic activity, but the initial effect is more than reversed in time. Within no more than three years the economy is worse off on a net basis, with the lagged effects outweighing the initial positive benefit.
More negative. Although only minimally negative at present, the multiplier is likely to become more negative over time since mandatory components of the government spending will control an ever-increasing share of budget outlays. These outlays have larger negative multipliers. In 2015, the composition of federal outlays was 68.3% mandatory and 31.7% discretionary; the composition was almost the exact opposite in 1962, around the time this data series originated (Chart 1). Mandatory spending includes Social Security, Medicare, veteran’s benefits and the Affordable Care Act. All of these programs are politically popular and conceptually may be highly laudatory. However, federal borrowing to sustain these programs does not generate an income stream for the economy as a whole to pay for these programs. As history has evidenced, the continual taking on of this kind of debt will eventually cause bankruptcy.
Due to the aging of America, the mandatory components of federal spending will accelerate sharply over the next decade, causing government outlays as a percent of economic activity to move higher. There have been proposals for increased infrastructure spending and others for additional federal entitlements like Social Security. However, the existing present value of all unfunded federal entitlements already totals $60 trillion, about ten times the amount held in the trust funds. When funds flow into these accounts, they are immediately spent to cover the federal deficit, with the Treasury issuing an IOU to the trust fund. Thus, the trust funds merely hold U.S. government debt.
Theoretically, increased infrastructure spending could serve to reverse or halt the trend to a more negative multiplier, if true infrastructure spending were to be substituted for transfer payments, but that is not what has been proposed. The new infrastructure spending would be in addition to existing government programs. Any new infrastructure projects must generate a cash flow for the aggregate economy that is greater than what would have been generated by the private sector.
The rising unfunded discretionary and mandatory federal spending will increase the size of the federal sector, which according to first-rate econometric evidence will contract economic activity. Two Swedish econometricians (Andreas Bergh and Magnus Henrekson, The Journal of Economic Surveys (2011)), substantiate that there is a “significant negative correlation” between the size of government and economic growth. Specifically, “an increase in government size by 10 percentage points is associated with a 0.5% to 1% lower annual growth rate.” This suggests that if spending increases, the government expenditure multiplier will become more negative over time, serving to confound even more dramatically the policy establishment and the public at large, both of whom appear ready to support increased, but unfunded, federal outlays.
Deleterious Levels. Federal debt has subtracted, to at least some degree, from U.S. economic growth since about 1989 when debt broke above 50% of GDP, a level to which this ratio has never returned (Chart 2). The macro consequences of the debt are becoming increasingly significant. This may seem surprising to many because of confusion about the scholarly work of Carmen Reinhardt and Kenneth Rogoff (R&R) in their 2009 book, This Time is Different.
The misinterpretations pertain to a key point in R&R’s book and accusations of data inaccuracies in the statistical calculations. R&R said debt induced panics run their course in six to ten years, with an average of eight years. The last panic was in