Taxes on Corporate Profits Have Collapsed

A.  Introduction:  The Plunge in Corporate Profit Tax Revenues

Corporate profit tax revenues have collapsed following the passage by Congress last December of the Trump-endorsed Republican tax plan.  And this is not because corporate profits have decreased:  They have kept going up.  The initial figures, for the first half of 2018, show federal corporate profit taxes (also referred to as corporate income taxes) collected have fallen to an annual rate of roughly just $150 billion.  This is only half, or less, of the $300 to $350 billion collected (at annual rates) over the past several years.  See the chart above.

The estimates on corporate profit taxes actually being paid through the first half of 2018 come from the National Income and Product Accounts (NIPA, and commonly also referred to as the GDP accounts) produced by the Bureau of Economic Analysis.  The figures are collected as part of the process of producing the GDP accounts, but for various reasons the figures on corporate profit taxes are not released with the initial GDP estimates (which come out at the end of the month that follows the end of each quarter), but rather one month later (i.e. on August 29 this time, for the estimates for the April to June quarter).  The quarterly estimates are seasonally adjusted (which is important, as tax payments have a strong seasonality to them), and are then shown at annual rates.  While we already saw such a collapse in corporate tax revenues in the figures for the first quarter of 2018 (first published in May), it is always best with the estimates of GDP and its components to wait until a second quarter’s figures are available to see whether any change is confirmed.  And it was.

This initial data on what is actually now being collected in taxes following the passage of the Republican tax plan last December suggests that the revenue losses will be substantially higher than the $1.5 trillion over ten years that the staff at the Joint Committee on Taxation (the official arbiters for Congress on such matters) forecast.  Indeed, the plunge in corporate profit tax collections alone looks likely to well exceed this.  On top of this, there were also sharp cuts in non-corporate business taxes and in income taxes for those in higher income groups.

This blog post will look at what the initial figures are revealing on the tax revenues being collected, as estimated in the GDP accounts.  The focus will be on corporate income taxes, although in looking at the total tax revenue losses we will also look briefly at what the initial data is indicating on reductions in individual income taxes being paid.

The chart above shows what the reduction has been in corporate profit taxes in dollar terms.  In the next section below we will look at this in terms of the taxes as a share of corporate profits.  That implicit average actual tax rate is more meaningful for comparisons over time, and it has also plunged.  And the implicit actual rate now being paid, of only about 7% for the taxes at the federal government level, shows how misleading it is to focus on the headline rate of tax on corporate profits of 21% (down from 35% before the new law).  The actual rate being paid is only one-third of this, as a consequence of the numerous loopholes built into the law.  The Republican proponents of the bill had argued that while they were cutting the headline rate from 35% to 21%, they were also (they asserted) ending many of the loopholes which allowed corporations to pay less.  But in fact numerous loopholes were added or expanded.

The next section of the post will then look at this in the longer term context, with figures on the implicit corporate profit tax rate going back to 1950.  The implicit rate has fallen steadily over time, from a rate that reached over 50% in the early 1950s, to just 7% now.  While Trump and his Republican colleagues argued the cut in corporate taxes was necessary in order for the economy to grow, the economy in fact grew at a faster pace in the 1950s and 1960s, when the rate paid varied between 30 and 50%, than it has in recent decades despite the now far lower rates corporations face.

But this is for the federal tax on corporate profits alone.  There are also taxes on corporate profits imposed at the state and local level, as well as by foreign governments (although such foreign taxes are then generally deductible from the taxes due domestically).  This overall tax burden is more meaningful for understanding whether the overall burden is too high.  But, as we shall see below, that rate has also fallen steadily over time.  There is again no evidence that lower rates lead to higher growth.

The final substantive section of the post will then look more closely at the magnitude of the revenue losses from the December bill.  They are massive, and based on the initial evidence could very well total over $2 trillion over ten years for the losses on the corporate profit tax alone.  The losses from the other tax cuts in the new law, primarily for the wealthy and for non-corporate business, will add to this.  A very rough estimate is that the losses in individual income tax revenues may total an additional $1 trillion, bringing the total to over $3 trillion.  This is double the $1.5 trillion loss in revenues originally forecast.

But first, an analysis of what we see from the initial evidence on what is being paid.

B.  Profit Taxes as a Share of Corporate Profits

The chart at the top of this post shows what has been collected, by quarter (but shown at an annual rate), by the federal tax on corporate profits over the last several years.  Those figures are in dollars, and show a fall in the first half of 2018 of a half or more compared to what was collected in recent years.  But for comparisons over time, it is more meaningful to look at the implicit corporate tax rate, as corporate profits change over time (and generally grow over time).  And this can be done as the National Income and Product Accounts include an estimate of what corporate profits have been, as part of its assessment of how national income is distributed among the major functional groups.

That share since 2013 has been:

Between 2013 and 2016, the implicit rate (quarter by quarter) varied between about 15 and 17%.  It came down to about 14% for most of 2017 for some reason (possibly tied to the change in administration in Washington, with its new interpretation of regulatory and tax rules), but one cannot know from the aggregate figures alone.  But the rate then fell sharply, by half, to just 7% after the new tax law entered into effect.

A point to note is that the corporate profit figures provided here are corporate profits as estimated in the National Income and Product Accounts.  They are a measure of what corporate profits actually are, in an economic sense, and will in general differ from what corporate profits are as defined for tax purposes.  Thus, for example, accelerated depreciation allowed for tax purposes will reduce taxable corporate profits.  But the BEA estimates for the NIPA accounts will reflect not the accelerated depreciation allowed for tax purposes, but rather an estimate of what depreciation actually was.  Thus the figures as shown in the chart above will be a measure of what the true average corporate tax rate actually was, before the adjustments made (as permitted under tax law) to arrive at taxable corporate profits.

That average rate is now just 7%.  That is only one-third of the headline rate under the new law of 21%.  Provisions in the tax code allow corporations to pay far less in tax than what the headline rate would suggest.  This is not new (the headline rate previously was 35%, but the actual average rate paid was just 15 to 17% between 2013 and 2016, and 14% in most of 2017).  But Trump administration officials had asserted that many of the loopholes allowing for lower taxes would be ended under the new tax law, so that the actual rate paid would be closer to the headline rate.  But this clearly did not happen.  As many independent analysts pointed out before the bill was passed, the new tax law had numerous provisions which would allow the system to be gamed.  And we now see the result of that in the figures.

C.  Corporate Taxes in a Longer Term Context

The cuts in corporate profit taxes are not new.  Taxes on corporate profits in the US used to be far higher:

In the early 1950s, the federal tax on corporate profits (actually paid, not the headline rate) reached over 50%.  While it then fell, it kept to a rate of between about 30% and 50% through the 1950s and 60s.  And this was a period of good economic growth in the US – substantially faster than it has been since.  A high tax rate on corporate profits did not block growth.  Indeed, if one looked just at the simple correlation, one might conclude that a higher tax on corporate profits acts as a spur to growth.  But this would be too simplistic, and I would not argue that.  But what one can safely conclude is that a high rate of tax on corporate profits does not act as a block to more rapid growth.

There have also been important distributional consequences, however.  Corporate wealth is primarily owned by the wealthy (duh), and the sharp decline in taxes paid on corporate profits means that a larger share of the overall tax burden has been shifted to taxes on individual incomes, which are primarily borne by the middle classes.  Based on figures in the NIPA accounts, in 1950 taxes on individual incomes (including Social Security taxes) accounted for 47% of total federal taxes, while taxes on corporate profits accounted for 35% (with the rest primarily various excise taxes such as on fuels, liquor, tobacco, etc., plus import duties).  By 2017, however, the share of taxes on individual incomes had grown to 87.4%, while the share on corporate profits had declined to just 8.6%.  There was a gigantic shift away from taxes on wealth to taxes on individual incomes – taxes that are borne primarily by the middle class.  And that share will now fall further in 2018, by about half.

The chart above is for federal corporate profit taxes alone.  It could be argued that what matters to growth is not just the corporate profit taxes paid at the federal level, but all such taxes, including those paid at the state and local level, as well as to foreign governments (although the taxes paid abroad are generally deductible on their domestic taxes, so that will be a wash).

That chart looks like:

This follows the same path as the chart for federal corporate profit taxes alone, with a similar decline.  With the federal share of such taxes averaging 84% over the period (up to 2017), this is not surprising.  The federal share will now fall sharply in 2018, due to the new tax law.  But over the 1950 to 2017 period, the chart covering all taxes on corporate profits is basically a close to proportionate increase over what the tax has been at the federal level alone.

So the same pattern holds, and the total of the taxes on corporate profits varied between 33% to over 50% in the 1950s and 60s, to between 15 and 20% in recent years before the plunge in the first half of 2018 to just 10%.  But the relatively high taxes in the 1950s and 60s did not lead to slow growth in those years, nor did the low taxes in recent decades lead to more rapid growth.  Rather, one had the reverse.

D.  An Estimate of the Revenue Losses Due to the Tax Bill

These initial figures on the taxes actually being paid following the passage of the Republican tax bill allow us to make an estimate of what the revenue losses will turn out to be.  These will be very rough estimates, as we only have data for half a year, and one should be cautious in extrapolating this to what the losses will be over a decade.  But they can give us a sense of the magnitude.  And it is large.  As we will see below, based on the evidence so far the revenue losses (from the cuts in both corporate taxes and in personal income taxes) might be over $3 trillion over ten years, or about double the $1.5 trillion loss estimate originally forecast.

First, for the federal taxes on corporate profits, as the largest changes are there:  As was discussed before (and seen in the charts above), corporate profit taxes paid as a share of corporate profits were relatively flat between 2013 and 2016, varying between 15 and 17% each quarter, before falling to 14% for most of 2017.  For the full 2013 to 2017 period, the simple average was 15.3%.  The implicit rate then fell to just 7.0% in the first half of 2018.  Had the rate instead remained at 15.3%, corporate profit taxes collected in 2018 would have been $184 billion higher (on an annual basis).

This is not small, and is twice as high as the estimate of the staff of the Joint Committee on Taxation of revenue losses of $91 billion in FY2019 (the first full year under the new tax regime) from all the tax measures affecting businesses (including non-corporate businesses, and covering both domestic business and overseas business).  It is three times as high as the estimated loss of $60 billion in FY18, but the new tax law did not affect the first quarter of FY2018 (October to December).

One should be cautious with any extrapolation of this loss estimate going forward, as not only is the time period of actual experience under the new tax regime short (only a half year), but the law is also a complicated one, with certain provisions changing over time.  But a simple extrapolation over ten years, based on the assumption that corporate profits grow at just a modest 3% a year in nominal terms (meaning 1% a year in real terms if inflation is 2% a year), and that the tax rate on corporate profits will be 7.0% a year (as seen so far in 2018) rather than the 15.3% of recent years, implies that the reduction in corporate profit tax revenues will sum to about $2.1 trillion.

Note that the losses would be greater (everything else equal) if the assumed growth rate of corporate profits is higher.  But the results are not very sensitive to this.  The total losses over ten years would be $2.2 trillion, for example, at an assumed nominal growth rate of 4% (i.e. with inflation still at 2%, then with corporate profits growing at 2% a year in real terms, or double the 1% rate of the base scenario).  Note this also counters the argument of some that such tax cuts will lead to such a large spurt in growth that total tax collections will rise despite the cut in the rates.  As will be discussed below, there is no evidence that this has ever been the case in the US.  But even assuming there were, the argument is undermined by the basic arithmetic.  In the example here, a doubling of the assumed growth rate of profits (from 1% in real terms to 2%) would imply taxes on corporate profits would still fall by $2.0 trillion over the next ten years.  This is not far from the $2.1 trillion loss if there is no rise at all in the growth of corporate profits.  And a doubling of the real growth rate is far above what anyone would reasonably assume could follow from such a cut in the tax rate.

Second, there were also substantial cuts in individual income taxes, although primarily for the wealthy.  While far less in proportional terms, the substantially higher taxes that are now paid by individuals than by corporations means that this is also significant for the totals.

Specifically, individual (federal) income taxes as a share of GDP in the NIPA accounts were quite steady in the quarterly GDP accounts for the period from 2015Q1 to 2017Q4, varying only between 8.22% and 8.44%.  The average was 8.31%.  But then this fell to an average of 7.89% in the first half of 2018 (7.90% in the first quarter, and 7.87% in the second quarter).  Had the rate remained at 8.31%, then $86 billion more in revenues (at an annual rate) would have been collected.

Extrapolating this out for ten years, assuming again just a modest rate of growth for GDP of 3% a year in nominal terms (i.e. just 1% a year in real terms if inflation is 2% a year), the total loss would be $1.0 trillion.  With a higher rate of growth, and everything else the same, the losses would again be larger.  This extrapolation is, however, particularly fraught, as the Republicans wrote into their bill that the cuts in individual taxes would be reversed in 2026.  They did this to keep the forecast cost of the tax bill to the $1.5 trillion envelope they had set, and an effort is already underway to make this permanent (Speaker Paul Ryan has said he will schedule a vote on this in September).  But even if we left out the tax revenue losses in the final two years of the period, the losses in individual taxes would still reach about $0.8 trillion.

