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!

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.

Productivity: Do Low Real Wages Explain the Slowdown?

GDP per Worker, 1947Q1 to 2016Q2,rev

A.  Introduction, and the Record on Productivity Growth

There is nothing more important to long term economic growth than the growth in productivity.  And as shown in the chart above, productivity (measured here by real GDP in 2009 dollars per worker employed) is now over $115,000.  This is 2.6 times what it was in 1947 (when it was $44,400 per worker), and largely explains why living standards are higher now than then.  But productivity growth in recent decades has not matched what was achieved between 1947 and the mid-1960s, and there has been an especially sharp slowdown since late 2010.  The question is why?

Productivity is not the whole story; distribution also matters.  And as this blog has discussed before, while all income groups enjoyed similar improvements in their incomes between 1947 and 1980 (with those improvements also similar to the growth in productivity over that period), since then the fruits of economic growth have gone only to the higher income groups, while the real incomes of the bottom 90% have stagnated.  The importance of this will be discussed further below.  But for the moment, we will concentrate on overall productivity, and what has happened to it especially in recent years.

As noted, the overall growth in productivity since 1947 has been huge.  The chart above is calculated from data reported by the BEA (for GDP) and the BLS (for employment).  It is productivity at its most basic:  Output per person employed.  Note that there are other, more elaborate, measures of productivity one might often see, which seek to control, for example, for the level of capital or for the education structure of the labor force.  But for this post, we will focus simply on output per person employed.

(Technical Note on the Data: The most reliable data on employment comes from the CES survey of employers of the BLS, but this survey excludes farm employment.  However, this exclusion is small and will not have a significant impact on the growth rates.  Total employment in agriculture, forestry, fishing, and hunting, which is broader than farm employment only, accounts for only 1.4% of total employment, and this sector is 1.2% of GDP.)

While the overall rise in productivity since 1947 has been huge, the pace of productivity growth was not always the same.  There have been year-to-year fluctuations, not surprisingly, but these even out over time and are not significant. There are also somewhat longer term fluctuations tied to the business cycle, and these can be significant on time scales of a decade or so.  Productivity growth slows in the later phases of a business expansion, and may well fall as an economic downturn starts to develop.  But once well into a downturn, with businesses laying off workers rapidly (with the least productive workers the most likely to be laid off first), one will often see productivity (of those still employed) rise.  And it will then rise further in the early stages of an expansion as output grows while new hiring lags.

Setting aside these shorter-term patterns, one can break down productivity growth over the close to 70 year period here into three major sub-periods.  Between the first quarter of 1947 and the first quarter of 1966, productivity rose at a 2.2% annual pace.  There was then a slowdown, for reasons that are not fully clear and which economists still debate, to just a 0.4% pace between the first quarter of 1966 and the first quarter of 1982.  The pace of productivity growth then rose again, to 1.4% a year between the first quarter of 1982 and the second quarter of 2016.  But this was well less than the 2.2% pace the US enjoyed before.

An important question is why did productivity growth slow from a 2.2% pace between the late 1940s and mid-1960s, to a 1.4% pace since 1982.  Such a slowdown, if sustained, might not appear like much, but the impact would in fact be significant.  Over a 50 year period, for example, real output per worker would be 50% higher with growth at a 2.2% than it would be with growth at a 1.4% pace.

There is also an important question of whether productivity growth has slowed even further in recent years.  This might well still be a business cycle effect, as the economy has recovered from the 2008/09 downturn but only slowly (due to the fiscal drag from cuts in government spending).  The pace of productivity growth has been especially slow since late 2010, as is clear by blowing up the chart from above to focus on the period since 2000:

GDP per Worker, 2000Q1 to 2016Q2,rev

Productivity has increased at a rate of just 0.13% a year since late 2010.  This is slow, and a real problem if it continues.  I would hasten to add that the period here (5 1/2 years) is still too short to say with any certainty whether this will remain an issue.  There have been similar multi-year periods since 1947 when the pace of productivity growth appeared to slow, and then bounced back.  Indeed, as seen in the chart above, one would have found a similar pattern had one looked back in early 2009, with a slow pace of productivity growth observed from about 2005.

There has been a good deal of work done by excellent economists on why productivity growth has been what it was, and what it might be in the future.  But there is no consensus.  Robert J. Gordon of Northwestern University, considered by many to be the “dean in the field”, takes a pessimistic view on the prospects in his recently published magnum opus “The Rise and Fall of American Growth”.  Erik Brynjolfsson and Andrew McAfee of MIT, in contrast, argue for a more optimistic view in their recent work “The Second Machine Age” (although “optimistic” might not be the right word because of their concern for the implication of this for jobs).  They see productivity growth progressing rapidly, if not accelerating.

