In the FT today, Martin Wolf discusses the symbiotic relationship of global creditors and debtors. According to the September 2011 IMF World Economic Outlook, China ran the largest current account surplus in 2007, while the US ran the largest current account deficit (in $). Well, if this creditor-debtor relationship is to become more ‘balanced’, then evidence of success should stem from these two giants.
Progress has been made. The IMF forecasts China’s 2011 current account surplus will be broadly unchanged since 2007 (in levels $). In contrast, the 2011 US current account deficit is expected to have improved by 35% compared to 2007 levels. It’s baby steps toward a more balanced global capital market place. What’s driving this? Primarily the real exchange rate.
The chart below illustrates the real effective exchange rates for China and the US, as measured by a broad set of trading partners and relative inflation. The BIS releases this data. Notably, the Chinese economy experienced real appreciation coincident with US real depreciation (I chose the colors pink and blue for consistency with the ‘baby steps’ theme). Spanning the years 2005 – current, the Chinese yuan appreciated 25% in real and trade-weighted terms, while that of the US dollar depreciated 14%.
This post is the third in a series that looks at the relationship between real economic growth and the top individual marginal tax rate. The first looked at the period from 1901 to 1928, the second from 1929 to 1940. This one will look at the period from 1940 to 1950.
Before I begin, a quick recap… both the 1901 – 1928 period and the 1929 – 1940 [link fixed] failed to show the textbook relationship between taxes and growth. In fact, it seems that for both those periods, there was at least a bit of support for the notion that growth was faster in periods of rising tax rates than in periods when tax rates were coming down. There were also a few other findings that might be surprising – the so-called Roaring 20s were a period in which the economy was often in recession. The New Deal era, on the other hand, coincided with some of the fastest economic growth rates this country has seen since reliable data has been kept. As we will see in this post, the period from 1940 to 1950, encompassing WW2 as well as the immediate post-war recovery, also is subject to a lot of popular misconceptions.
Real GDP figures used in this post come from Bureau of Economic Analysis. Top individual marginal tax rate figures used in this post come from the IRS. As in previous posts, I’m using growth rate from one year to the next (e.g., the 1980 figure shows growth from 1980 to 1981) to avoid “what leads what” questions. If there is a causal relationship between the tax rate and the growth rate, the growth rate from 1980 to 1981 cannot be causing the 1980 tax rate.
The following graph shows the growth rate in real GDP from one year to the next (black line) and the top marginal tax rate (gray bars) for the period from 1940 to 1950.
Finally, in the fourth decade we looked at in this series so far, we see a graph that doesn’t contradict textbook economics: growth seems to slow down as tax rates rise, reaching its lowest point (on the graph) when tax rates peaked. Then, after tax rates begin to fall, growth picks up again. So why do we see this negative correlation between tax rates and subsequent growth rates during the 1940 to 1950 period when we saw the opposite in the previous periods?
Well, as I’ve pointed out many times in the past, there is a quadratic relationship between tax rates and subsequent growth rates (kind of like the Laffer curve, but with real GDP growth taking the place of tax collections), and the fastest growth tends to occur when the top marginal rate is somewhere around 65%. (At this juncture I have to point out things can be true whether we like them or not. If you’re looking for a micro-foundations reason why raising tax rates can create faster economic growth, try this.)
In any case, tax rates in 1940 were at 79%, and they reached a high of 94% in 1944 and 1945. Clearly, at 79% the top marginal tax rates were already above optimum, and raising them simply moved them even farther away from the optimum growth rate. Conversely, cutting tax rates down to the low 80% following the end of WW2 moved tax rates closer to optimum.
But growth does not live by tax rates alone and the graph above hints at a few other misconceptions. Let’s start with a big one shared by folks on the left and the right, namely that World War 2 led to faster economic growth. In fact, many folks go so far as to say the economy suffered very slow growth until the outbreak of WW2, which as we saw in the last post in the series, is a comical claim. The graph below shows growth rates from 1938 to 1944. (Remember – for our purposes, growth is from t to t+1… thus, growth in 1938 is the percentage change between the 1938 real GDP and the 1939 real GDP.) As with Figure 2 in the previous post, the best ever year of the Reagan administration is also included for comparison purposes.
Notice… growth was already fairly quick from 1938 to 1939, and from 1939 to 1940… and then it really jumped from 1940 to 1941. Pearl Harbor was December 7, 1941, so most of that latter jump came before the American entry into the war. Now, one might say that somewhere around 1938 was the beginning of US involvement in WW2, what with Liberty Ships and the Arsenal of Democracy and all. Put another way, that big jump in growth came before the US was in the war, but as an administration whose policies had already generated several years of very rapid growth since 1933 took an increasing role in the economy. Apparently the economic policies followed were good enough to overcome even tax rates that were significantly above optimum.