Adding the lower revenues from the taxes on corporate profits and the taxes on individual incomes, the total revenue losses would come, over the ten years, to about $3 trillion.  This is double the $1.5 trillion loss that had been forecast.  It is not a small difference.

To give a sense of the magnitude, the loss in 2018 alone (a total of $270 billion) would allow a doubling of the entire budgets (based on FY2017 actual outlays) of the Departments of Education, Housing and Urban Development, and Labor; the Environmental Protection Agency; all international assistance programs (foreign aid); NASA; the National Science Foundation; the Army Corps of Engineers (civil works); and the Small Business Administration.  Note I am not arguing that all of their budgets should necessarily be doubled (although many should, indeed, be significantly increased).  Rather, the point is simply to give readers a sense of the size of the revenues lost as a consequence of the tax cut bill.

As another comparison to give a sense of the magnitude, just half of the lost revenue (now and into the future) would suffice to fund fully the Social Security Trust Fund for the foreseeable future.  If nothing is done, the Social Security Trust Fund will run out at some point around 2034.  Republicans have asserted that nothing can be done for Social Security except to scale back (already low) Social Security pensions.  This is not true.  Just half of the revenues that will be lost under the tax cut bill would suffice to ensure the pensions can be paid in full for at least 75 years (the forecast period used by the Social Security trustees).

But as noted above, proponents of the tax cuts argue that the lower taxes will spur growth.  This has been discussed in earlier posts on this blog, where we have seen that there is no evidence that this will follow.  There are not only basic conceptual problems with this argument (a misreading of basic economics), but also no indication in what we have in fact observed for the economy that this has ever been the case (whether in the years immediately following the major tax cuts of Reagan or Bush, nor if one focuses on the longer term).

Administration officials have not surprisingly argued that the relatively rapid pace of growth in the second quarter of 2018 (of 4.2% at an annual rate in the end-August BEA estimates) is evidence of the tax cut working as intended.  But it is not.  Not only should one not place much weight on one quarter’s figures (the quarterly figures bounce around), but this followed first-quarter figures which were modest at best (with GDP growth of an estimated 2.2% at an annual rate).

But more fundamentally, one should dig into the GDP figures to see what is going on.  The argument that tax cuts (especially cuts in corporate profit taxes) will spur growth is based on the presumption that such cuts will spur business investment.  More such investment, especially in equipment, could lead to higher productivity and hence higher growth.  But growth in business investment in equipment has slowed in the first half of 2018.  Such investment grew at the rates of 9.1%, 9.7%, 9.8%, and 9.9% through the four quarters of 2017 (all at annual rates).  It then decelerated to a pace of 8.5% in the first quarter of 2018 and to a pace of 4.4% in the second quarter.  While still early (these figures too bounce around a good deal), the evidence so far is the exact opposite of what proponents have argued the tax cut bill would do.

So what might be going on?  As noted before, there is first of all a good deal of volatility in the quarterly figures for GDP growth.  But to the extent growth has accelerated this year, a more likely explanation is simple Keynesian stimulus.  Taxes were cut, and while most of the cuts went to the rich, some did go to the lower and middle classes.  In addition, government spending is now rising, while it been kept flat or falling for most of the Obama years (since 2010).  It is not surprising that such stimulus would spur growth in the short run.

The problem is that with the economy now running at or close to full capacity, such stimulus will not last for long.  And when it was needed, in the years from 2010 until 2016, as the economy recovered from the 2008/09 downturn (but slowly), such stimulus measures were repeatedly blocked by a Republican-controlled Congress.  This sequence for fiscal policy is the exact opposite of the path that should have been followed.  Contractionary policies were followed after 2010 when unemployment was still high, while expansionary fiscal policies are being followed now, when unemployment is low.  The result is that the fiscal deficit is rising soon to exceed $1 trillion in a year (5% of GDP), which is unprecedented for a period with the economy at full employment.

E.  Conclusion

We now have initial figures on what is being collected in taxes following the tax cut bill of last December.  While still early, the figures for the first two quarters of 2018 are nonetheless clear for corporate profit taxes:  They have fallen by half.  Corporate profit taxes paid would be an estimated $184 billion higher in 2018 had the tax rate remained at the level it had been over the last several years.

While this post has not focused on personal income taxes, they too were cut.  The reduction here was more modest – only by about 5% overall (although certain groups got far more, while others less).  But with their greater importance in overall federal tax collections, this 5% reduction is leading to an estimated $86 billion reduction in revenues (in 2018) from this source.

Based on what has been observed in the first two quarters of 2018, the two taxes together (corporate and individual) will see a combined reduction in taxes paid of about $270 billion in 2018.  Extrapolating over ten years, the combined losses may be on the order of $3 trillion.

These losses are huge.  And they are double what had been earlier forecast for the tax bill.  Just half of what is being lost would suffice to ensure Social Security would be fully funded for the foreseeable future.  And the rest could fund programs to rebuild and strengthen the physical infrastructure and human capital on which growth ultimately depends.  Or some could be used to reduce the deficit and pay down the public debt.  But instead, massive tax cuts are going to the rich.

Why Do the Quarterly GDP Figures Bounce Around So Much?: Econ 101

A.  Introduction

The Bureau of Economic Analysis (BEA) released on July 27 its initial estimate of GDP growth in the second quarter of 2018 (what it technically calls its “advance estimate”).  It was a good report:  Its initial estimate is that GDP grew at an annualized rate of 4.1% in real terms in the quarter.  Such growth, if sustained, would be excellent.

But as many analysts noted, there are good reasons to believe that such a growth rate will not be sustained.  There were special, one-time, factors, such as that the second quarter growth (at a 4.1% annual rate) had followed a relatively modest rate of growth in the first quarter of 2.2%.  Taking the two together, the growth was a good, but not outstanding, rate of 3.1%.

More fundamentally, with the economy now at full employment, few (other than Trump) expect growth at a sustained rate of 4% or more.  Federal Reserve Board members, for example, on average expect GDP growth of 2.8% in 2018 as a whole, with this coming down to a rate of 1.8% in the longer run.  And the Congression Budget Office (in forecasts published in April) is forecasting GDP growth of 3.0% in 2018, coming down to an average rate of 1.8% over 2018 to 2028.  The fundamental issue is that the population is aging, so the growth rate of the labor force is slowing.  As discussed in an earlier post on this blog, unless the productivity of those workers started to grow at an unprecedented rate (faster than has ever been achieved in the post-World War II period), we cannot expect GDP to grow for a sustained period going forward at a rate of 3%, much less 4%.

But there will be quarter to quarter fluctuations.  As seen in the chart at the top of this post covering the period just since 2006, there have been a number of quarters in recent years where GDP grew at an annualized rate of 4% or more.  Indeed, growth reached 5.1% in the second quarter of 2012, with this followed by an also high 4.9% rate in the next quarter.  But it then came back down.  And there were also two quarters (setting aside the period of the 2008/09 recession) which had growth of a negative 1.0%.  On average, GDP growth was around 2% (at an annual rate) during Obama’s two terms in office (2.2% annually from the end of the recession in mid-2009).

Seen in this context, the 4.1% rate in the initial estimate for the second quarter of 2018 was not special.  There have been a number of such cases (and with even substantially higher growth rates for a quarter or even two) in the recent past, even though average growth was just half that.  The quarterly rates bounce around.  But it is of interest to examine why they bounce around so much, and that is the purpose of this blog post.

B.  Reasons for this Volatility

There are a number of reasons why one should not be surprised that these quarter to quarter growth rates in GDP vary as they do.  I will present several here.  And note that these reasons are not mutually exclusive.  Several of them could be acting together and be significant factors in any given quarter.

a)  There may have been actual changes in growth:

To start, and to be complete, one should not exclude the possibility that the growth in the quarter (or the lack of it) was genuine.  Perhaps output did speed up (or slow down) as estimated.  Car plants might go on extra shifts (or close for a period) due to consumers wanting to buy more cars (or fewer cars) in the period for some reason.  There might also be some policy change that might temporarily spur production (or the opposite).  For example, Trump’s recent trade measures, and the response to them from our trading partners, may have brought forward production and trade that would have been undertaken later in the year, in order to avoid tariffs threatened to be imposed later.  This could change quarterly GDP even though GDP for the year as a whole will not be affected positively (indeed the overall impact would likely be negative).

[Side note:  But one special factor in this past quarter, cited in numerous news reports (see, for example, here, here, here, here, and here), was that a jump in exports of soybeans was a key reason for the higher-than-recently-achieved rate of GDP growth.  This was not correct.  Soybean exports did indeed rise sharply, with this attributed to the response threatened by China and others to the new tariffs Trump has imposed.  China and others said they would respond with higher tariffs of their own, targeted on products such as soybeans coming from the US.  There was thus a rush to export soybeans in the period between when China first announced they would impose such retaliatory tariffs (in late March) and when they were then imposed (ultimately on July 6).

But while soybean exports did indeed increase sharply in the April to June quarter, soybeans are a crop that takes many months to grow.  Whatever increase in shipments there was had to come out of inventories.  An increase in exports would have to be matched by a similar decrease in inventories, with this true also for corn and other such crops.  There would be a similar issue for any increase in exports of Kentucky bourbon, also a target of retaliatory tariffs.  Any decent bourbon is aged for at least three years.

One must keep in mind that GDP (Gross Domestic Product) is a measure of production, and the only production that might have followed from the increased exports of soybeans or similar products would have been of packing and shipping services.  But packing and shipping costs are only a relatively small share of the total value of the products being exported.

Having said that, one should not then go to the opposite extreme and assume that the threatened trade war had no impact on production and hence GDP in the quarter.  It probably did.  With tariffs and then retaliatory tariffs being threatened (but to be imposed two or three months in the future), there were probably increased factory orders to make and ship various goods before such new tariffs would enter into effect.  Thus there likely was some impact on GDP, but to an extent that cannot be quantified in what we see in the national level accounts.  And with such factory orders simply bringing forward orders that likely would have been made later in the year, one may well see a fallback in the pace of GDP growth in the remainder of the year.  But there are many other factors as well affecting GDP growth, and we will need to wait and see what the net impact will be.]

So one should not exclude the possibility that the fluctuation in the quarterly growth rate is real.  But it could be due to many other factors as well, as we will discuss below.

b)  Change at an Annualized Rate is Not the Change in a Quarter:

While easily confused, keep in mind also that in the accounts as normally published and presented in the US, the rates of growth of GDP (and of the other economic variables) are shown as annual equivalent rates.  The actual change in the quarter is only about one-fourth of this (a bit less due to compounding).  That is, in the second quarter of 2018, the BEA estimated that GDP (on a seasonally adjusted basis, which I will discuss below as a separate factor) grew by 1.00% (and yes, exactly 1.00% within two significant digits).  But at an annualized rate (some say “annual rate”, and either term can be used), this would imply a rate of growth of 4.06% (which rounded becomes 4.1%).  It is equal to slightly more than 4.0% due to compounding.  [Technically, 1% growth in the quarter means 1.00 will grow to 1.01, and taking 1.01 to the fourth power yields 1.0406, or an increase of 4.06%.]

Thus it is not correct to say that “GDP grew by 4.1% in the second quarter”.  It did not – it grew by 1.0%.  What is correct is to say that “GDP grew at an annualized rate of 4.1% in the second quarter”.

Not all national statistical agencies present such figures in annualized terms.  European agencies, for example, generally present the quarterly growth figures as simply the growth in the quarter.  Thus, for example, Eurostat on June 7 announced that GDP in the eurozone rose by an estimated 0.4% in the first quarter of 2018.  This 0.4% was the growth in the quarter.  But that 0.4% growth figure would be equivalent to growth of 1.6% on an annualized basis (actually 1.61%, if the growth had been precisely 0.400%).  Furthermore, the European agencies will generally also focus on the growth in GDP over what it had been a year earlier in that same quarter.  In the first quarter of 2018, this growth over the year-earlier period was an estimated 2.5% according to the Eurostat release.  But the growth since the year-earlier period is not the same as the growth in the current quarter at an annualized rate.  They can easily be confused if one is not aware of the conventions used by the different agencies.

c)  Don’t confuse the level of GDP with the change in GDP:

Also along the lines of how we might misleadingly interpret figures, one needs to keep in mind that while the quarterly growth rates can, and do, bounce around a lot, the underlying levels of GDP are really not changing much.  While a 4% annual growth rate is four times as high as a 1% growth rate, for example, the underlying level of GDP in one calendar quarter is only increasing to a level of about 101 (starting from a base of 100 in this example) with growth at a 4% annual rate, versus to a level of 100.25 when  growth is at an annual rate of 1%.  While such a difference in growth rates matters a great deal (indeed a huge deal) if sustained over time, the difference in any one quarter is not that much.