But such explanations are focused on possible productivity growth as dictated by what is possible technologically.  A separate factor, I would argue, is whether investment in fact takes place that makes use of the technology that is available.  And this may well be a dominant consideration when examining the change in productivity over the short and medium terms.  A technology is irrelevant if it is not incorporated into the actual production process.  And it is only incorporated into the production process via investment.

To understand productivity growth, and why it has fallen in recent decades and perhaps especially so in recent years, one must therefore also look at the investment taking place, and why it is what it is.  The rest of this blog post will do that.

B.  The Slowdown in the Pace of Investment

The first point to note is that net investment (i.e. after depreciation) has been falling in recent decades when expressed as a share of GDP, with this true for both private and public investment:

Domestic Fixed Investment, Total, Public, and Private, Net, percentage of GDP, 1951 to 2015, updated Aug 16, 2016

Total net investment has been on a clear downward trend since the mid-1960s.  Private net investment has been volatile, falling sharply with the onset of an economic downturn and then recovering.  But since the late 1970s its trend has also clearly been downward. Net private investment has been less than 3 1/2% of GDP in recent years, or less than half what it averaged between 1951 and 1980 (of over 7% of GDP).  And net public investment, while less volatile, has plummeted over time.  It averaged 3.1% of GDP between 1951 and 1968, but is only 0.5% of GDP now (as of 2015), or less than one-sixth of what it was before.

With falling net investment, the rates of growth of public and private capital stocks (fixed assets) have fallen (where 2014 is the most recent year for which the BEA has released such data):

Rate of Growth In Per Capita Net Stock of Private and Government Fixed Assets, edited, 1951 to 2014

Indeed, expressed in per capita terms, the stock of public capital is now falling.  The decrepit state of our highways, bridges, and other public infrastructure should not be a surprise.  And the stock of private capital fell each year between 2009 and 2011, with some recovery since but still at almost record low growth.

Even setting aside the recent low (or even negative) figures, the trend in the pace of growth for both public and private capital has declined since the mid-1960s.  Why might this be?

C.  Why Has Investment Slowed?

The answer is simple and clear for pubic capital.  Conservative politicians, in both the US Congress and in many states, have forced cuts in public investment over the years to the current low levels.  For whatever reasons, whether ideological or something else, conservative politicians have insisted on cutting or even blocking much of what the United States used to invest in publicly.

Yet public, like private, investment is important to productivity.  It is not only commuters trying to get to work who spend time in traffic jams from inadequate roads, and hence face work days of not 8 1/2 hours, but rather 10 or 11 or even 12 hours (with consequent adverse impacts on their productivity).  It affects also truck drivers and repairmen, who can accomplish less on their jobs due to time spent in jams.  Or, as a consequence of inadequate public investment in computer technology, a greater number of public sector workers are required than otherwise, in jobs ranging from issuing driver’s licenses to enrolling people in Medicare.  Inadequate public investment can hold back economic productivity in many ways.

The reasons behind the fall in private investment are less obvious, but more interesting. An obvious possible cause to check is whether private profitability has fallen.  If it has, then a reduction in private investment relative to output would not be a surprise.  But this has in fact not been the case:

Rate of Return on Produced Assets, 1951 to 2015, updated

The nominal rate of return on private investment has not only been high, but also surprisingly steady over the years.  Profits are defined here as the net operating surplus of all private entities, and is taken from the national account figures of the BEA.  They are then taken as a ratio to the stock of private produced assets (fixed assets plus inventories) as of the beginning of the year.  This rate of return has varied only between 8 and 13% over the period since at least 1951, and over the last several years has been around 11%.

Many might be surprised by both this high level of profitability and its lack of volatility.  I was.  But it should be noted that the measure of profitability here, net operating surplus, is a broad measure of all the returns to capital.  It includes not only corporate profitability, but also profits of unincorporated businesses, payments of interest (on borrowed capital), and payments of rents (as on buildings). That is, this is the return on all forms of private productive capital in the economy.