Growth peaked between 1941 and 1942 and then began to shrink. In part, as we saw, that was because tax rates got too far above optimum. In part, on the other hand, it is because too much of the country’s labor pool was shipped abroad to fight in the war. But regardless… if the war had been a catalyst for jumpstarting the economy, the peak would not have occurred when it did… and growth would not have started accelerating so many years before the country’s entry into the war..
There’s one more myth that is worth tackling. That myth is that there was some sort of stupendous economic boom following WW2. And it only makes sense that there would be such a boom – the GIs came home, tax rates were cut in 1946 and again in 1948, government spending dropped, and rationing and price controls went by the wayside. And as Figure 1 shows, real GDP had a post-war nadir (I always wanted to use that word!!!) in 1947, and recovered after that. But it is important to put that recovery into context.
The graph below shows the rate of growth from 1947 (the bottom) to 1950 – the post-war miracle, as it were – and it compares it to the rate of growth from 1933 (the bottom of the Great Depression) to 1936, the heart of the New Deal.
As Figure 3 shows, there really is no comparison between the two recoveries. Whereas during the post war recovery, the economy grew almost 13% over three years following the bottom, it grew almost three times faster following the bottom in 1933. And from the previous post, we saw what happened during the rest of the 1930s. We’ll see what followed the post-War recovery in the next post on this series.
As always, if you want my spreadsheets, drop me a line. I’m at my first name which is mike and a period and my last name which is kimel at gmail period com.
Readers here will know more about the US federal government income statement than I. However, given the near ubiquitous deficit hysteria, I wanted to illustrate the truth about the budget deficit. The truth is, that deficit hysteria has been set in motion by A surge in government spending on items like unemployment compensation, food stamps, and other types of ‘support payments to persons for whom no current service is rendered’ AND low tax receipts. Yes, long-term reform is needed; but my general conclusion is that the deficit hysteria is sorely misplaced.
First things first, the fiscal deficit – receipts minus net outlays as a % of GDP – is big. In June 2011, the 12-month rolling sum of net receipts (the budget deficit) was roughly 8.5% of a rolling average of GDP. This is down from its 10.6% peak in February 2010, but the level of deficit spending clearly makes some nervous.
Why should they be nervous about the ‘level’ of the deficit? I don’t know, since recent ‘excess’ deficits are cyclically endogenous. The chart below illustrates the spending and tax receipt components of the US Treasury’s net borrowing (see Table 9 of the Monthly Treasury Statement). Weak tax receipts and big spending are driving the federal deficits (spending, as we will see below, has surged on items directly related to the business cycle).
READ MORE AFTER THE JUMP! In June, the 12-month rolling sum of tax receipts – mostly corporate and individual income taxes and social insurance and retirement receipts – was 15.6%, which is up from its 14.5% cyclical low in January 2010. On the spending side, net outlays in June 2010 were a large 24.2% of GDP and down just slightly from the 25.3% peak in February 2010.
Deficit hysteria should be more appropriately placed as “lack of jobs and tax receipts hysteria”. At this point, the budget could just as easily worsen as it could improve, given the fragile state of the US economy (see Tim Duy’s recent post at Economist’s View).
Why the wrong hysteria?
Reason 1. Taxes. Some would love to increase taxes – but the fact of the matter is, that tax receipts remain well below their long-term average of 18% of GDP. Tax receipts will not improve without new jobs since individual income taxes account for near 50% of total receipts.
Reason 2. The spending has been on cyclical items.
The best time to ‘worry’ about government spending is NOT when the economy is barely moving.
The chart below illustrates the big ticket items of the monthly outlays – roughly 87% of total outlays. The broad spending components are listed in Table 9 of the Monthly Treasury Statement. The long-term average shares of total spending are indicated in the legend.
The items health, medicare, and income security (inc security) are all above their respective long-term averages. But spending on income security outlays is the only spending component to have broken its trend, i.e., surge. According to the GAO’s budget glossary (link here, .pdf), this item includes the following cyclical spending:
Support payments (including associated administrative expenses) to persons for whom no current service is rendered. Includes retirement, disability, unemployment, welfare, and similar programs, except for Social Security and income security for veterans, which are in other functions. Also includes the Food Stamp, Special Milk, and Child Nutrition programs (whether the benefits are in cash or in kind); both federal and trust fund unemployment compensation and workers’ compensation; public assistance cash payments; benefits to the elderly and to coal miners; and low- and moderate-income housing benefits.
It’s spending on unemployment and food stamps that’s driving spending at the margin.
The same deal exists with the ‘smaller ticket items’. Of these
OK – so deficit hysteria is about, but it’s misplaced. One could argue for more, not less, spending to get the jobs growth, hence tax receipts, up.