Indeed, I personally find the estimated quarter to quarter levels of GDP in the US (after seasonal adjustment, which will be discussed below) to be surprisingly stable.  Keep in mind that GDP is a flow, not a stock.  It is like the flow of water in a river, not a stock such as the body of water in a reservoir.  Flows can go sharply up and down, while stocks do not, and some may mistakenly treat the GDP figures in their mind as a stock rather than a flow.  GDP measures the flow of goods and services produced over some period of time (a calendar quarter in the quarterly figures).  A flow of GDP to 101 in some quarter (from a base of 100 in the preceding quarter) is not really that different to an increase to 100.25.  While this would matter (and matter a good deal) if the different quarterly increases are sustained over time, this is not that significant when just for one quarter.

d)  Statistical noise matters:

Moving now to more substantive reasons why one should expect a significant amount of quarter to quarter volatility, one needs to recognize that GDP is estimated based on surveys and other such sources of statistical information.  The Bureau of Economic Analysis (BEA) of the US Department of Commerce, which is responsible for the estimates of the GDP accounts in the US (which are formally called the National Income and Product Accounts, or NIPA), bases its estimates on a wide variety of surveys, samples of tax returns, and other such partial figures.  The estimates are not based on a full and complete census of all production each quarter.  Indeed, such an economic census is only undertaken once every five years, and is carried out by the US Census Bureau.

One should also recognize that an estimate of real GDP depends on two measures, each of which is subject to sampling and other error.  One does not, and cannot, measure “real GDP” directly.  Rather, one estimates what nominal GDP has been (based on estimates in current dollars of the value of all economic transactions that enter into GDP), and then how much prices have changed.  Price indices are estimated based on the prices of surveyed samples, and the components of real GDP are then estimated from the nominal GDP of the component divided by the relevant price index.  Real GDP is only obtained indirectly.

There will then be two sets of errors in the measurements:  One for the nominal GDP flows and one for the price indices.  And surveys, whether of income flows or of prices, are necessarily partial.  Even if totally accurate for the firms and other entities sampled, one cannot say with certainty whether those sampled in that quarter are fully representative of everyone in the economy.  This is in particular a problem (which the BEA recognizes) in capturing what is happening to newly established firms.  Such firms will not be included in the samples used (as they did not exist when the samples were set up) and the experiences of such newly established firms can be quite different from those of established firms.

And what I am calling here statistical “noise” encompasses more than simply sampling error.  Indeed, sampling error (the fact that two samples will come up with different results simply due to the randomness of who is chosen) is probably the least concern.  Rather, systemic issues arise whenever one is trying to infer measures at the national level from the results found in some survey.  The results will depend, for example, on whether all the components were captured well, and even on how the questions are phrased.  We will discuss below (in Section C, where we look at a comparison of estimates of GDP to estimates of Gross Domestic Income, or GDI, which in principle should be the same) that the statistical discrepancy between the estimates of GDP and GDI does not vary randomly from one quarter to the next but rather fairly smoothly (what economists and statisticians call “autocorrelation” – see Section C).  This is an indication that there are systemic issues, and not simply something arising from sample randomness.

Finally, even if that statistical error was small enough to allow one to be confident that we measured real GDP within an accuracy of just, say, +/- 1%, one would not then be able to say whether GDP in that quarter had increased at an annualized rate of about 4%, or decreased by about 4%.  A small quarterly difference looms large when looked at in terms of annualized rates.

I do not know what the actual statistical error might be in the GDP estimates, and it appears they are well less than +/- 1% (based on the volatility actually observed in the quarter to quarter figures).  But a relatively small error in the estimates of real GDP in any quarter could still lead to quite substantial volatility in the estimates of the quarter to quarter growth.

e)  Seasonal adjustment is necessary, but not easy to do:

Economic activity varies over the course of the year, with predictable patterns.  There is a seasonality to holidays, to when crops are grown, to when students graduate from school and enter the job market, and much much more.  Thus the GDP data we normally focus on has been adjusted by various statistical methods to remove the seasonality factor, making use of past data to estimate what the patterns are.

The importance of this can be seen if one compares what the seasonally adjusted levels of GDP look like compared to the levels before seasonal adjustment.  Note the level of GDP here is for one calendar quarter – it will be four times this at an annual rate:

There is a regular pattern to GDP:  It is relatively high in the last quarter of each year, relatively low in the first quarter, and somewhere in between in the second and third quarters.  The seasonally adjusted series takes account of this, and is far smoother.  Calculating quarterly growth rates from a series which has not been adjusted for seasonality would be misleading in the extreme, and not of much use.

But adjusting for seasonality is not easy to do.  While the best statisticians around have tried to come up with good statistical routines to do this, it is inherently difficult.  A fundamental problem is that one can only look for patterns based on what they have been in the past, but the number of observations one has will necessarily be limited.  If one went back to use 20 years of data, say, one would only have 20 observations to ascertain the statistical pattern.  This is not much.  One could go back further, but then one has the problem that the economy as it existed 30 or 40 years ago (and indeed even 20 years ago) was quite different from what it is now, and the seasonal patterns could also now be significantly different.  While there are sophisticated statistical routines that have been developed to try to make best use of the available data (and the changes observed in the economy over time), this can only be imperfect.

Indeed, the GDP estimates released by the BEA on July 27 incorporated a number of methodological changes (which we will discuss below), one of which was a major update to the statistical routines used for the seasonal adjustment calculations.  Many observers (including at the BEA) had noted in recent years that (seasonally adjusted) GDP growth in the first quarter of each year was unusually and consistently low.  It then recovered in the second quarter.  This did not look right.

One aim of the update to the seasonal adjustment statistical routines was to address this issue.  Whether it was fully successful is not fully clear.  As seen in the chart at the top of this post (which reflects estimates that have been seasonally adjusted based on the new statistical routines), there still appear to be significant dips in the seasonally adjusted first quarter figures in many of the years (comparing the first quarter GDP figures to those just before and just after – i.e. in 2007, 2008, 2010, 2011, 2014, and perhaps 2017 and 2018.  This would be more frequent than one would expect if the residual changes were now random over the period).  However, this is an observation based just on a simple look at a limited sample.  The BEA has looked at this far more carefully, and rigorously, and believes that the new seasonal adjustment routines it has developed have removed any residual seasonality in the series as estimated.

f)  The timing of weekends and holidays may also enter, and could be important:

The production of the goods and services that make up the flow of GDP will also differ on Saturdays, Sundays, and holidays.  But the number of Saturdays, Sundays, and certain holidays may differ from one year to the next.  While there are normally 13 Saturdays and 13 Sundays in each calendar quarter, and most holidays will be in the same quarter each year, this will not always be the case.

For example, there were just 12 Sundays in the first quarter of 2018, rather than the normal 13.  And there will be 14 Sundays in the third quarter of 2018, rather than the normal 13.  In 2019, we will see a reversion to the “normal” 13 Sundays in each of the quarters.  This could have an impact.

Assume, just for the sake of illustration, that production of what goes into GDP is only one-half as much on a Saturday, Sunday, or holiday, than it is on a regular Monday through Friday workday.  It will not be zero, as many stores, as well as certain industrial plants, are still open, and I am just using the one-half for illustration.  Using this, and based on a simple check of the calendars for 2018 and 2019, one will find there were 62 regular, Monday through Friday, non-holiday workdays in the first quarter of 2018, while there will be 61 such regular workdays in the first quarter of 2019.  The number of Saturdays, Sundays, and holidays were 28 in the first quarter of 2018 (equivalent to 14 regular workdays in terms of GDP produced, assuming the one-half figure), while the number of Saturdays, Sundays, and holidays will be 29 in the first quarter of 2019 (equivalent to 14.5 regular workdays).  Thus the total regular work-day equivalents will be 76 in 2018 (equal to 62 plus 14), falling to 75.5 in 2019 (equal to 61 plus 14.5).  This will be a reduction of 0.7% between the periods in 2018 and 2019 (75.5/76), or a fall of 2.6% at an annualized rate.  This is not small.

The changes due to the timing of holidays could matter even more, especially for certain countries around the world.  Easter, for example, was celebrated in March (the first quarter) in 2013 and 2016, but came in April (the second quarter) in 2014, 2015, 2017, and 2018.  In Europe and Latin America, it is customary to take up to a week of vacation around the Easter holidays.  The change in economic activity from year to year, with Easter celebrated in one quarter in one year but a different one in the next, will make a significant difference to economic activity as measured in the quarter.

And in Muslim countries, Ramadan (a month of fasting from sunrise to sunset), followed by the three-day celebration of Eid al-Fitr, will rotate through the full year (in terms of the Western calendar) as it is linked to the lunar cycle.

Hence it would make sense to adjust the quarterly figures not only for the normal seasonal adjustment, but also for any changes in the number of weekends and holidays in some particular calendar quarter.  Eurostat and most (but not all) European countries make such an adjustment for the number of working days in a quarter before they apply the seasonal adjustment factors.  But I have not been able to find how the US handles this.  The adjustment might be buried somehow in the seasonal adjustment routines, but I have not seen a document saying this.  If no adjustment is made, then this might explain part of the quarterly fluctuations seen in the figures.

g)  There have been, and always will be, updates to the methodology used:

As noted above, the GDP figures released on July 27 reflected a major update in the methodology followed by the BEA to arrive at its GDP estimates.  Not only was there extensive work on the seasonal adjustment routines, but there were definitional and other changes.  The accounts were also updated to reflect the findings from the 2012 Economic Census, and prices were changed from a previous base of 2009 to now 2012.  The July 27 release summarized the changes, and more detail on what was done is available from a BEA report issued in April.  And with the revisions in definitions and certain other methodological changes, the BEA revised its NIPA figures going all the way back to 1929, the first year with official GDP estimates.

The BEA makes such changes on a regularly scheduled basis.  There is normally an annual change released each year with the July report on GDP in the second quarter of the year.  This annual change incorporates new weights (from recent annual surveys) and normally some limited methodological changes, and the published estimates are normally then revised going back three and a half years.  See, for example, this description of what was done in July 2017.

On top of this, there is then a much larger change once every five years.  The findings from the most recent Economic Census (which is carried out every five years) are incorporated, seasonal adjustment factors are re-estimated, and major definitional or methodological changes may be incorporated.  The July 2018 release reflected one of those five-year changes.  It was the 15th such comprehensive revision to the NIPA accounts undertaken by the BEA.

I stress this to make the point that the GDP figures are estimates, and as estimates are always subject to change.  The professionals at the BEA are widely admired around the world for the quality of their work, and do an excellent job in my opinion.  But no estimates will ever be perfect.  One has to recognize that there will be a degree of uncertainty surrounding any such estimates, and that the quarter to quarter volatility observed will derive at least in part from the inherent uncertainty in any such estimates.

C.  Estimates of GDP versus Estimates of GDI

One way to develop a feel for how much the changes in quarterly GDP may be due to the inherent uncertainty in the estimates is to compare it to the estimated quarterly changes in Gross Domestic Income (GDI).  GDP (Gross Domestic Product) measures the value of everything produced.  GDI measures the value of all incomes (wages, profits, rents, etc.) generated.  In principle, the totals should be the same, as the value of whatever is produced accrues to someone as income.  They should add up to the same thing.

But the BEA arrives at its estimates of GDP and of GDI by different routes.  As a consequence, the estimates of the totals will then differ.  The differences are not huge in absolute amount, nor have they grown over time (as a share of GDP or of GDI).  That is, on average the estimates match each other over time, with the same central tendency.  But they differ by some amount in any individual quarter, and hence the quarter to quarter growth rates will differ.  And for the reasons reviewed above, those slight changes in the levels in any individual quarter can translate into often major differences in the growth rates from one quarter to the next.  And these differences may appear to be particularly large when the growth rates are then presented in annualized terms.

For the period since 2006, the two sets of growth rates were (where the initial estimate for the second quarter of 2018 will not be available until the end-August figures come out):

As is seen, the alternative estimates of growth in any individual quarter can be quite different.  There was an especially large difference in the first quarter of 2012, when the estimated growth in GDP was 3.2% at an annual rate, while the estimated growth in GDI was a giant 8.7%.

Which is correct?  Was the growth rate in the first quarter of 2012 3.2% (as found with the GDP estimate) or 8.7% (as found with the GDI estimate)?  The answer is we do not know, and indeed that probably neither is correct.  What is most likely is that the true figure is probably somewhere in between.

Furthermore, and also moderating what the impact on the differences in the respective estimated growth rates will be, it is not the case that the estimates of GDP and GDI are statistically independent of each other, with the two bouncing around randomly with respect to each other.  Rather, if one looks at what the BEA calls the “statistical discrepancy” (the difference between GDP and GDI), one finds that if, say, the estimate of GDP were above the estimate of GDI in one quarter, then it likely would also be above in the next quarter.  Not by the same amount, and the differences would evolve over time, but moving more like waves than as balls ricocheting around.  Economists and statisticians refer to this as “autocorrelation”, and it indicates that there is some systemic error in the estimates of GDP and of GDI, which carries over from one quarter to the next.  What the source of that is, we do not know.  If we did know, then it would be eliminated.  But the fact such autocorrelation exists tells us that there is some source of systemic error in the measures of GDP and GDI, and we have not been able to discover the source.