The real rates of return have been more volatile, and were especially low between 1974 and 1983, when inflation was high.  They are measured here by adjusting the nominal returns for inflation, using the GDP deflator as the measure for inflation.  But this real rate of return was a good 9.6% in 2015.  That is high for a real rate of return.  It was higher than that only for one year late in the Clinton administration, and for several years between the early 1950s and the mid-1960s.  But it was never higher than 11%.  The current real rate of return on private capital is far from low.

Why then has private investment slowed, in relation to output, if profitability is as high now as it has ever been since the 1950s?  One could conceive of several possible reasons. They include:

a)  Along the lines of what Robert Gordon has argued, perhaps the underlying pace of technological progress has slowed, and thus there is less of an incentive to undertake new investments (since the returns to replacing old capital with new capital will be less).  The rate of growth of capital then slows, and this keeps up profitability (as the capital becomes more scarce relative to output) even as the attractiveness of new investment diminishes.

b)  Conservatives might argue that the reduced pace of investment could be due to increased governmental regulations, which makes investment more difficult and raises its cost.  This might be difficult to reconcile with the rate of return on capital nonetheless remaining high, but in principle could be if one argues that the slower pace of new investment keeps up profitability as capital then becomes more scarce relative to output. But note that this argument would require that the increased burden of regulation began during the Reagan years in the early 1980s (when the share of private investment in GDP first started to slow – see the chart above), and built up steadily since then through both Republican and Democratic administrations.  It would not be something that started only recently under Obama.

c)  One could also argue that the reduced investment might be a consequence of “Baumol’s Cost Disease”.  This was discussed in earlier posts on this blog, both for overall government spending and for government investment in infrastructure specifically.  As discussed in those posts, Baumol’s Cost Disease explains why activities where productivity growth may be relatively more difficult to achieve than in other activities, will see their relative costs increase over time.  Construction is an example, where productivity growth has been historically more difficult to achieve than has been the case in manufacturing.  Thus the cost of investing, both public and private, relative to the cost of other items will increase over time.  This can then also be a possible explanation of slowing new investment, with that slower investment then keeping profitability up due to increasing scarcity of capital.

One problem with each of the possible explanations described above is that they all depend on capital investments becoming less attractive than before, either due to higher costs or due to reduced prospective return.  If such factors were indeed critical, one would need to take into account also the effect of taxes on investment returns.  And such taxes have been cut sharply over this same period.  As discussed in an earlier blog post, taxes on corporate profits, for example, are taxed now at an effective rate of less than 20%, based on what is actually paid after all the legal deductions and credits are included.  And this tax rate has fallen steadily over time.  The current 20% rate is less than half the effective rate that applied in the 1950s and 1960s, when the effective rate averaged almost 45%.  And the tax rate on long-term capital gains, as would apply to returns on capital to individuals, fell from a peak of just below 40% in the mid-1970s to just 15% following the Bush II tax cuts and to 20% since 2013.

Such sharp cuts in taxes on profits implies that the after-tax rate of return on assets has risen sharply (the before-tax rate of return, shown on the chart above, has been flat).  Yet despite this, private investment has fallen steadily since the early 1980s as a share of GDP.

Such explanations for the reason behind the fall in private investment since the early 1980s are therefore questionable.  However, the purpose of this blog post is not to debate this. Economists are good at coming up with models, possibly convoluted, which can explain things ex post.  Several could apply here.

Rather, I would suggest that there might be an alternative explanation for why private investment has been declining.  While consistent with basic economics, I have not seen it before.  This explanation focuses on the stagnant real wages seen since the early 1980s, and the impact this would have on whether or not to invest.

D.  The Impact of Low Real Wages

Real wages have stagnated in the US since the early 1980s, as has been discussed in earlier posts on this blog (see in particular this post).  The chart below, updated to the most recent figures available, compares the real median wage since 1979 (the earliest year available for this data series) to real GDP per worker employed:

Real GDP per Worker versus Real Median Wage, 1979Q1 to 2016Q2, rev

Real median wages have been flat overall:  Just 3% higher in 2016 than what they were 37 years before.  But real GDP per worker is almost 60% higher over this same period.  This has critically important implications for both private investment and for productivity growth. To sum up in one line the discussion that will follow below, there is less and less reason to invest in new, productivity enhancing, capital, if labor is available at a stagnant real wage that has changed little in 37 years.

Traditional economics, as commonly taught, would find it difficult to explain the observed stagnation in real wages while productivity has risen (even if at a slower pace than before). A core result taught in microeconomics is that in “perfectly competitive” markets, labor will be paid the value of its marginal product.  One would not then see a divergence such as that seen in this chart between growth in productivity and a lack of growth in the real wage.