The chart illustrates the contribution to Y/Y GDI growth coming from each of the main income components. (Click to enlarge.)The series is deflated using the GDP deflator, since the BEA only releases the nominal numbers. All references to GDP and GDI below refer to the real series.
Observations I note:
1. The Y/Y growth rate of GDI surpassed that of GDP in Q2 2010, continuing into Q3 2010. In Q3 2010, GDI grew at a 3.6% annual clip, while GDP marked a lesser 3.2% rate. Don’t know what this means, exactly; but it could imply that the economy is expanding more rapidly than the GDP measure would suggest.
(more after the jump)
2. The Q3 2010 corporate profit contribution to annual income growth, 2.2%, is overwhelming that from wages and salary accruals (labor income), 0.73%. This oversized contribution is rather remarkable, given that domestic corporate profits are just 8% of GDI, while that of wages and salaries is 55%. This will probably even out, though, as history shows a more balanced contribution between profits and wages.
3. The chart illustrates the ‘stickiness’ of labor income. The corporate profit contribution turned negative in Q4 2006, while that of wages and accruals turned negative in Q3 2008. That’s a near 2-yr lag from profits to wages. Wages are recovering now; but there will be further quarters of weak wage growth relative to profits, as claims remain elevated above the 350k mark.
4. The contribution to GDI growth from net interest payments is in negative territory. Low rates are dragging this component.
5. Supplements to wages and salaries – government transfer payments like unemployment insurance, for example – contributed 0.3% to annual GDI growth in Q3 2010. Interesting thing about this, is that the average contribution spanning the 2000-2004 period, 0.5%, outweighs that during the 2005-2010 period, 0.14%. I say interesting because the labor decline was far deeper in this cycle compared to the previous cycle. (See Calculated Risk chart from 12.3.2010)
Overall, the GDI report implies that the economy may be improving more quickly than the GDP report suggests. There’s plenty of room for improvement in this picture, however, as the labor wages remain stuck in the mud with corporate profits strong.
Tomorrow we’ll see the Q4 2010 GDP report – consensus forecast is for 3.5% Q/Q SAAR.
Even though Europe is on the forefront of global bond news these days, I’d like to revisit the US Treasury market. Specifically, I’ll look at the Canadian-US bond spreads, which tell an interesting tale of Fed purchases and US deficit fears.
First, the Canadian over US government bond spreads for two longer term issues, 10yr and 30yr in chart below, have been falling for some time. Today (Jan. 10, 2011), the 10-yr Canadian Treasury over the 10-yr Treasury spread is around -12 basis points (bps), i.e., the Canadian 10-yr bond is 12 bps lower than the US 10-yr. The 30-yr spread is roughly -86 bps.
The recent divergence of the ‘spread’ between these two spreads presents a bit of a conundrum, since the two have more or less moved in lockstep.
Note: in the chart above, each dotted line represents the period average for the 30 calendar day (30-c.day) moving average spread of similar color.
The conundrum is this: the 30-yr spread has deviated well below its 2002-2011 average of 8 bps, while the 10-yr spread is sitting roughly at its average, -13 bps. But this is not a conundrum if you consider recent US policy, holding all else equal.
One the one hand, the Federal Reserve is concentrating its bond purchases in the long end of the curve, primarily below the 10-yr maturity. According to the NY Fed, 23% of the $600 bn will be allocated to the 7yr-10yr part of the curve, while just 4% will support the 17yr-30yr end. Therefore, and holding all else equal, the CAN-US spread proxies somewhat the effects of Fed policy in the bond market. The Fed is supporting the 10-yr spread roughly at trend(Section II in chart above), while contemporaneously raising inflation expectations relative to that in Canada.
On the other hand, without Fed support the 30-yr spread is pricing in not only rising inflation expectations but also an increasing US sovereign risk premium relative to that in Canada. This is a similar premium that was attached to Canadian sovereign debt in the early- to mid- 1990s (Section I in the chart above).
Compare the chart below, which illustrates the annual federal deficit in the two countries as a percentage of GDP, to the chart above. Notice how when the red line, (Canadian government deficit) moves aboe the blue line (US government deficit), the average spread drops (Section III in first chart)? That premium is now feeding into the 30-yr spread at an increasing rate (Section II of first chart).
I am in no way suggesting that the US should undergo a similar fiscal austertiy program as that taken in Canada in 1995 (please see Stephen Gordon at Worthwhile Canadian Initiative). What I am demonstrating, though – and rather qualitatively, I might add – is that absent active Fed purchases in the back end of the curve, there is a risk premium emerging in the US bond market relative to that of at least one country with markedly lower government deficits, all else equal, of course.