Estimates are estimates.  We need to recognize that there will be statistical uncertainty in any such figures.  Even if they even out over time, the estimated growth from one quarter to the next will reflect such statistical volatility.  The differences seen in the estimated rates of growth in any one quarter for total output (estimated by way of GDP versus by way of GDI) provides a useful benchmark for how to judge the reported changes seen in growth for GDP in any individual quarter.  The true volatility (for purely statistical reasons) is likely to be at least as much, if not more.

D.  Conclusion

There are many reasons, then, to expect the quarterly growth figures to bounce around.  One should not place too much weight on the estimates from any individual quarter.  It is the longer term trends that matter.  The estimated figure for growth in GDP of 4.1% in the second quarter was not out of line with what has been seen in a number of quarters in recent years.  But growth since mid-2009 has only been about one half as much on average, despite several quarters when estimated growth was well in excess of 4.1%.

To conclude, some may find of interest three country cases I am personally familiar with which illustrate why one needs to exercise care, and with an understanding of the country context, when considering what is meaningful or not for reported figures on GDP growth.  The countries are Japan, China, and an unidentified, but newly independent, former colony in the 1960s.

a)  Japan:  In the late 1990s / early 2000s, while holding a position within the World Bank Group, I was responsible for assessments of the prospects and risks of the countries of East Asia where the World Bank was active.  This was not long after the East Asia crisis of 1997, and the countries were just beginning to recover.  Japan was important, both as a trading partner to the others and because Japan itself had gone through a somewhat similar crisis following 1990, when the Japanese financial bubble burst.

As part of this, I followed closely the quarterly GDP growth figures for Japan.  But as many analysts at the time noted, the quarter to quarter figures behaved in ways that were difficult to understand.  Components went up when one would have thought they would go down (and vice versa), the quarterly changes were far more extreme than seen elsewhere, and in general the quarter to quarter fluctuations were difficult to make sense of.  The volatility in the figures was far greater than one would have expected for an economy such as Japan’s.

This view among analysts was such a common one that the government agency responsible for the estimates felt it necessary to issue a news release in June 2000 defending its work and addressing a number of the concerns that had been raised.

I have no doubt that the Japanese government officials responsible for the estimates were well-qualified and serious professionals.  But it is not easy to estimate GDP and its components, the underlying data on which the statisticians relied might have had problems (including sample sizes that were possibly too small), and there may have been segments of the economy (in the less formal sectors) which might not have been captured well.

I have not followed closely in recent years, and do not know if the issues continue.  But Japan’s case illustrates that even a sophisticated agency, with good professionals, can have difficulty in arriving at GDP estimates that behave as one would expect.

b)  China:  The case of China illustrates the mirror image problem of what was found in Japan.  While the Japanese GDP estimates bounced around far too sharply from one quarter to the next, the GDP estimates for China showed remarkable, and not believable, stability.

Chinese growth rates have normally been presented as growth of GDP in the current period over what it was in the same period one year ago.  Seasonal adjustment is then not needed, and indeed China only started to present seasonally adjusted figures in 2011.  However, these estimates are still not fully accepted by many analysts.  Comparing GDP in the current quarter to what it was in the same quarter a year before overcomes this, but at the cost that it does not present information on growth just in the quarter, as opposed to total growth over the preceding year.

And the growth rates reported over the same quarter in the preceding year have been shockingly smooth.  Indeed, in recent years (from the first quarter of 2015 through to the recently released figures for the second quarter of 2018), China’s reported growth of its GDP over the year-earlier period has not been more than 7.0% nor less than 6.7% in each and every quarter.  Specifically, the year on year GDP growth rates from the first quarter of 2015 through to the second quarter of 2018 were (in sequence):  7.0%, 7.0%, 6.9%, 6.8%, 6.7%, 6.7%, 6.7%, 6.8%, 6.9%, 6.9%, 6.8%, 6.8%, 6.8%, and 6.7% (one can find the figures in, for example, the OECD database).  Many find this less than credible.

There are other problems as well in the Chinese numbers.  For example, it has often been the case that the reported growth in provincial GDP of the 31 provincial level entities in China was higher in almost all of the 31 provinces, and sometimes even in all of the provinces, than GDP growth was in China as a whole.  This is of course mathematically impossible, but not surprising when political rewards accrue to those with fast reported growth.

With such weak credibility, analysts have resorted to coming up with proxies to serve as indicators of what quarter to quarter might have been.  These might include electricity consumption, or railway tonnage carried, or similar indicators of economic production.  Indeed, there is what has been labeled the “Li index”, named after Li Keqiang (who was vice premier when he formulated it, and later China’s premier).  Li said he did not pay much attention to the official GDP statistics, but rather focused on a combination of electricity production, rail cargo shipments, and loan disbursements.  Researchers at the Federal Reserve Bank of San Francisco who reproduced this and fitted it through some regression analysis found that it worked quite well.

And the index I found most amusing is calculated using nighttime satellite images of China, with an estimation of how much more night-time illumination one finds over time.  This “luminosity” index tracks well what might be going on with China’s GDP.

c)  An unidentified, newly independent, former colony:  Finally, this is a story which I must admit I received third hand, but which sounds fully believable.  In the mid-1970s I was working for a period in Kuala Lumpur, for the Government of Malaysia.  As part of an economic modeling project I worked closely with the group in the national statistical office responsible for estimating GDP.  The group was led by a very capable, and talkative, official (of Tamil origin), who related a story he had heard from a UN consultant who had worked closely with his group in the early 1970s to develop their system of national accounts.

The story is of a newly independent country in the mid-1960s (whose name I was either not told or cannot remember), and its estimation of GDP.  An IMF mission had visited it soon after independence, and as is standard, the IMF made forecasts of what GDP growth might be over the next several years.  Such forecasts are necessary in order to come up with estimates for what the government accounts might be (as tax revenues will depend on GDP), for the trade accounts, for the respective deficits, and hence for what the financing needs might be.

Such forecasts are rarely very good, especially for a newly independent country where much is changing.  But something is needed.

As time passed, the IMF received regular reports from the country on what estimated GDP growth actually was.  What they found was that reported GDP growth was exactly what had been forecast.  And when asked, the national statisticians responded that who were they to question what the IMF officials had said would happen!

What Has Been Happening to Real Wages? Sadly, Not Much

A.  Introduction

There is little that is more important to a worker than his or her wages.  And as has been discussed in an earlier post on this blog, real wages in the US have stagnated since around 1980.  An important question is whether this has changed recently.  Trump has claimed that his policies (of lifting regulations, slashing corporate taxes, and imposing high tariffs on our trading partners) are already leading to higher wages for American workers.  Has that been the case?

The answer is no.  As the chart at the top of this post shows, real wages have been close to flat.  Nominal wages have grown with inflation, but once inflation is taken into account, real wages have barely moved.  And one does not see any sharp change in that trend after Trump took office in January 2017.

It is of course still early in Trump’s term, and the experience so far does not mean real wages will not soon rise.  We will have to see.  One should indeed expect that they would, as the unemployment rate is now low (continuing the path it has followed since 2010, first under Obama and now, at a similar pace, under Trump).  But the primary purpose of this blog post is to look at the numbers on what the experience has been in recent years, including since Trump took office.  We will see that the trend has not much changed.  And to the extent that it has changed, it has been for the worse.

We will first take an overall perspective, using the chart at the top of this post and covering the period since 2006.  This will tell us what the overall changes have been over the full twelve years.  For real wages, the answer (as noted above) is that not much has changed.

But the overall perspective can mask what the year to year changes have been.  So we will then examine what these have been, using 12 month moving averages for the changes in nominal wages, the consumer price index, and then the real wage.  And we will see that changes in the real wage have actually been trending down of late, and indeed that the average real wage in June 2018 was below where it had been in June 2017.

We will then conclude with a short discussion of whether labor market trends have changed since Trump took office.  They haven’t.  But those trends, in place since 2010 as the economy emerged from the 2008/09 downturn, have been positive.  At some point we should expect that, if sustained, they will lead to rising real wages.  But we just have not seen that yet.

B.  Nominal and Real Wages Since 2006

It is useful first to start with an overall perspective, before moving to an examination of the year to year changes.  The chart at the top of this post shows average nominal wages in the private sector, in dollars per hour, since March 2006, and the equivalent in real terms, as deflated by the consumer price index (CPI).  The current CPI takes the prices of 1982-84 (averaged over that period) as the base, and hence the real wages shown are in terms of the prices of 1982-84.  For June 2018, for example, average private sector wages were $26.98 per hour, equivalent to $10.76 per hour in terms of the prices of 1982-84.

The data series comes from the Current Employment Survey of the Bureau of Labor Statistics, which comes out each month and is the source of the closely watched figures on the net number of jobs created each month.  The report also provides figures on average private sector wages on a monthly basis, but this particular series only started being reported in March 2006.  That is part of the reason why I started the chart with that date, but it is in any case a reasonable starting point for this analysis as it provides figures starting a couple of years before the economic collapse of 2008, in the last year of Bush’s presidential term, through to June 2018.

The BLS report also only provides figures on average wages in the private sector.  While it would be of interest also to see the similar figures on government wages, they are not provided for some reason.  If they had been included, the overall average wage would likely have increased at an even slower pace than that shown for the private sector only, as government wages have been increasing at a slower pace than private wages over this period.  But government employment is only 15% of total employment in the US.  Private wages are still of interest, and will provide an indication of what the market pressures have (or have not) been.

The chart shows that nominal wages have increased at a remarkably steady pace over this period.  Many may find that lack of fluctuation surprising.  The economy in 2008 and early 2009 went through the sharpest economic downturn since the Great Depression, and unemployment eventually hit 10.0% (in October 2009).  Yet nominal private sector wages continued to rise.  As we will discuss in more detail below, nominal wages were increasing at about a 3% annual pace through 2008, and then continued to increase (but at about a 2% pace) even after unemployment jumped.

But while nominal wages rose at this steady pace, it was almost all just inflation.  After adjusting for inflation, average real wages were close to flat for the period as a whole.  They were not completely flat:  Average real wages over the period (March 2006 to June 2018) rose at an annual rate of 0.57% per year.  This is not much.  It is in fact remarkably similar to the 0.61% growth in the average real wage between 1979 and 2013 in the data that were discussed in my blog post from early 2015 that looked at the factors underlying the stagnation in real wages in the decades since 1980.

But as was discussed in that blog post, the average real wage is not the same as the median real wage.  The average wage is the average across all wage levels, including the wages of the relatively well off.  The median, in contrast, is the wage at the point where 50% of the workers earn less and 50% earn more.  Due to the sharp deterioration in the distribution of income since around 1980 (as discussed in that post), the median real wage rose by less than the average real wage, as the average was pulled up by the more rapid increase in wages of those who are relatively well off.  And indeed, the median real wage rose by almost nothing over that period (just 0.009% per year between 1979 and 2013) when the average real wage rose at the 0.61% per year pace.  If that same relationship has continued, there would have been no increase at all in the median real wage in the period since 2006.  But the median wage estimates only come out with a lag (they are estimated through a different set of surveys at the Census Bureau), are only worked out on an annual basis, and we do not yet have such estimates for 2018.

C.  12 Month Changes in Nominal Wages, the Consumer Price Index, and Real Wages Since 2006

While the chart at the top of this post tracks the cumulative changes in wages over this period, one can get a better understanding of the underlying dynamics by looking at how the changes track over time.  For this we will focus on percentage changes over 12 month periods, worked out month by month on a moving average basis.  Or another way of putting it, these will be the percentage changes in the wages or the CPI over what it had been one year earlier, worked out month by month in overlapping periods.

For average nominal wages (in the private sector) this is:

Note that the date labels are for the end of each period.  Thus the point labeled at the start of 2008 will cover the percentage change in the nominal wage between January 2007 and January 2008.  And the starting date label for the chart will be March 2007, which covers the period from March 2006 (when the data series begins) to March 2007.

Prior to the 2008/09 downturn, nominal wages were growing at roughly 3% a year.  Once the downturn struck they continued to increase, but at a slower pace of roughly 2% a year or a bit below.  And this rate then started slowly to rise over time, reaching 2.7% in the most recent twelve-month period ending in June 2017.  The changes are remarkably minor, as was also noted above, and cover a period where unemployment was as high as 10% and is now just 4%.  There has been very little year to year volatility.

[A side note:  There is a “bump” in late 2008/early 2009, with wage growth over the year earlier period rising from around 3% to around 3 1/2%.  This might be considered surprising, as the bump up is precisely in the period when jobs were plummeting and unemployment increasing, in the worst period of the economic collapse.  But while I do not have the detailed microdata from the BLS surveys to say with certainty, I suspect this is a compositional effect.  When businesses start to lay off workers, they will typically start with the least experienced, and lowest paid, workers.  That will leave them with a reduced labor force, but one whose wages are on average higher.]