(The more careful observers among the readers of this post might note that the productivity curve shown here is for average productivity, and not the marginal productivity of an extra worker.  This is true.  Marginal productivity for the economy as a whole cannot be easily observed, nor indeed even be well defined.  However, one should note that the average productivity curve, as shown here, is rising over time.  This can only happen if marginal productivity on new investments are above average productivity at any point in time.  For other reasons, the real average wage would not rise permanently above average productivity (there would be an “adding-up” problem otherwise), but the theory would still predict a rise in the real wage with the increase in observed productivity.)

There are, however, clear reasons why workers might not be paid the value of their marginal product in the real world.  As noted, the theory applies in markets that are assumed to be perfectly competitive, and there are many reasons why this is not the case in the world we live in.  Perfect competition assumes that both parties to the transaction (the workers and employers) have complete information on not only the opportunities available in the market and on the abilities of the individual worker, but also that there are no costs to switching to an alternative worker or employer.  If there is a job on the other side of the country that would pay the individual worker a bit more, then the theory assumes the worker will switch to it.  But there are, of course, significant costs to moving to the other side of the country.  Furthermore, there will be uncertainty on what the abilities of any individual worker will be, so employers will normally seek to keep the workers they already have to fill their needs (as they know what these workers can do), than take a risk on a largely unknown new worker who might be willing to work for a lower wage.

For these and other reasons, labor markets are not perfectly competitive, and one should not then be surprised to find workers are not being paid the value of their marginal product.  But there is also an important factor coming from the macroeconomy. Microeconomics assumes that all resources, including labor resources, are being fully employed.  But unemployment exists and is often substantial.  Additional workers can then be hired at the current wage, without a need for the firm to raise that wage.  And that will hold whether or not the productivity of those workers has risen.

In such an environment, when unemployment is substantial one should not be surprised to find a divergence between growth in productivity and growth in the real wage.  And while there have of course been sharp fluctuations arising from the business cycle in the rate of unemployment from year to year, the simple average in the rate since 1979 has been 6.4%.  This is well in excess of what is normally considered the full employment rate of unemployment (of 5% or less).  Macro policy (both fiscal and monetary) has not done a very good job in most of the years since 1979 in ensuring there is sufficient demand in the aggregate in the economy to allow all workers who want to be employed in fact to be employed.

In such an environment, of workers being available for hire at a stagnant real wage which over time diverges more and more from their productivity, consider the investment decision a private firm faces.  Suppose they see a market opportunity and can sell more. To produce more, they have two options.  They can hire more labor to work with their existing plant and equipment to produce more, or they can invest in new plant and equipment.  If they choose the latter, they can produce more with fewer workers than they would otherwise need at the new level of production.  There will be more output per unit of labor input, or put another way, productivity will rise if the latter option is chosen.

But in an economy where labor is available at a flat real wage that has not changed in decades, the best choice will often simply be to hire more labor.  The labor is cheap.  New investment has a cost, and if the cost of the alternative (hire more labor) is low enough, then it is more profitable for the firm simply to hire more labor.  Productivity in such a case will then not go up, and may indeed even go down.  But this could be the economically wise choice, if labor is cheap enough.

Viewed in this way, one can see that the interpretation of many conservatives on the relationship between productivity growth and the real wage has it backwards.  Real wages have not been stagnant because productivity growth has been slow.  Labor productivity since 1979 has grown by a cumulative 60%, while real median wages have been basically flat.

Rather, the causation may well be going the other way.  Stagnant and low real wages have led to less and less of an incentive for private firms to invest.  And such a cut-back is precisely what we saw in the chart above on private (as well as public) investment as a share of GDP.  With less investment, the pace of productivity growth has then slowed.

As a reflection of this confusion, conservatives have denounced any effort to raise wages, asserting that if this is done, jobs will be lost as firms choose instead to invest and automate.  They assert that raising the minimum wage, which is currently lower in real terms than what it was when Harry Truman was president, would lead to minimum wage workers losing their jobs.  As a former CEO of McDonalds put it in a widely cited news report from last May, a $15 minimum wage would lead to “a job loss like you can’t believe.”   Fast food outlets like McDonalds would then find it better to invest in robotic arms to bag the french fries, he said, rather than hire workers to do this.

This is true.  The confusion comes from the widespread presumption that this is necessarily bad.  Outlets like McDonalds would then require fewer workers, but they would still need workers (including to operate the robotic arms), and those workers would be more productive.  They could be paid more, and would be if the minimum wage is raised.

