The Unlikely Rise Of Donald Trump And Bernie Sanders by Bill O’Grady of Confluence Investment Management
In the spring of 2014, we wrote a series of Weekly Geopolitical Reports that looked at the 2016 elections.1 In these reports, we described the economic and political environment that had the potential to make the 2016 election historically important. The emergence and remarkable staying power of Donald Trump and Bernie Sanders suggests that our earlier analysis and conclusions may be coming to pass.
In this report, we will recap the economic and political factors that led us to conclude last year that the next presidential cycle could be unusually significant. From there, we will look at the unlikely rise of Donald Trump and Bernie Sanders and what their success thus far signals about the electorate and the next presidential election. Finally, we will analyze their potential impact on the election, including the possibility that each might mount an extra-party candidacy. As always, we will conclude with market ramifications.
The Economic Problem
The U.S. economy is growing at a very slow pace, slow enough that some prominent economists are calling the current situation “secular stagnation,” a period of substandard
growth. We think there is ample evidence that secular stagnation has developed in the U.S. and it is affecting global economic growth as well.
This chart shows real GDP from 1901 through 2018 on a logarithmic scale; the 2015-18 period, shown in gray on the above chart, is the consensus forecast from the Philadelphia FRB’s survey of professional forecasters. The key point of this graph is the deviation from trend. Note that GDP has been well below trend in two periods, the Great Depression and now. It is worth noting that the theory of secular stagnation originated during the 1930s.
Although the reasons for persistently below-trend growth are complicated, the most common factor from both eras is excessive private sector debt growth.
The chart below shows detrended GDP (the lower line on the above graph) along with private sector non-financial debt as a percentage of GDP.
In both periods of below-trend growth, debt levels had reached high levels. In the 1930s debt crisis, both household and business debt increased but the latter was probably the more important factor. In the current situation, household debt is more critical. It appears to us that until debt levels fall to what borrowers feel is a manageable level, economic growth will remain depressed.
The first debt increase mainly occurred due to the export boom that developed after WWI. After the 1921 recession, business activity rose as the U.S. economy began to take a pre-eminent position in the world. However, much like Japan in the 1980s or China today, the investment/export growth model only works if the rest of the world can absorb the goods that the exporting nation wants to sell. When that avenue began to falter,3 the U.S. found itself with too much productive capacity and too much debt.
In the 1930-45 period, debt levels were reduced by two methods—vicious foreclosures and bankruptcies before WWII and essentially a “debt swap” between the private sector and the government sector, facilitated by war spending. As the government increased defense spending, jobs were created that increased household income. Ration programs limited household spending which freed up cash for debt service, and increased business activity allowed the business sector to repair balance sheets. This allowed private sector debt to fall; however, it was replaced with expanding government debt that was used to fund the war effort. After the war ended, debt levels were at such low levels that both businesses and households were able to borrow to lift the economy. Financial repression where interest rates were held below the rate of inflation allowed the government to reduce the debt burden to manageable levels by the 1970s.
The steady increase in debt levels after the war peaked in 2008. This rising debt occurred mostly due to the burdens brought by the U.S. superpower role. As part of that role, America provides the reserve currency, meaning it must run persistent trade deficits in order to provide the reserve currency to support global liquidity and trade. The U.S. has used two methods to provide this liquidity since 1945. The first policy structure was designed to build a regulated economy that created a large number of high-paying, relatively low-skilled jobs. The program restricted disruptive technologies by concentrating industries and fostering the growth of labor unions.4 It also featured high marginal tax rates to discourage entrepreneurship as new businesses can upset the established order and lead to job losses. This led to hiring and rising incomes for average households.
Although the economy successfully created a broad path to the middle class, it was inefficient. Persistent inflation became a serious issue. To address inflation, President Carter implemented a series of supply side measures designed to improve the efficiency of the economy. These included the deregulation of financial services and transportation. He also appointed Paul Volcker as Federal Reserve Chairman; he implemented a “hard money” monetary policy. President Reagan took Carter’s reforms and expanded them further, leading to additional deregulation and globalization.
The good news was that the policies brought inflation under control. The problem was the broad path to the middle class in the developed world was dramatically narrowed. To now survive in the labor force, workers needed to rapidly adapt to new technologies and methods and compete on a global scale. Those who could were greatly rewarded; those who could not were left behind.
This chart shows the share of total income captured by the top 10% of income earners and inflation as measured by CPI. As the data shows, when this share is above 42%, inflation tends to be non-existent. When the top 10% share is below 42%, the CPI average is 5.3%. Inequality isn’t necessarily the cause of low inflation, but deregulation and globalization, which are effective against inflation, tend to cause increasing income inequality.
This led to a conflict between domestic and foreign policy. Containing inflation was a key domestic goal, but widening income differentials weakened the average household’s ability to consume, which undermined the reserve currency role of the superpower. The way the U.S. resolved this conundrum was through debt.
This chart shows how much of U.S. consumption is being funded through employee compensation. From 1950 to the early 1980s, wages generally funded between 90% and 95% of consumption. After deregulation, wages funded a steadily shrinking degree of consumption. Much of consumption was funded by household debt, as shown on the chart; note how it rose steadily as deregulation and globalization expanded. Of course, transfer payments played a role as well.
Donald Trump The Political Situation
Using debt to address the requirements of providing the reserve currency was never going to be a permanent solution to the problem of running a domestic economy and meeting the requirements of global hegemony.