There have been larger fluctuations in the consumer price index:

But note that “larger” should be interpreted in a relative sense.  The absolute changes were generally not all that large (with some exceptions), and can mostly be attributed to changes in the prices of a limited number of volatile commodities, namely for food items and energy (oil).  The prices of such commodities go up and down, but over time they even out.  Thus for understanding inflationary trends, analysts will often focus instead on the so-called “core CPI”, which excludes food and energy prices.  For the full period being examined here, the regular CPI rose at a 1.88% annual pace while the core CPI rose at a 1.90% pace.  Within round-off, these are essentially the same.

But what matters to wage earners is what their wages earn, including for food and energy.  Thus to examine the impact on real living standards, what matters is the real wage defined in terms of the regular CPI index.  And this was:

With the relatively steady changes in average nominal wages, year to year, the fluctuations will basically be the mirror image of what has been happening to inflation.  When prices fell, real wages rose, and when prices rose more than normal, real wages fell.

Prices are now again rising, although still within the norm of the last twelve years.  For the 12 months ending in June 2018, the CPI (using the seasonally adjusted series) rose at a 2.8% rate.  The average nominal wage rate rose at a rate of 2.74% and thus the real wage fell slightly by 0.05% (calculated before rounding).  Average real wages are basically the same as (and formally slightly below) where they were a year ago.

D.  Employment and Unemployment

There is thus no evidence that the measures Trump has trumpeted (of deregulation, slashing taxes for corporations, and launching a trade war) have led to a step up in real wages.  This should not be surprising.  Deregulation which spurs industry consolidation increases the power of firms to raise prices while holding down wages.  And there is no reason to believe that tax cuts will lead quickly to higher wages.  Corporations do not pay their workers out of generosity or out of some sense of charity.  In a market economy they pay their employees what they need to in order to get the workers in the number and quality they need.  And although there can be winners in a trade war, there will also certainly be losers, and overall there will be a loss.  Workers, on average, will lose.

But what is surprising is that wages are not now rising by more in an economy that has reached full employment.  Federal Reserve Chair Jerome Powell, for example, has called this “a puzzle”.  And indeed it is.

The labor market turned around in the first two years of the Obama administration, and since then employment has grown consistently:

This has continued (although at a slightly slower pace) since Trump took office in January 2017.  The same trend as before has continued.  And this trend growth in net jobs each month has meant a steady fall in the unemployment rate:

Again, the pace since Trump took office is similar to (but a bit slower than) the pace when Obama was still in office.  But the somewhat slower pace should not be surprising.  With the economy at close to full employment, one should expect the pace to slow.

Indeed, the unemployment rate cannot go much lower.  There is always a certain amount of “churn” in the job market, which means an unemployment rate of zero is impossible.  And many economists in fact have taken a somewhat higher rate of unemployment (or at least 5.0%) as the appropriate target for “full employment”, arguing that anything lower will lead to a wage and price spiral.

But we have not seen any sign of that so far.  Nominal wages are rising at only a modest pace, and indeed over the last year at a pace less than inflation.

E.  Conclusion

There has been no step up in real wages since Trump took office.  Indeed, over the past twelve months, they fell slightly.  But while there is no reason to believe there should have been a jump in real wages following from Trump’s economic policies (of deregulation, tax cuts for corporations, and trade war), it is surprising that the economy is not now well past the point where low unemployment should have been spurring more substantial wage gains.

This very well could change, and indeed I would expect it to.  There is good reason to believe that the news for the real wage will be a good deal more positive over the next year than it has been over the past year.  But we will have to wait and see.  So far it has not happened.

The Simple Economics of What Determines the Foreign Trade Balance: Econ 101

“There’s no reason that we should have big trade deficits with virtually every country in the world.”

“We’re like the piggybank that everybody is robbing.”

“the United States has been taken advantage of for decades and decades”

“Last year,… [the US] lost  … $817 billion on trade.  That’s ridiculous and it’s unacceptable.”

“Well, if they retaliate, they’re making a mistake.  Because, you see, we have a tremendous trade imbalance. … we can’t lose”

Statements made by President Trump at the press conference held as he left the G-7 meetings in, Québec, Canada, June 9, 2018.

 

A.  Introduction

President Trump does not understand basic economics.  While that is not a surprise, nor something necessarily required or expected of a president, one should expect that a president would appoint advisors who do understand, and who would tell him when he is wrong.  Unfortunately, this president has been singularly unwilling to do so.  This is dangerous.

Trump is threatening a trade war.  Not only by his words at the G-7 meetings and elsewhere, but also by a number of his actions on trade and tariffs in recent months, Trump has made clear that he believes that a trade deficit is a “loss” to the nation, that countries with trade surpluses are somehow robbing those (such as the US) with a deficit, that raising tariffs can and will lead to reductions in trade deficits, and that if others then also raise their tariffs, the US will in the end necessarily “win” simply because the US has a trade deficit to start.

This is confused on many levels.  But it does raise the questions of what determines a country’s trade balance; whether a country “loses” if it has a trade deficit; and what is the role of tariffs.  This Econ 101 blog post will first look at the simple economics of what determines a nation’s trade deficit (hint:  it is not tariffs); will then discuss what tariffs do and where do they indeed matter; and will then consider the role played by foreign investment (into the US) and whether a trade deficit can be considered a “loss” for the nation (a piggybank being robbed).

B.  What Determines the Overall Trade Deficit?

Let’s start with a very simple case, where government accounts are aggregated together with the rest of the economy.  We will later then separate out government.

The goods and services available in an economy can come either from what is produced domestically (which is GDP, or Gross Domestic Product) or from what is imported.  One can call this the supply of product.  These goods and services can then be used for immediate consumption, or for investment, or for export.  One can call this the demand for product.  And since investment includes any net change in inventories, the goods and services made available will always add up to the goods and services used.  Supply equals demand.

One can put this in a simple equation:

GDP + Imports = Domestic Consumption + Domestic Investment + Exports

Re-arranging:

(GDP – Domestic Consumption) – Domestic Investment = Exports – Imports

The first component on the left is Domestic Savings (what is produced domestically less what is consumed domestically).  And Exports minus Imports is the Trade Balance.  Hence one has:

Domestic Savings – Domestic Investment = Trade Balance

As one can see from the way this was derived, this is simply an identity – it always has to hold.  And what it says is that the Trade Balance will always be equal to the difference between Domestic Savings and Domestic Investment.  If Domestic Savings is less than Domestic Investment, then the Trade Balance (Exports less Imports) will be negative, and there will be a trade deficit.  To reduce the trade deficit, one therefore has to either raise Domestic Savings or reduce Domestic Investment.  It really is as straightforward as that.

Where this becomes more interesting is in determining how the simple identity is brought about.  But here again, this is relatively straightforward in an economy which, like now, is at full employment.  Hence GDP is essentially fixed:  It cannot immediately rise by either employing more labor (as all the workers who want a job have one), nor by each of those laborers suddenly becoming more productive (as productivity changes only gradually through time by means of either better education or by investment in capital).  And GDP is equal to labor employed times the productivity of each of those workers.

In such a situation, with GDP at its full employment level, Domestic Savings can only rise if Domestic Consumption goes down, as Domestic Savings equals GDP minus Domestic Consumption.  But households want to consume, and saving more will mean less for consumption.  There is a tradeoff.

The only other way to reduce the trade deficit would then be to reduce Domestic Investment.  But one generally does not want to reduce investment.  One needs investment in order to become more productive, and it is only through higher productivity that incomes can rise.

Reducing the trade deficit, if desirable (and whether it is desirable will be discussed below), will therefore not be easy.  There will be tradeoffs.  And note that tariffs do not enter directly in anything here.  Raising tariffs can only have an impact on the trade balance if they have a significant impact for some reason on either Domestic Savings or Domestic Investment, and tariffs are not a direct factor in either.  There may be indirect impacts of tariffs, which will be discussed below, but we will see that the indirect effects actually could act in the direction of increasing, not decreasing, the trade deficit.  However, whichever direction they act in, those indirect effects are likely to be small.  Tariffs will not have a significant effect on the trade balance.

But first, it is helpful to expand the simple analysis of the above to include Government as a separate set of accounts.  In the above we simply had the Domestic sector.  We will now divide that into the Domestic Private and the Domestic Public (or Government) sectors.  Note that Government includes government spending and revenues at all levels of government (state and local as well as federal).  But the government deficit is primarily a federal government issue.  State and local government entities are constrained in how much of a deficit they can run over time, and the overall balance they run (whether deficit or surplus) is relatively minor from the perspective of the country as a whole.

It will now also be convenient to write out the equations in symbols rather than words, and we will use:

GDP = Gross Domestic Product

C = Domestic Private Consumption

I = Domestic Private Investment

G = Government Spending (whether for Consumption or for Investment)

X = Exports

M = Imports

T = Taxes net of Transfers

Note that T (Taxes net of Transfers) will be the sum total of all taxes paid by the private sector to government, minus all transfers received by the private sector from government (such as for Social Security or Medicare).  I will refer to this as simply net Taxes (T).

The basic balance of goods or services available (supplied) and goods or services used (demanded) will then be:

GDP + M = C + I + G + X

We will then add and subtract net Taxes (T) on the right-hand side:

GDP + M = (C + T) + I + (G – T) + X

Rearranging:

GDP – (C + T) – (G – T) – I = X – M

(GDP – C – T) – I + (T – G) = X – M

Or in (abbreviated) words:

Dom. Priv. Savings – Dom. Priv. Investment + Govt Budget Balance = Trade Balance

Domestic Private Savings (savings by households and private businesses) is equal to what is produced in the economy (GDP), less what is privately consumed (C), less what is paid in net Taxes (T) by the private sector to the public sector.  Domestic Private Investment is simply I, and includes investment both by private businesses and by households (primarily in homes).  And the Government Budget Balance is equal to what government receives in net Taxes (T), less what Government spends (on either consumption items or on public investment).  Note that government spending on transfers (e.g. Social Security) is already accounted for in net Taxes (T).

This equation is very much like what we had before.  The overall Trade Balance will equal Domestic Private Savings less Domestic Private Investment plus the Government Budget Balance (which will be negative when a deficit, as has normally been the case except for a few years at the end of the Clinton administration).  If desired, one could break down the Government Budget Balance into Public Savings (equal to net Taxes minus government spending on consumption goods and services) less Public Investment (equal to government spending on investment goods and services), to see the parallel with Domestic Private Savings and Domestic Private Investment.  The equation would then read that the Trade Balance will equal Domestic Private Savings less Domestic Private Investment, plus Government Savings less Government Investment.  But there is no need.  The budget deficit, as commonly discussed, includes public spending not only on consumption items but also on investment items.

This is still an identity.  The balance will always hold.  And it says that to reduce the trade deficit (make it less negative) one has to either increase Domestic Private Savings, or reduce Domestic Private Investment, or increase the Government Budget Balance (i.e. reduce the budget deficit).  Raising Domestic Private Savings implies reducing consumption (when the economy is at full employment, as now).  Few want this.  And as discussed above, a reduction in investment is not desirable as investment is needed to increase productivity over time.

This leaves the budget deficit, and most agree that it really does need to be reduced in an economy that is now at full employment.  Unfortunately, Trump and the Republican Congress have moved the budget in the exact opposite direction, primarily due to the huge tax cut passed last December, and to a lesser extent due to increases in certain spending (primarily for the military).  As discussed in an earlier post on this blog, an increase in the budget deficit to a forecast 5% of GDP at a time when the economy is at full employment is unprecedented in peacetime.

What this implies for the trade balance is clear from the basic identity derived above.  An increase in the budget deficit (a reduction in the budget balance) will lead, all else being equal, to an increase in the trade deficit (a reduction in the trade balance).  And it might indeed be worse, as all else is not equal.  The stated objective of slashing corporate taxes is to spur an increase in corporate investment.  But if private investment were indeed to rise (there is in fact little evidence that it has moved beyond previous trends, at least so far), this would further worsen the trade balance (increase the trade deficit).

Would raising tariffs have an impact?  One might argue that this would raise net Taxes paid, as tariffs on imports are a tax, which (if government spending is not then also changed) would reduce the budget deficit.  While true, the extent of the impact would be trivially small.  The federal government collected $35.6 billion in all customs duties and fees (tariffs and more) in FY2017 (see the OMB Historical Tables).  This was less than 0.2% of FY2017 GDP.  Even if all tariffs (and other fees on imports) were doubled, and the level of imports remained unchanged, this would only raise 0.2% of GDP.  But the trade deficit was 2.9% of GDP in FY2017.  It would not make much of a difference, even in such an extreme case.  Furthermore, new tariffs are not being pushed by Trump on all imports, but only a limited share (and a very limited share so far).  Finally, if Trump’s tariffs in fact lead to lower imports of the items being newly taxed, as he hopes, then tariffs collected can fall.  In the extreme, if the imports of such items go to zero, then the tariffs collected will go to zero.