The error in the argument comes from the presumption that the workers being employed at the current minimum wage of $7.25 an hour do not and can not possess the skills needed to be employed in some other job.  There is no reason to believe this to be the case.  There was no problem with ensuring workers could be fully employed at a minimum wage which in real terms was higher in 1950, when Harry Truman was president, than what it is now.  And average worker productivity is 2.4 times higher now than what it was then.

Ensuring full employment in the economy as a whole is not a responsibility of private business.  Rather, it is a government responsibility.  Fiscal and monetary policy need to be managed so that labor markets are tight enough to ensure all workers who want a job can get a job, while not so tight at to lead to inflation.

Following the economic collapse at the end of the Bush administration in 2008, monetary policy did all it could to try to ensure sufficient aggregate demand in the economy (interest rates were held at or close to zero).  But monetary policy alone will not be enough when the economy collapsed as far as it did in 2008.  It needs to be complemented by supportive fiscal policy.  While there was the initial stimulus package of Obama which was critical to stabilizing the economy, it did not go far enough and was allowed to run out. And government spending from 2010 was then cut, acting as a drag which kept the pace of recovery slow.  The economy has only in the past year returned to close to full employment.  It is not a coincidence that real wages are finally starting to rise (as seen in the chart above).

E.  Conclusion

Productivity growth is key in any economy.  Over the long run, living standards can only improve if productivity does.  Hence there is reason to be concerned with the slower pace of productivity growth seen since the early 1980s, and especially in recent years.

Investment, both public and private, is what leads to productivity growth, but the pace of investment has slowed since the levels seen in the 1950s and 60s.  The cause of the decline in public investment is clear:  Conservative politicians have slowed or even blocked public investment.  The result is obvious in our public infrastructure:  It is overused, under-maintained, and often an embarrassment.

The cause of the slowdown in private investment is less obvious, but equally important. First, one cannot blame a decline in private investment on a fall in profitability:  Profitability is higher now than it has been in all but one year since the mid-1960s.

Rather, one needs to recognize that the incentive to invest in productivity enhancing tools will not be there (or not there to the same extent) if labor can be hired at a wage that has stagnated for decades, and which over time became lower and lower relative to existing productivity.  It then makes more sense for firms to hire more workers with their existing stock of capital and other equipment, rather than invest in new, productivity enhancing, capital.  And this is what we have observed:  Workers are being hired, but productivity is not growing.

An argument is often made that if firms did indeed invest in capital and equipment that would raise productivity, that workers would then lose their jobs.  This is actually true by definition:  If productivity is higher, then the firm needs fewer workers per unit of output than they would otherwise.  But whether more workers would be employed in the economy as a whole does not depend on the actions of any individual firm, but rather on whether fiscal and monetary policy is managed to ensure full employment.

That is, it is the investment decisions of private firms which determine whether productivity will grow or not.  It is the macro management decisions of government which determine whether workers will be fully employed or not.

To put this bluntly, and in simplistic “bumper sticker” type terms, one could say that private businesses are not job creators, but rather job destroyers.  And that is fine.  Higher productivity means that a firm needs fewer workers to produce what they make than would otherwise have been needed, and this is important for ensuring efficiency.  As a necessary complement to this, however, it is the actions of government, through its fiscal and monetary policies, which “creates” jobs by managing aggregate demand to ensure all workers who want to be employed, are employed.

The Impact of the Reagan and Bush Tax Cuts: Not a Boost to Employment, nor to Growth, nor to the Fiscal Accounts

Private Employment Following Tax Law Changes

A.  Introduction

The belief that tax cuts will spur growth and new jobs, and indeed even lead to an improvement in the fiscal accounts, remains a firm part of Republican dogma.  The tax plans released by the main Republican presidential candidates this year all presume, for example, that a spectacular jump in growth will keep fiscal deficits from increasing, despite sharp cuts in tax rates.  And conversely, Republican dogma also holds that tax increases will kill growth and thus then lead to a worsening in the fiscal accounts.  The “evidence” cited for these beliefs is the supposed strong recovery of the economy in the 1980s under Reagan.

But the facts do not back this up.  There have been four major rounds of changes in the tax code since Reagan, and one can look at what happened after each.  While it is overly simplistic to assign all of what followed solely to the changes in tax rates, looking at what actually happened will at least allow us to examine the assertion underlying these claims that the Reagan tax cuts led to spectacular growth.