Tim Geithner’s extraordinary denial that the US is deliberately weakening its currency is a reminder that the [Hong Kong Monetary Authority] should no longer talk blithely of the “unparalleled credibility” of US monetary policy.
Today Statistics Canada released impressive June employment figures from its Labour Force Survey (LFS). In case you missed it, the April gains, +109,000 new jobs, set a record. And the June gains, +93,000, were nearly as spectacular. (Note: the unemployment rate for Canada in the chart to the left is through May, not June)
Canada’s labor market bounced back fully and then some. Spanning May 2008, when job loss became the norm as the global credit crunch started to take hold, to December 2009, 259k jobs were lost. However, this year through June 2010, the labour market added back 308k jobs, which is +50k new jobs during the expansion or roughly +500k in “US”.
I’m afraid that the US labour market is a far different story. To regain employment lost since June 2008, 6.9 MILLION jobs need to be added back to the employment figures of the current population survey.
I digress. Every time I hear the Canadian statistics, I immediately multiply the statistic by 10 to control for the population differential; thus, +109,000 new jobs in Canada would be equivalent to roughly +1,090,000 in the US, all else equal. In translating the job gains into “U.S”, I understand the magnitude with more clarity – not very different form learning a new language by translating the words in your head.
Is +50k Canadian still equivalent (roughly) to +500k US? The short answer is pretty much – the 2009 US/CAN relative population was just over 9; but in thinking about relative population figures, I stumbled upon a rather remarkable relative employment figure between the US and Canada. The Canadian employment picture has become much much brighter than that in the US over the last decade.
The chart illustrates US employment relative to that in Canada, Germany, and Japan (Germany and Japan are there for comparison). As you can see, employment in the US relative to our neighbor to the North has dropped markedly. There is a secular downward trend in US employment relative to that in Canada.
And it’s not just a population issue. On a population-adjusted basis, the employment figures in Germany, Canada, and Japan are trending upward relative to that in the US – and for Canada, this is a secular trend rather than a cyclical phenomenon.
The US employment picture is fading compared to other developed nations. And remember, Japan and Germany saw near-zero annual population growth spanning the years 2000-2009.
Households in the US and the UK are members of the “most levered club”. But put their balance sheets side-by-side, and the outlook for the US economy looks a little brighter than that for the UK. Why? Both are dropping debt burden, but a qualitative analysis suggests that the UK household leverage (probably) should be falling at a more accelerated pace.
The chart illustrates leverage in the US and UK, or household debt (loans) as a percentage of disposable income (DPI) through Q3 2009 and Q2 2009, respectively (the UK releases Q3 Economic Accounts at the end of December). By Q2 2009, UK and US households dropped leverage rather coincidentally, -4.8% and -4.4%, respectively. However, the debt bubble was bigger in the UK than in the US, peaking at 160% of DPI compared to 131% in the US. Why isn’t leverage falling more quickly? Spending.
To be fair, UK Q3 statistics may paint a very different picture. However, that is unlikely, given that real retail sales continue to grow, 3.2% at an annualized rate in the three months ending in October.
Oh, it all makes sense now: UK retail sales remained firm in 2009, and real home values hit a (probably local rather than global) cyclical low much earlier than in the US.
This is an ominous sign for the UK economy. Households are kicking the can down the road: de-leveraging – paying down debt by dropping consumption and saving a relatively higher share of income – is inevitable.
China exported its way to a $2 trillion dollar fortress of F/X reserves ($USD mostly), while the US borrowed its way into a hole deep enough to spark a vast global recession. Who’s to blame?
Given the symbiotic relationship in the chart above, it’s hard to blame any one individual, group, or even country. But blame we do. Martin Wolf, at the Financial Times, wrote an interesting article about the need for a “co-operative adjustment” of global current account deficits and surpluses. He argues the following:
China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.
It sounds so imminent: re-balance now, or else. Sure the tides of portfolio flows must change; structural current account imbalances are now proven to cause economic catastrophe, as illustrated by the 2-yr case study of late. But it’s not going to happen over night. It takes a long time for re-balancing of any kind to fully pass through. Just look at Japan in the 1990’s.
Data note: you can download Japan Flow of Funds data here, and US Flow of Funds data here.
The chart above illustrates the debt bubbles in the US financial crisis and in 1990’s Japan. In Japan, the households didn’t accumulate as much debt relative to the non-financial business sector; however, both sectors dropped leverage. And notice, that it took about a decade for households and firms to do so.
What’s overly obvious is that the Chinese will not be bullied into revaluing the yuan just because the US says so. And also evident is that there is a (very lengthy) de-leveraging process underway in key economies. By default, the debt-reducing developed world will force the Chinese to focus policy more inward (domestic demand) and less outward (export demand), as US consumers drop debt levels. But sit back and relax, it’s gonna be a while.