Thus, for several reasons, any impact on government revenues from the new Trump tariffs will be minor.

The notion that raising tariffs would be a way to eliminate the trade deficit is therefore confused.  The trade balance will equal the difference between Domestic Savings and Domestic Investment.  Adding in government, the trade balance will equal the difference between Domestic Private Savings and Domestic Private Investment, plus the equivalent for government (the Government Budget Balance, where a budget deficit will be a negative).  Tariffs have little to no effect on these balances.

C.  What Role Do Tariffs Play, Then?

Do tariffs then matter?  They do, although not in the determination of the overall trade deficit.  Rather, tariffs, which are a tax, will change the price of the particular import relative to the price of other products.  If applied only to imports from some countries and not from others, one can expect to see a shift in imports towards those countries where the tariffs have not been imposed.  And in the case when they are applied globally, on imports of the product from any country, one should expect that prices for similar products made in the US will then also rise.  To the extent there are alternatives, purchases of the now more costly products (whether imported or produced domestically) will be reduced, while purchases of alternatives will increase.  And there will be important distributional changes.  Profits of firms producing the now higher priced products will increase, while the profits of firms using such products as an input will fall.  And the real incomes of households buying any of these products will fall due to the higher prices.

Who wins and who loses can rapidly become turn into something very complicated.  Take, for example, the new 25% tariff being imposed by the Trump administration on steel (and 10% on aluminum).  The tariffs were announced on March 8, to take effect on March 23.  Steel imports from Canada and Mexico were at first exempted, but later the Trump administration said those exemptions were only temporary.  On March 22 they then expanded the list of countries with temporary exemptions to also the EU, Australia, South Korea, Brazil, and Argentina, but only to May 1.  Then, on March 28, they said imports from South Korea would receive a permanent exemption, and Australia, Brazil, and Argentina were granted permanent exemptions on May 2.  After a short extension, tariffs were then imposed on steel imports from Canada, Mexico, and the EU, on May 31.  And while this is how it stands as I write this, no one knows what further changes might be announced tomorrow.

With this uneven application of the tariffs by country, one should expect to see shifts in the imports by country.  What this achieves is not clear.  But there are also further complications.  There are hundreds if not thousands of different types of steel that are imported – both of different categories and of different grades within each category – and a company using steel in their production process in the US will need a specific type and grade of steel.  Many of these are not even available from a US producer of steel.  There is thus a system where US users of steel can apply for a waiver from the tariff.  As of June 19, there have been more than 21,000 petitions for a waiver.  But there were only 30 evaluators in the US Department of Commerce who will be deciding which petitions will be granted, and their training started only in the second week of June.  They will be swamped, and one senior Commerce Department official quoted in the Washington Post noted that “It’s going to be so unbelievably random, and some companies are going to get screwed”.  It would not be surprising to find political considerations (based on the interests of the Trump administration) playing a major role.

So far, we have only looked at the effects of one tariff (with steel as the example).  But multiple tariffs on various goods will interact, with difficult to predict consequences.  Take for example the tariff imposed on the imports of washing machines announced in late January, 2018, at a rate of 20% in the first year and at 50% should imports exceed 1.2 million units in the year.  This afforded US producers of washing machines a certain degree of protection from competition, and they then raised their prices by 17% over the next three months (February to May).

But steel is a major input used to make washing machines, and steel prices have risen with the new 25% tariff.  This will partially offset the gains the washing machine producers received from the tariff imposed on their product.  Will the Trump administration now impose an even higher tariff on washing machines to offset this?

More generally, the degree to which any given producer will gain or lose from such multiple tariffs will depend on multiple factors – the tariff rates applied (both for what they produce and for what they use as inputs), the degree to which they can find substitutes for the inputs they need, and the degree to which those using the product (the output) will be able to substitute some alternative for the product, and more.  Individual firms can end up ahead, or behind.  Economists call the net effect the degree of “net effective protection” afforded the industry, and it can be difficult to figure out.  Indeed, government officials who had thought they were providing positive protection to some industry often found out later that they were in fact doing the opposite.

Finally, imposing such tariffs on imports will lead to responses from the countries that had been providing the goods.  Under the agreed rules of international trade, those countries can then impose commensurate tariffs of their own on products they had been importing from the US.  This will harm industries that may otherwise have been totally innocent in whatever was behind the dispute.

An example of what can then happen has been the impact on Harley-Davidson, the American manufacturer of heavy motorcycles (affectionately referred to as “hogs”).  Harley-Davidson is facing what has been described as a “triple whammy” from Trump’s trade decisions.  First, they are facing higher steel (and aluminum) prices for their production in the US, due to the Trump steel and aluminum tariffs.  Harley estimates this will add $20 million to their costs in their US plants.  For a medium-sized company, this is significant.  As of the end of 2017, Harley-Davidson had 5,200 employees in the US (see page 7 of this SEC filing).  With $20 million, they could pay each of their workers $3,850 more.  This is not a small amount.  Instead, the funds will go to bolster the profits of steel and aluminum firms.

Second, the EU has responded to the Trump tariffs on their steel and aluminum by imposing tariffs of their own on US motorcycle imports.  This would add $45 million in costs (or $2,200 per motorcycle) should Harley-Davidson continue to export motorcycles from the US to the EU.  Quite rationally, Harley-Davidson responded that they will now need to shift what had been US production to one of their plants located abroad, to avoid both the higher costs resulting from the new steel and aluminum tariffs, and from the EU tariffs imposed in response.

And one can add thirdly and from earlier, that Trump pulled the US out of the already negotiated (but still to be signed) Trans-Pacific Partnership agreement.  This agreement would have allowed Harley-Davidson to export their US built motorcycles to much of Asia duty-free.  They will now instead be facing high tariffs to sell to those markets.  As a result, Harley-Davidson has had to set up a new plant in Asia (in Thailand), shifting there what had been US jobs.

Trump reacted angrily to Harley-Davidson’s response to his trade policies.  He threatened that “they will be taxed like never before!”.  Yet what Harley-Davidson is doing should not have been a surprise, had any thought been given to what would happen once Trump started imposing tariffs on essential inputs needed in the manufacture of motorcycles (steel and aluminum), coming from our major trade partners (and often closest allies).  And it is positively scary that a president should even think that he should use the powers of the state to threaten an individual private company in this way.  Today it is Harley-Davidson.  Who will it be tomorrow?

There are many other examples of the problems that have already been created by Trump’s new tariffs.  To cite a few, and just briefly:

a)  The National Association of Home Builders estimated that the 20% tariff imposed in 2017 on imports of softwood lumber from Canada added nearly $3,600 to the cost of building an average single-family home in the US and would, over the course of a year, reduce wages of US workers by $500 million and cost 8,200 full-time US jobs.

b)  The largest nail manufacturer in the US said in late June that it has already had to lay off 12% of its workforce due to the new steel tariffs, and that unless it is granted a waiver, it would either have to relocate to Mexico or shut down by September.

c)  As of early June, Reuters estimated that at least $2.5 billion worth of investments in new utility-scale solar installation projects had been canceled or frozen due to the tariffs Trump imposed on the import of solar panel assemblies.  This is far greater than new investments planned for the assembly of such panels in the US.  Furthermore, the jobs involved in such assembly work are generally low-skill and repetitive, and can be automated should wages rise.

So there are consequences from such tariffs.  They might be unintended, and possibly not foreseen, but they are real.

But would the imposition of tariffs necessarily reduce the trade deficit, as Trump evidently believes?  No.  As noted above, the trade deficit would only fall if the tariffs would, for some reason, increase domestic savings or reduce domestic investment.  But tariffs do not enter directly into those factors.  Indirectly, one could map out some chains of possible causation, but these changes in some set of tariffs (even if broadly applied to a wide range of imports) would not have a major effect on overall domestic savings or investment.  They could indeed even act in the opposite direction.

Households, to start, will face higher prices from the new tariffs.  To try to maintain their previous standard of living (in real terms) they would then need to spend more on what they consume and hence would save less.  This, by itself, would reduce domestic savings and hence would increase the trade deficit to the extent there was any impact.

The impacts on firms are more various, and depend on whether the firm will be a net winner or loser from the government actions and how they might then respond.  If a net winner, they have been able to raise their prices and hence increase their profits.  If they then save the extra profits (retained earnings), domestic savings would rise and the trade deficit would fall.  But if they increase their investments in what has now become a more profitable activity (and that is indeed the stated intention behind imposing the tariffs), that response would lead to an increase in the trade deficit.  The net effect will depend on whether their savings or their investment increases by more, and one does not know what that net change might be.  Different firms will likely respond differently.

One also has to examine the responses of the firms who will be the net losers from the newly imposed tariffs.  They will be paying more on their inputs and will see a reduction in their profits.  They will then save less and will likely invest less.  Again, the net impact on the trade deficit is not clear.

The overall impact on the trade deficit from these indirect effects is therefore uncertain, as one has effects that will act in opposing directions.  In part for this reason, but also because the tariffs will affect only certain industries and with responses that are likely to be limited (as a tariff increase today can be just as easily reversed tomorrow), the overall impact on the trade balance from such indirect effects are likely to be minor.

Increases in individual tariffs, such as those being imposed now by Trump, will not then have a significant impact on the overall trade balance.  But tariffs still do matter.  They change the mix of what is produced, from where items will be imported, and from where items will be produced for export (as the Harley-Davidson case shows).  They will create individual winners and losers, and hence it is not surprising to see the political lobbying as has grown in Washington under Trump.  Far from “draining the swamp”, Trump’s trade policy has made it critical for firms to step up their lobbying activities.

But such tariffs do not determine what the overall trade balance will be.

D.  What Role Does Foreign Investment Play in the Determination of the Trade Balance?

While tariffs will not have a significant effect on the overall trade balance, foreign investment (into the US) will.  To see this, we need to return to the basic macro balance derived in Section B above, but generalize it a bit to include all foreign financial flows.

The trade balance is the balance between exports and imports.  It is useful to generalize this to take into account two other sources of current flows in the national income and product accounts which add to (or reduce) the net demand for foreign exchange.  Specifically, there will be foreign exchange earned by US nationals working abroad plus that earned by US nationals on investments they have made abroad.  Economists call this “factor services income”, or simply factor income, as labor and capital are referred to as factors of production.  This is then netted against such income earned in the US by foreign nationals either working here or on their investments here.  Second, there will be unrequited transfers of funds, such as by households to their relatives abroad, or by charities, or under government aid programs.  Again, this will be netted against the similar transfers to the US.

Adding the net flows from these to the trade balance will yield what economists call the “current account balance”.  It is a measure of the net demand for dollars (if positive) or for foreign exchange (if a deficit) from current flows.  To put some numbers on this, the US had a foreign trade deficit of $571.6 billion in 2017.  This was the balance between the exports and imports of goods and services (what economists call non-factor services to be more precise, now that we are distinguishing factor services from non-factor services).  It was negative – a deficit.  But the US also had a surplus in 2017 from net factor services income flows of $216.8 billion, and a deficit of $130.2 billion on net transfers (mostly from households sending funds abroad).  The balance on current account is the sum of these (with deficits as negatives and surpluses as positives) and came to a deficit of $485.0 billion in 2017, or 2.5% of GDP.  As a share of GDP, this deficit is significant but not huge.  The UK had a current account deficit of 4.1% of GDP in 2017 for example, while Canada had a deficit of 3.0%.

The current account for foreign transactions, basically a generalization of the trade balance, is significant as it will be the mirror image of the capital account for foreign transactions.  That is, when the US had a current account deficit of $485.0 billion (as in 2017), there had to be a capital account surplus of $485.0 billion to match this, as the overall purchases and sales of dollars in foreign exchange transactions will have to balance out, i.e. sum to zero.  The capital account incorporates all transactions for the purchase or sale of capital assets (investments) by foreign entities into the US, net of the similar purchase or sale of capital assets by US entities abroad.  When the capital account is a net positive (as has been the case for the US in recent decades), there is more such investment going into the US than is going out.  The investments can be into any capital assets, including equity shares in companies, or real estate, or US Treasury or other bonds, and so on.

But while the two (the current account and the capital account) have to balance out, there is an open question of what drives what.  Look at this from the perspective of a foreigner, wishing to invest in some US asset.  They need to get the dollars for this from somewhere.  While this would be done by means of the foreign exchange markets, which are extremely active (with trillions of dollars worth of currencies being exchanged daily), a capital account surplus of $485 billion (as in 2017) means that foreign entities had to obtain, over the course of the year, a net of $485 billion in dollars for their investments into the US.  The only way this could be done is by the US importing that much more than it exported over the course of the year.  That is, the US would need to run a current account deficit of that amount for the US to have received such investment.

If there is an imbalance between the two (the current account and the capital account), one should expect that the excess supply or demand for dollars will lead to changes in a number of prices, most directly foreign exchange rates, but also interest rates and other asset prices.  These will be complex and we will not go into here all the interactions one might then have.  Rather, the point to note is that a current account deficit, even if seemingly large, is not a sign of disequilibrium when there is a desire on the part of foreign investors to invest a similar amount in US markets.  And US markets have traditionally been a good place to invest.  The US is a large economy, with markets for assets that are deep and active, and these markets have normally been (with a few exceptions) relatively well regulated.