The four major changes in the tax code were the following.  While each of the laws made numerous changes in the tax code, I will focus here on the changes made in the highest marginal rate of tax on income.  The so-called “supply-siders” treat the highest marginal rate to be of fundamental importance since, under their view, this will determine whether individuals will make the effort to work or not, and by how much.  The four episodes were:

a)  The Reagan tax cuts signed into law in August 1981, which took effect starting in 1982. The highest marginal income tax rate was reduced from 70% before to 50% from 1982 onwards.  There was an additional round of tax cuts under a separate law passed in 1986, which brought this rate down further to 38.5% in 1987 and to 28% from 1988 onwards. While this could have been treated as a separate tax change episode, I have left this here as part of the Reagan legacy.  Under the Republican dogma, this should have led to an additional stimulant to growth.  We will see if that was the case.  There was also a more minor change under George H.W. Bush as part of a 1990 budget compromise, which brought the top rate partially back from 28.0% to 31.0% effective in 1991.  While famous as it went against Bush’s “read my lips” pledge, the change was relatively small.

b)  The tax rate increases in the first year of the Clinton presidency.  This was signed into law in August 1993, with the tax rate increases applying in that year.  The top marginal income tax rate was raised to 39.6%.

c)  The tax cuts in the George W. Bush presidency that brought the top rate down from 39.6% to 38.6% in 2002 and to 35.0% in 2003.  The initial law was signed in June 2001, and then an additional act passed in 2003 made further tax cuts and brought forward in time tax cuts being phased in under the 2001 law.

d)  The tax rate increases for those with very high incomes signed into law in December 2012, just after Obama was re-elected, that brought the marginal rate for the highest income earners back to 39.6%.

We therefore have four episodes to look at:  two of tax cuts and two of tax increases.  For each, I will trace what happened from when the tax law changes were signed up to the end of the administration responsible (treating Reagan and Bush I as one).  The questions to address are whether the tax cut episodes led to exceptionally good job growth and GDP growth, while the the tax increases led to exceptionally poor job and GDP growth. We will then look at what happened to the fiscal accounts.

B.  Jobs and GDP Growth Following the Changes in Tax Law

The chart at the top of this post shows what happened to private employment, by calendar quarter relative to a base = 100 for the quarter when the new law was signed. The data is from the Bureau of Labor Statistics (downloaded, for convenience, from FRED).  A chart using total employment would look almost exactly the same (but one could argue that government employment should be excluded as it is driven by other factors).

As the chart shows, private job growth was best following the Clinton and Obama tax increases, was worse under Reagan-Bush I, and abysmal under Bush II.  There is absolutely no indication that big tax cuts, such as those under Reagan and then Bush II, are good for job growth.  I would emphasize that one should not then jump to the conclusion that tax increases are therefore good for job growth.  That would be overly simplistic.  But what the chart does show is that the oft-stated claim by Republican pundits that the Reagan tax cuts were wonderful for job growth simply has no basis in fact.

How about the possible impact on GDP growth?  A similar chart shows (based on BEA data on the GDP accounts):

Real GDP Following Tax Law Changes

Once again, growth was best following the Clinton tax increases.  Under Reagan, GDP growth first fell following the tax cuts being signed into law (as the economy moved down into a recession, which by NBER dating began almost exactly as the Reagan tax cut law was being signed), and then recovered.  But the path never catches up with that followed during the Clinton years.  Indeed after a partial catch-up over the initial three years (12 calendar quarters), the GDP path began to fall steadily behind the pace enjoyed under Clinton.  Higher taxes under Clinton were clearly not a hindrance to growth.

The Bush II and Obama paths are quite similar, even though growth during these Obama years has had to go up against the strong headwinds of fiscal drag from government spending cuts.  Federal government spending on goods and services (from the GDP accounts, with the figures in real, inflation-adjusted, terms) rose at a 4.4% per annum pace during the eight years of the Bush II administration, and rose at a 5.6% rate during Bush’s first term.  Federal government spending since the late 2012 tax increases were signed under Obama have fallen, in contrast, at a 2.8% per annum rate.

There is therefore also no evidence here that tax cuts are especially good for growth and tax increases especially bad for growth.  If anything, the data points the other way.

