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.
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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.
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.
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.
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.
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.
Median income growth also stalled.
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.
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.
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.
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 2.5% of GDP, the lowest level since the pre-WWII era. The budget data would suggest that policymakers are preparing for the U.S. to slowly relinquish the superpower role.
Republic or Empire? The Hobson’s Choice…
The economic and political distortions caused by the superpower role have become increasingly difficult to manage. The Great Financial Crisis had a number of causes but excessive debt was probably the key issue. That debt accumulation was partially caused by the consumption requirements of the superpower role. However, there have been festering political problems that have also grown. The Snowden revelations and the Wikileaks showed an American government deeply involved in surveillance that is hard to justify constitutionally. The growing issue of inequality is also a worry. All these concerns essentially are centered on the above question—Is the U.S. a republic? If not, should it be? If we decide to return to a republic, what are the ramifications?
If the U.S. is going to maintain the superpower role, we believe these three issues must be addressed:
1. Household debt levels need to fall further and consumption needs to be funded through means other than debt. There are basically two paths to this outcome. The first would require moving, in part, to the pre-deregulation policies of the late 1970s where the economy created lots of high-paying, low-skilled jobs. The second would be to expand the social safety net and create some form of guaranteed income.
2. Americans will simply have to accept intrusive surveillance and heavy government intrusion on security matters. Superpower nations have enemies and intelligence is necessary to protect the U.S. from those enemies. Constitutional changes may be necessary, as will creating appropriate safeguards.
3. Large government is unavoidable for a superpower; consumption has to be constantly supported and the military has to be large. The populous will have to accept the idea that the superpower role is important enough to live with a large, intrusive government.
The changes brought from point one above might end the deregulatory policies that began with Carter and have created some obvious benefits in terms of new technologies and low inflation. As discussed in our series on the 2016 elections,2 the establishment class will oppose these changes vigorously. They may be more open to guaranteed national income and higher taxes if it allows the establishment to maintain globalization and deregulation. The populist classes will oppose the second two points. Although a grand political bargain is possible, a figure that could lead this reconciliation is not evident at this point.
Of course, there is an alternative. The U.S. may simply decide that the costs of hegemony have become too rich. The distortions to the economy, the difficult interplay between inflation and income distribution and the need for a large military and intrusive security “state” may simply be too much to bear. After all, hegemons come and go. Rome, Spain, the Netherlands and Britain were all dominant at one point in history. They all faded and humans still roam the earth.
To some extent, this was the argument made by Senator Taft after WWII. His position failed to gain support, most likely due to the enormity of the communist threat. However, with that threat essentially passed, the costs of hegemony are looking, to many Americans, as being too high.
This issue has been evolving since 1990 when the Cold War came to a close. As we have noted before, American foreign policy has been mostly adrift since the Soviet Union devolved. The ways in which the hegemon role affected the economy and security have not been appreciated. However, the debates tied to income inequality and the rise of populism have raised economic and civil liberty concerns as well.
We are particularly concerned about the problem of “generational forgetfulness.” In this process, a generation of leaders implements a difficult policy to address a serious problem. The next generation, being well aware of the difficulties that led to the initial decision, maintains the policy. The third generation begins to question the policy, and by the fourth generation the policy is reversed. The implementation of Glass-Steagall and its eventual repeal followed this pattern.
The leaders who thrust the U.S. into the superpower role did not appear to be driven by the desire to accumulate power. Instead, their concern was to avoid the power vacuum that developed after WWI that led to WWII. Simply put, Roosevelt and those who followed him wanted to avoid WWIII. It is clear they were successful in this goal.
However, like the situation that occurred with Glass-Steagall, it has been a long time since the superpower role was accepted. The world has changed; the threat of communism has passed and the threats that have come after probably don’t rise to the same level as Leninism. The costs of hegemony are clear; the benefits of being a superpower appear to be, at best, ill-distributed, and at worst, turning America into a country that many Americans struggle to recognize.
Although the U.S. hasn’t completely abandoned the role, there is growing evidence the policy is under threat. Populist elements in both major parties are Jeffersonian by nature and this archetype shuns hegemony. The Tea Party and Occupy Wall Street movements are both pressing for smaller government.
3 The law, which separated investment and commercial banking, was strongly maintained from the 1930s into the 1980s. Slowly, the rules softened, and by the late 1990s it was fully repealed.
What may be missed, however, is that a world without a superpower will probably look something like the period of 1919-1939. Non-democratic governments will arise. Regional conflicts will become more commonplace. New geopolitical arrangements will likely emerge.
What does an investor do in this situation? Our answer, thus far, has been that international investing should be executed with great care and that commodity prices will likely become dear as hoarding will increase. This position hasn’t changed. However, we also expect North American markets to benefit from the relative calm and safety that a peaceful region will provide. Thus, a focus on the U.S., Canada and Mexico will likely make sense.
At the same time, we remain well aware that the U.S. may be exiting a role it has fulfilled for nearly seven decades. There will likely be market trends that may occur that will surprise even the most seasoned investor. Why? Because there are so few that remember how the country and markets operated before the Great Depression and WWII. The market correlations and relationships nearly all of us have learned as investors have occurred with the U.S. providing superpower stability. How markets will react if the U.S. relinquishes that role will provide surprises.
August 25, 2014