Foreign nationals and firms thus have good reason to invest a share of their assets in the US markets.  And the US has welcomed this, as all countries do.  But the only way they can obtain the dollars to make these investments is for the US to run a current account deficit.  Thus a current account deficit should not necessarily be taken as a sign of weakness, as Trump evidently does.  Depending on what governments are doing in their market interventions, a current account deficit might rather be a sign of foreign entities being eager to invest in the country.  And that is a good sign, not a bad one.

E.  An “Exorbitant Privilege”

The dollar (and hence the US) has a further, and important, advantage.  It is the world’s dominant currency, with most trade contracts (between all countries, not simply between some country and the US) denominated in dollars, as are contracts for most internationally traded commodities (such as oil).  And as noted above, investments in the US are particularly advantageous due to the depth and liquidity of our asset markets.  For these reasons, foreign countries hold most of their international reserves in dollar assets.  And most of these are held in what have been safe, but low yielding, short-term US Treasury bills.

As noted in Section D above, those seeking to make investments in dollar assets can obtain the dollars required only if the US runs a current account deficit.  This is as true for assets held in dollars as part of a country’s international reserves as for any other investments in US dollar assets.  Valéry Giscard d’Estaing in the 1960s, then the Minister of Finance of France, described this as an “exorbitant privilege” for the US (although this is often mistakenly attributed Charles de Gaulle, then his boss as president of France).

And it certainly is a privilege.  With the role of the dollar as the preferred reserve currency for countries around the world, the US is able to run current account deficits indefinitely, obtaining real goods and services from those countries while providing pieces of paper generating only a low yield in return.  Indeed, in recent years the rate of return on short-term US Treasury bills has generally been negative in real terms (i.e. after inflation).  The foreign governments buying these US Treasury bills are helping to cover part of our budget deficits, and are receiving little to nothing in return.

So is the US a “piggybank that everybody is robbing”, as Trump asserted to necessarily be the case when the US is has a current account deficit?  Not at all.  Indeed, it is the precise opposite.  The current account deficit is the mirror image of the foreign investment inflows coming into the US.  To obtain the dollars needed to do this those countries must export more real goods to the US than they import from the US.  The US gains real resources (the net exports), while the foreign entities then invest in US markets.  And for governments obtaining dollars to hold as their international reserves, those investments are primarily in the highly liquid and safe, short-term US Treasury bills, despite those assets earning low or even negative returns.  This truly is an “exorbitant privilege”, not a piggybank being robbed.

Indeed, the real concern is that with the mismanagement of our budget (tax cuts increasing deficits at a time when deficits should be reduced) plus the return to an ideologically driven belief in deregulating banks and other financial markets (such as what led to the financial and then economic collapse of 2008), the dollar may lose its position as the place to hold international reserves.  The British pound had this position in the 1800s and then lost it to the dollar due to the financial stresses of World War I.  The dollar has had the lead position since.  But others would like it, most openly by China and more quietly Europeans hoping for such a role for the euro.  They would very much like to enjoy this “exorbitant privilege”, along with the current account deficits that privilege conveys.

F.  Summary and Conclusion

Trump’s beliefs on the foreign trade deficit, on the impact of hiking tariffs, and on who will “win” in a trade war, are terribly confused.  While one should not necessarily expect a president to understand basic economics, one should expect that a president would appoint and listen to advisors who do.  But Trump has not.

To sum up some of the key points:

a)  The foreign trade balance will always equal the difference between domestic savings and domestic investment.  Or with government accounts split out, the trade balance will equal the difference between domestic private savings and domestic private investment, plus the government budget balance.  The foreign trade balance will only move up or down when there is a change in the balance between domestic savings and domestic investment.

b)  One way to change that balance would be for the government budget balance to increase (i.e. for the government deficit to be reduced).  Yet Trump and the Republican Congress have done the precise opposite.  The massive tax cuts of last December, plus (to a lesser extent) the increase in government spending now budgeted (primarily for the military), will increase the budget deficit to record levels for an economy in peacetime at full employment.  This will lead to a bigger trade deficit, not a smaller one.

c)  One could also reduce the trade deficit by making the US a terrible place to invest in.  This would reduce foreign investment into the US, and hence the current account deficit.  In terms of the basic savings/investment balance, it would reduce domestic investment (whether driven by foreign investors or domestic ones).  If domestic savings was not then also reduced (a big if, and dependant on what was done to make the US a terrible place to invest in), this would lead to a similar reduction in the trade deficit.  This is of course not to be taken seriously, but rather illustrates that there are tradeoffs.  One should not simplistically assume that a lower trade deficit achieved by any means possible is good.

d)  It is also not at all clear that one should be overly concerned about the size of the trade and current account deficits, at where they are today.  The US had a trade deficit of 2.9% of GDP in 2017 and a current account deficit of 2.5% of GDP.  While significant, these are not huge.  Should they become much larger (due, for example, to the forecast increases in government budget deficits to record levels), they might rise to problematic levels.  But at the current levels for the current account deficit, we have seen the markets for foreign exchange and for interest rates functioning pretty well and without overt signs of concern.  The dollars being made available through the current account deficit have been bought up and used for investments in US markets.

e)  Part of the demand for dollars to be invested and held in the US markets comes from the need for international reserves by governments around the world.  The dollar is the dominant currency in the world, and with the depth and liquidity of the US markets (in particular for short-term US Treasury bills) most of these international reserves are held in dollars.  This has given the US what has been called an “exorbitant privilege”, and permits the US to run substantial current account deficits while providing in return what are in essence paper assets yielding just low (or even negative) returns.

f)  The real concern should not be with the consequences of the dollar playing such a role in the system of international trade, but rather with whether the dollar will lose this privileged status.  Other countries have certainly sought this, most openly by China but also more quietly for the euro, but so far the dollar has remained dominant.  But there are increasing concerns that with the mismanagement of the government budget (the recent tax cuts) plus ideologically driven deregulation of banks and the financial markets (as led to the 2008 financial collapse), countries will decide to shift their international reserves out of the dollar towards some alternative.

g)  What will not reduce the overall trade deficit, however, is selective increases in tariff rates, as Trump has started to do.  Such tariff increases will shift around the mix of countries from where the imports will come, and/or the mix of products being imported, but can only reduce the overall trade deficit to the extent such tariffs would lead somehow to either higher domestic savings and/or lower domestic investment.  Tariffs will not have a direct effect on such balances, and indirect effects are going to be small and indeed possibly in the wrong direction (if the aim is to reduce the deficits).

h)  What such tariff policies will do, however, is create a mess.  And they already have, as the Harley-Davidson case illustrates.  Tariffs increase costs for US producers, and they will respond as best they can.  While the higher costs will possibly benefit certain companies, they will harm those using the products unless some government bureaucrat grants them a special exemption.

But what this does lead to is officials in government picking winners and losers.  That is a concern.  And it is positively scary to have a president lashing out and threatening individual firms, such as Harley-Davidson, when the firms respond to the mess created as one should have expected.

The Mismanagement of Fiscal Policy Under Trump: Deficits When There Should be Surpluses

A.  Introduction

Since World War II, the US has never run such high fiscal deficits in times of full employment as it will now.  With the tax cuts pushed through by the Republican Congress and signed into law by Trump in December, and to a lesser extent the budget passed in March, it is expected that the US will soon be running a fiscal deficit of over $1.0 trillion a year, exceeding 5% of GDP.  This is unprecedented.

We now have good estimates of how high the deficits will grow under current policy and in a scenario which assumes (optimistically) that the economy will remain at full employment, with no downturn.  The Congressional Budget Office (CBO) published on April 9 its regular report on “The Budget and Economic Outlook”, this year covering fiscal years 2018 to 2028.  In this report to Congress and to the public, the CBO assesses the implications of federal budget and tax policy, as set out under current law.  The report normally comes out in January or February of each year but was delayed this year in order to reflect the tax bill approved in December and also the FY18 budget, which was only approved in March (even though the fiscal year began last October).

The forecast is that the deficits will now balloon.  This should not be a surprise given the magnitude of the tax cuts pushed through Congress in December and then signed into law by Trump, but recall that the Republicans pushing through the tax bill asserted deficits would not increase as a result.  The budget approved in March also provides for significant increases in legislated spending – especially for the military but also for certain domestic programs.  But as will be discussed below, government spending (other than on interest) over the next decade is in fact now forecast by the CBO to be less than what it had forecast last June.

The CBO assessment is the first set of official estimates of what the overall impact will be.  And they are big.  The CBO forecasts that even though the economy is now at full employment (and assumed to remain there for the purposes of the scenario used), deficits are forecast to grow to just short of $1 trillion in FY2019, and then continue to increase, reaching over $1.5 trillion by FY2028.  In dollar terms, it has never been that high – not even in 2009 at the worst point in the recession following the 2008 collapse of the economy.

That is terrible fiscal policy.  While high fiscal deficits are to be expected during times of high unemployment (as tax revenues are down, while government spending is the only stabilizing element for the economy when both households and corporations are cutting back on spending due to the downturn), standard policy would be to limit deficits in times of full employment in order to bring down the public debt to GDP ratio.  But with the tax cuts and spending plans this is not going to happen under Trump, even should the economy remain at full employment.  And it will be far worse when the economy once again dips into a recession, as always happens eventually.

This blog post will first discuss the numbers in the new CBO forecasts, then the policy one should follow over the course of the business cycle in order to keep the public debt to GDP under control, and finally will look at the historical relationship between unemployment and the fiscal deficit, and how the choices made on the deficit by Trump and the Republican-controlled Congress are unprecedented and far from the historical norms.

B.  The CBO Forecast of the Fiscal Deficits

The forecasts made by the CBO of the fiscal accounts that would follow under current policies are always eagerly awaited by those concerned with what Congress is doing.  Ten-year budget forecasts are provided by the CBO at least annually, and typically twice or even three times a year, depending on the decisions being made by Congress.

The CBO itself is non-partisan, with a large professional staff and a director who is appointed to a four-year term (with no limits on its renewal) by the then leaders in Congress.  The current director, Keith Hall, took over on April 1, 2015, when both the House and the Senate were under Republican control.  He replaced Doug Elmensdorf, who was widely respected as both capable and impartial, but who had come to the end of a term.  Many advocated that he be reappointed, but Elmensdorf had first taken the position when Democrats controlled the House and the Senate.  Hall is a Republican, having served in senior positions in the George W. Bush administration, and there was concern that his appointment signaled an intent to politicize the position.

But as much as his party background, a key consideration appeared to have been Hall’s support for the view that tax cuts would, through their impact on incentives, lead to more rapid growth, with that more rapid growth then generating more tax revenue which would partially or even fully offset the losses from the lower tax rates.  I do not agree.  An earlier post on this blog discussed that that argument is incomplete, and does not take into account that there are income as well as substitution effects (as well as much more), which limit or offset what the impact might be from substitution effects alone.  And another post on this blog looked at the historical experience after the Reagan and Bush tax cuts, in comparison to the experience after the (more modest) increases in tax rates on higher income groups under Clinton and Obama.  It found no evidence in support of the argument that growth will be faster after tax cuts than when taxes are raised.  What the data suggest, rather, is that there was little to no impact on growth in one direction or the other.  Where there was a clear impact, however, was on the fiscal deficits, which rose with the tax cuts and fell with the tax increases.

Given Hall’s views on taxes, it was thus of interest to see whether the CBO would now forecast that an acceleration in GDP growth would follow from the new tax cuts sufficient to offset the lower tax revenues following from the lower tax rates.  The answer is no.  While the CBO did forecast that GDP would be modestly higher as a result of the tax cuts (peaking at 1.0% higher than would otherwise be the case in 2022 before then diminishing over time, and keep in mind that these are for the forecast levels of GDP, not of its growth), this modestly higher GDP would not suffice to offset the lower tax revenues following from the lower tax rates.

Taking account of all the legislative changes in tax law since its prior forecasts issued in June 2017, the CBO estimated that fiscal revenues collected over the ten years FY2018 to FY2027 would fall by $1.7 trillion from what it would have been under previous law.  However, after taking into account its forecast of the resulting macroeconomic effects (as well as certain technical changes it made in its forecasts), the net impact would be a $1.0 trillion loss in revenues.  This is almost exactly the same loss as had been estimated by the staff of the Joint Committee on Taxation for the December tax bill, which also factored in an estimate of a (modest) impact on growth from the lower tax rates.

Fiscal spending projections were also provided, and the CBO estimated that legislative changes alone (since its previous estimates in June 2017) would raise spending (excluding interest) by $450 billion over the ten year period.  However, after taking into account certain macro feedbacks as well as technical changes in the forecasts, the CBO is now forecasting government spending will in fact be $100 billion less over the ten years than it had forecast last June.  The higher deficits over those earlier forecast are not coming from higher spending but rather totally from the tax cuts.