C.  The Impact on the Fiscal Accounts

The argument of those favoring tax cuts goes beyond the assertion that they will be good for growth in jobs and in GDP.  Some indeed go so far as to assert that the resulting stimulus to growth will be so strong that tax revenues will actually rise as a result, since while the tax rates will be lower, they will be applied against resulting higher incomes and hence “pay for themselves”.  This would be nice, if true.  Something for nothing. Unfortunately, it is a fairy tale.

What happened to federal income taxes following the changes in the tax rates?  Using CBO data on the historical fiscal accounts:

Real Federal Income Tax Revenues Following Tax Law Changes

Federal income tax revenues (in real terms) either fell or at best stagnated following the Reagan and then the Bush II tax cuts.  The revenues rose following the Clinton and Obama tax increases.  The impact is clear.

While one would think this should be obvious, the supply-siders who continue to dominate Republican thinking on these issues assert the opposite has been the case (and would be, going forward).  Indeed, in what must be one of the worst economic forecasts ever made in recent decades by economists (and there have been many bad forecasts), analysts at the Center for Data Analysis at the conservative Heritage Foundation concluded in 2001 that the Bush II tax cuts would lead government to “effectively pay off the publicly held federal debt by FY 2010”.  Publicly held federal debt would fall below 5% of GDP by FY2011 they said, and could not go any lower as some federal debt is needed for purposes such as monetary operations.  But actual publicly held federal debt reached 66% of GDP that year.  That is not a small difference.

Higher tax revenues help then make it possible to bring down the fiscal deficit.  While the deficit will also depend on public spending, a higher revenue base, all else being equal, will lead to a lower deficit.

So what happened to the fiscal deficit following these four episodes of major tax rate changes?  (Note to reader:  A reduction in the fiscal deficit is shown as a positive change in the figure.)

Change in Fiscal Deficit Relative to Base Year Following Tax Law Changes

The deficit as a share of GDP was sharply reduced under Clinton and even more so under Obama.  Indeed, under Clinton the fiscal accounts moved from a deficit of 4.5% of GDP in FY1992 to a surplus of 2.3% of GDP in FY2000, an improvement of close to 7% points of GDP.  And in the period since the tax increases under Obama, the deficit has been reduced by over 4% points of GDP, in just three years.  This has been a very rapid base, faster than that seen even during the Clinton years.  Indeed, the pace of fiscal deficit reduction has been too fast, a consequence of the federal government spending cuts discussed above.  This fiscal drag held back the pace of recovery from the downturn Obama inherited in 2009, but at least the economy has recovered.

In contrast, the fiscal deficit deteriorated sharply following the Reagan tax cuts, and got especially worse following the Bush II tax cuts.  The federal fiscal deficit was 2.5% of GDP in FY1981, when Reagan took office, went as high as 5.9% of GDP in FY1983, and was 4.5% of GDP in FY1992, the last year of Bush I (it was 2.5% of GDP in FY2015 under Obama).  Bush II inherited the Clinton surplus when he took office, but brought this down quickly (on a path initially similar to that seen under Reagan).  The deficit was then 3.1% of GDP in FY2008, the last full year when Bush II was in office, and hit 9.8% of GDP in FY2009 due largely to the collapsing economy (with Bush II in office for the first third of this fiscal year).

Republicans continue to complain of high fiscal deficits under the Democrats.  But the deficits were cut sharply under the Democrats, moving all the way to a substantial surplus under Clinton.  And the FY2015 deficit of 2.5% of GDP under Obama is not only far below the 9.8% deficit of FY2009, the year he took office, but is indeed lower than the deficit was in any year under Reagan and Bush I.  The tax increases signed into law by Clinton and Obama certainly helped this to be achieved.

D.  Conclusion

The still widespread belief among Republicans that tax cuts will spur growth in jobs and in GDP is simply not borne out be the facts.  Growth was better following the tax increases of recent decades than it was following the tax cuts.

I would not conclude from this, however, that tax increases are therefore necessarily good for growth.  The truth is that tax changes such as those examined here simply will not have much of an impact in one direction or the other on jobs and output, especially when a period of several years is considered.  Job and output growth largely depends on other factors.  Changes in marginal income tax rates simply will not matter much if at all. Economic performance was much better under the Clinton and Obama administrations not because they raised income taxes (even though they did), but because these administrations managed better a whole host of factors affecting the economy than was done under Reagan, Bush I, or Bush II.

Where the income tax rates do matter is in how much is collected in income taxes.  When tax rates are raised, more is collected, and when tax rates are cut, less is collected.  This, along with the management of other factors, then led to sharp reductions in the fiscal deficit under Clinton and Obama (and indeed to a significant surplus by the end of the Clinton administration), while fiscal deficits increased under Reagan, Bush I, and Bush II.