Finally, the higher deficits will have to be funded by higher government borrowing, and this will lead to higher interest costs.  Interest costs will also be higher as the expansionary fiscal policy at a time when the economy is already at full employment will lead to higher interest rates, and those higher interest rates will apply to the entire public debt, not just to the increment in debt resulting from the higher deficits.  The CBO forecasts that higher interest costs will add $650 billion to the deficits over the ten years.

The total effect of all this will thus be to increase the fiscal deficit by $1.6 trillion over the ten years, over what it would otherwise have been.  The resulting annual fiscal deficits, in billions of dollars, would be as shown in the chart at top of this post.  Under the assumed scenario that the economy will remain at full employment over the entire period, the fiscal deficit will still rise to reach almost $1 trillion in FY19, and then to over $1.5 trillion in FY28.  Such deficits are unprecedented for when the economy is at full employment.

The deficits forecast would then translate into these shares of GDP, given the GDP forecasts:

The CBO is forecasting that fiscal deficits will rise to a range of 4 1/2 to 5 1/2% of GDP from FY2019 onwards.  Again, this is unprecedented for the US economy in times of full employment.

C.  Fiscal Policy Over the Course of the Business Cycle

As noted above, fiscal policy has an important role to play during economic downturns to stabilize conditions and to launch a recovery.  When something causes an economic downturn (such as the decision during the Bush II administration not to regulate banks properly in the lead up to the 2008 collapse, believing “the markets” would do this best), both households and corporations will reduce their spending.  With unemployment increasing and wages often falling even for those fortunate enough to remain employed, as well as with the heightened general concerns on the economy, households will cut back on their spending.  Similarly, corporations will seek to conserve cash in the downturns, and will cut back on their spending both for the inputs they would use for current production (they cannot sell all of their product anyway) and for capital investments (their production facilities are not being fully used, so why add to capacity).

Only government can sustain the economy in such times, stopping the downward spiral through its spending.  Fiscal stimulus is needed, and the Obama stimulus program passed early in his first year succeeded in pulling the economy out of the freefall it was in at the time of his inauguration.  GDP fell at an astounding 8.2% annual rate in the fourth quarter of 2008 and was still crashing in early 2009 as Obama was being sworn in.  It then stabilized in the second quarter of 2009 and started to rise in the third quarter.  The stimulus program, as well as aggressive action by the Federal Reserve, accounts for this turnaround.

But fiscal deficits will be high during such economic downturns.  While any stimulus programs will add to this, most of the increase in the deficits in such periods occur automatically, primarily due to lower tax revenues in the downturn.  Incomes and employment are lower, so taxes due will be lower.  There is also, but to a much smaller extent, some automatic increase in government spending during the downturns, as funds are paid out in unemployment insurance or for food stamps for the increased number of the poor.  The deficits will then add to the public debt, and the public debt to GDP ratio will rise sharply (exacerbated in the short run by the lower GDP as well).

One confusion, sometimes seen in news reports, should be clarified.  While fiscal deficits will be high in a downturn, for the reasons noted above, and any stimulus program will add further to those deficits, one should not equate the size of the fiscal deficit with the size of the stimulus.  They are two different things.  For example, normally the greatest stimulus, for any dollar of expenditures, will come from employing directly blue-collar workers in some government funded program (such as to build or maintain roads and other such infrastructure).  A tax cut focused on the poor and middle classes, who will spend any extra dollar they receive, will also normally lead to significant stimulus (although probably less than via directly employing a worker).  But a tax cut focused on the rich will provide only limited stimulus as any extra dollar they receive will mostly simply be saved (or used to pay down debt, which is economically the same thing).  The rich are not constrained in how much they can spend on consumption by their income, as their income is high enough to allow them to consume as much as they wish.

Each of these three examples will add equally to the fiscal deficit, whether the dollar is used to employ workers directly, to provide a tax cut to the poor and middle classes, or to provide a tax cut to the rich.  But the degree of stimulus per dollar added to the deficit can be dramatically different.  One cannot equate the size of the deficit to the amount of stimulus.

Deficits are thus to be expected, and indeed warranted, in a downturn.  But while the resulting increase in public debt is to be expected in such conditions, there must also come a time for the fiscal deficits to be reduced to a level where at least the debt to GDP ratio, if not the absolute level of the debt itself, will be reduced.  Debt cannot be allowed to grow without limit.  And the time to do this is when the economy is at full employment.  It was thus the height of fiscal malpractice for the tax bills and budget passed by Congress and signed into law by Trump not to provide for this, but rather for the precise opposite.  The CBO estimates show that deficits will rise rather than fall, even under a scenario where the economy is assumed to remain at full employment.

It should also be noted that the deficit need not be reduced all the way to zero for the debt to GDP ratio to fall.  With a growing GDP and other factors (interest rates, the rate of inflation, and the debt to GDP ratio) similar to what they are now, a good rule of thumb is that the public debt to GDP ratio will fall as long as the fiscal deficit is around 3% of GDP or less.  But the budget and tax bills of Trump and the Congress will instead lead to deficits of around 5% of GDP.  Hence the debt to GDP ratio will rise.

[Technical note for those interested:  The arithmetic of the relationship between the fiscal deficit and the debt to GDP ratio is simple.  A reasonable forecast, given stated Fed targets, is for an interest rate on long-term public debt of 4% and an inflation rate of 2%.  This implies a real interest rate of 2%.  With real GDP also assumed to grow in the CBO forecast at 2% a year (from 2017 to 2028), the public debt to GDP ratio will be constant if what is called the “primary balance” is zero (as the numerator, public debt, will then grow at the same rate as the denominator, GDP, each at either 2% a year in real terms or 4% a year in nominal terms) .  The primary balance is the fiscal deficit excluding what is paid in interest on the debt.  The public debt to GDP ratio, as of the end of FY17, was 76.5%.  With a nominal interest rate of 4%, this would lead to interest payments on the debt of 3% of GDP.  A primary balance of zero would then imply an overall fiscal deficit of 3% of GDP.  Hence a fiscal deficit of 3% or less, with the public debt to GDP ratio roughly where it is now, will lead to a steady debt to GDP ratio.

More generally, the debt to GDP ratio will be constant whenever the rate of growth of real GDP matches the real interest rate, and the primary balance is zero.  In the case here, the growth in the numerator of debt (4% in nominal terms, or 2% in real terms when inflation is 2%) matches the growth in the denominator of GDP (2% in real terms, or 4% in nominal terms), and the ratio will thus be constant.]

Putting this in a longer-term context:

Federal government debt rose to over 100% of GDP during World War II.  The war spending was necessary.  But it did not then doom the US to perpetual economic stagnation or worse.  Rather, fiscal deficits were kept modest, the economy grew well, and over the next several decades the debt to GDP ratio fell.

For the fiscal balances over this period (with fiscal deficits as negative and fiscal surpluses as positive):

Fiscal balances were mostly but modestly in deficit (and occasionally in surplus) through the 1950s, 60s, and 70s.  The 3% fiscal deficit rule of thumb worked well, and one can see that as long as the fiscal deficit remained below 3% of GDP, the public debt to GDP ratio fell, to a low of 23% of GDP in FY1974.  It then stabilized at around this level for a few years, but reversed and started heading in FY1982 after Reagan took office.  And it kept going up even after the economy had recovered from the 1982 recession and the country was back to full employment, as deficits remained high following the Reagan tax cuts.

The new Clinton budgets, along with the tax increase passed in 1993, then stabilized the accounts, and the economy grew strongly.  The public debt to GDP ratio, which had close to doubled under Reagan and Bush I (from 25% of GDP to 48%), was reduced to 31% of GDP by the year Clinton left office.   But it then started to rise again following the tax cuts of Bush II (plus with the first of the two recessions under Bush II).  And it exploded in 2008/2009, at the end of Bush II and the start of Obama, as the economy plunged into the worst economic downturn since the Great Depression.

The debt to GDP ratio did stabilize, however, in the second Obama term, and actually fell slightly in FY2015 (when the deficit was 2.4% of GDP).  But with the deficits now forecast to rise to the vicinity of 5% of GDP (and to this level even with the assumption that there will not be an economic downturn at some point), the public debt to GDP ratio will soon be approaching 100% of GDP.

This does not have to happen.  As noted above, one need not bring the fiscal deficits all the way down to zero.  A fiscal deficit kept at around 3% of GDP would suffice to stabilize the public debt to GDP ratio, while something less than 3% would bring it down.

D.  Historical Norms

What stands out in these forecasts is how much the deficits anticipated now differ from the historical norms.  The CBO report has data on the deficits going back to FY1968 (fifty years), and these can be used to examine the relationship with unemployment.  As discussed above, one should expect higher deficits during an economic downturn when unemployment is high.  But these deficits then need to be balanced with lower deficits when unemployment is lower (and sufficiently low when the economy is at or near full employment that the public debt to GDP ratio will fall).

A simple scatter-plot of the fiscal balance (where fiscal deficits are a negative balance) versus the unemployment rate, for the period from FY1968 to now and then the CBO forecasts to FY2028, shows:

While there is much going on in the economy that affects the fiscal balance, this scatter plot shows a surprisingly consistent relationship between the fiscal balance and the rate of unemployment.  The red line shows what the simple regression line would be for the historical years of FY1968 to FY2016.  The scatter around it is surprisingly tight.  [Technical Note:  The t-statistic is 10.0, where anything greater than 2.0 is traditionally considered significant, and the R-squared is 0.68, which is high for such a scatter plot.]

An interesting finding is that the high deficits in the early Obama years are actually very close to what one would expect given the historical norm, given the unemployment rates Obama faced on taking office and in his first few years in office.  That is, the Obama stimulus programs did not cause the fiscal deficits to grow beyond what would have been expected given what the US has had in the past.  The deficits were high because unemployment was high following the 2008 collapse.

At the other end of the line, one has the fiscal surpluses in the years FY1998 to 2000 at the end of the Clinton presidency.  As noted above, the public debt to GDP ratio stabilized soon after Clinton took office (in part due to the tax increases passed in 1993), with the fiscal deficits reduced to less than 3% of GDP.  Unemployment fell to below 5% by mid-1997 and to a low of 3.8% in mid-2000, as the economy grew well.  By FY1998 the fiscal accounts were in surplus.  And as seen in the scatter plot above, the relationship between unemployment and the fiscal balance was close in those years (FY1998 to 2000) to what one would expect given the historical norms for the US.

But the tax cuts and budget passed by Congress and signed by Trump will now lead the fiscal accounts to a path far from the historical norms.  Instead of a budget surplus (as in the later Clinton years, when the unemployment rate was similar to what the CBO assumes will hold for its scenario), or even a deficit kept to 3% of GDP or less (which would suffice to stabilize the debt to GDP ratio), deficits of 4 1/2 to 5 1/2 % of GDP are foreseen.  The scatter of points for the fiscal deficit vs. unemployment relationship for 2018 to 2028 is in a bunch by itself, down and well to the left of the regression line.  One has not had such deficits in times of full employment since World War II.

E.  Conclusion

Fiscal policy is being mismanaged.  The economy reached full employment by the end of the Obama administration, fiscal deficits had come down, and the public debt to GDP ratio had stabilized.  There was certainly more to be done to bring down the deficit further, and with the aging of the population (retiring baby boomers), government expenditures (for Social Security and especially for Medicare and other health programs) will need to increase in the coming years.  Tax revenues to meet such needs will need to rise.

But the Republican-controlled Congress and Trump pushed through measures that will do the opposite.  Taxes have been cut dramatically (especially for corporations and rich households), while the budget passed in March will raise government spending (especially for the military).  Even assuming the economy will remain at full employment with no downturn over the next decade (which would be unprecedented), fiscal deficits will rise to around 5% of GDP.  As a consequence, the public debt to GDP ratio will rise steadily.

This is unprecedented.  With the economy at full employment, deficits should be reduced, not increased.  They need not go all the way to zero, even though Clinton was able to achieve that.  A fiscal deficit of 3% of GDP (where it was in the latter years of the Obama administration) would stabilize the debt to GDP ratio.  But Congress and Trump pushed through measures to raise the deficit rather than reduce it.

This leaves the economy vulnerable.  There will eventually be another economic downturn.  There always is one, eventually.  The deficit will then soar, as it did in 2008/2009, and remain high until the economy fully recovers.  But there will then be pressure not to allow the debt to rise even further.  This is what happened following the 2010 elections, when the Republicans gained control of the House.  With control over the budget, they were able to cut government spending even though unemployment was still high.  Because of this, the pace of the recovery was slower than it need have been.  While the economy did eventually return to full employment by the end of Obama’s second term, unemployment remained higher than should have been the case for several years as a consequence of the cuts.

At the next downturn, the fiscal accounts will be in a poor position to respond as they need to in a crisis.  Public debt, already high, will soar to unprecedented levels, and there will be arguments from conservatives not to allow the debt to rise even further.  Recovery will then be even more difficult, and many will suffer as a result.