Higher tax collections when tax rates go up and lower collections when they go down should not be a surprising finding.  Indeed, it should be obvious.  Yet one still sees, for example in the tax plans issued by the Republican presidential candidates this year, reliance on the belief that a miraculous jump in growth will keep deficits from growing.

There is no evidence that such miracles happen.

Initial Claims for Unemployment Insurance Are at Record Lows

Weekly Initial Claims for Unemployment Insurance, January 7, 2006, to November 21, 2015

Weekly Initial Claims for Unemployment Insurance as a Ratio to Employment, January 1967 to October 2015

 

Initial claims for unemployment insurance are now at their lowest level, in terms of absolute numbers, in forty years, and the lowest ever when measured relative to employment (although the series goes back only to 1967).  There has been a steady improvement in the job market since soon after Barack Obama took office in January 2009, with (as discussed in a recent post on this blog) a steady increase in private sector jobs and an unemployment rate now at just 5.0%.  Yet the general discussion still fails to recognize this.  I will discuss some of the possible reasons for this perception later in this post.

Initial claims for unemployment insurance provides a good measure of the strength of the labor market, as it shows how many workers have been involuntarily laid off from a job and who are then thus eligible for unemployment insurance.  The US Department of Labor reports the figure weekly, where the numbers in the chart above are those updated through the release of November 25, 2015 (with data through November 21).  While there is a good deal of noise in the weekly figures due to various special factors (and hence most of the focus is on the four week moving average), it does provide a high frequency “yardstick” of the state of the labor market.  The charts above are for the four week moving averages.

The measure has been falling steadily (abstracting from the noise) since soon after President Obama took office.  News reports have noted that the weekly figures have been below 300,000 for some time now (close to a year).  This is a good number.  Even in the best year of the Bush administration (2006, at the height of the housing bubble), weekly initial claims for unemployment insurance averaged 312,000.  So far in 2015 (through November 21) it has averaged 279,000, and the lowest figure was just 259,250 for the week of October 24.  Initial claims for unemployment have not been so low in absolute numbers since December 1973.

But the population and labor force have grown over time.  When measured as a ratio to the number of those employed, initial claims for unemployment insurance have never been so low, although the series only begins in January 1967.  It is now well below the lowest points ever reached in the George W. Bush administration, in the Reagan administration, and even in the Clinton administration, under which the economy enjoyed the longest period of economic expansion ever recorded in the US (back to at least 1854, when the recession dating of the NBER begins).

Why then has the job market been seen by many as being especially weak under Obama? It should not be because of the unemployment rate, which has fallen steadily to 5.0% and is now well below where it was at a similar point during the Reagan administration.  Private job creation has also been steady and strong (although government jobs have been cut, for the first time in an economic downturn in at least a half century).  There has also been no increase in the share of part time employment, despite assertions from Republican politicians that Obamacare would have led to this.  And growth in GDP, while it would have been faster without the fiscal drag of government spending cuts seen 2010, has at least been steady.

What has hurt?  While no one can say for sure as the issue is some sense of the general perception of the economy, the steady criticism by Republican officials and pundits has probably been a factor.  The Obama administration has not been good at answering this.

But also important, and substantive, is that wages have remained stagnant.  While this stagnation in wages has been underway since about 1980, increased attention is being paid to it now (which is certainly a good thing).  In part due to this stagnation, the recovery that we have seen in the economy since the trough in mid-2009 has mostly been for the benefit of the very rich.  Professor Emmanuel Saez of UC Berkeley has calculated, based on US tax return data, that the top 1% have captured 58% of US income growth over the period 2009 to 2014.  The top 1% have seen their real incomes rise over this period by a total of 27% in real terms, while the bottom 99% have seen income growth over the period of only 4.3%.  Furthermore, most of this income growth for the bottom 99% only started in 2013.  For the period from 2009 through 2012, the top 1% captured 91% of the growth in national income.  The bottom 99% saw their real incomes rise by only 0.8% total over that period.

The issue then is not really one of jobs or overall growth.  Rather it is primarily a distribution problem.  The recovery has not felt like a recovery not because jobs or growth have been poor (although they would have been better without the fiscal drag), but rather because most of the gains of the growth have accrued to the top 1%.  It has not felt like a recovery for the other 99%, and for an understandable reason.