The Trump effect: is this time different?

LevyInstituteAn interesting recent paper here from the Levy Economics Institute of Bard College on the prospects for the US economy in the coming years. The authors use their model, which was developed with the late post-Keynesian economist Wynne Godley (one of the few to have predicted the Great Recession), to take stock of the current situation and to discuss alternative future scenarios.

Nikiforos and Zezza argue that the US economy has performed relatively poorly since the Great Recession, and growth outcomes continue to disappoint. Although headline unemployment is relatively low, there remains substantial labour underutilization in the form of ‘marginally attached workers’ and involuntary part-time workers, which when added to the headline rate is known as the U6 measure. The latter is nearly double the headline rate, and helps to explain the continued weakness in wage growth.

The US economy faces three headwinds which continue to constrain growth: income inequality, fiscal conservatism, and the weak performance of net exports (exports minus imports).

Rising income inequality can weaken consumption growth in the absence of an increase in consumer credit by redistributing purchasing power from low-income households with a high propensity to consume, to high-income households, which tend to have a lower propensity to consume. Despite weak wage growth and rising profit flows, private investment spending among firms has recently weakened, indicating that weak consumption may be constraining investment, rather than this being caused by inadequate profits. Prior to the recession, poorer households overcame this constraint via debt-financed consumption, which supported growth for some years, particularly under President Clinton but also under Bush. The subsequent buildup in debt proved unsustainable and since the recession, some degree of deleveraging (reducing debt relative to income) has weakened growth. Despite this, household debt remains at historically high levels.

Secondly, fiscal conservatism has also been a drag on growth in demand. Growth in government expenditure since the end of the recession has to date been negative overall. This is unusual when compared with the record of fiscal policy during recoveries from recessions in previous decades.

Thirdly, after an initial recovery following the recession, export growth has weakened due to the strong dollar and weaker global growth of many of the United States’ trading partners. Real net exports since around the middle of 2014 have not grown at all.

According to official government and IMF forecasts for the US economy, any acceleration in growth will rely on increasing private sector indebtedness or rising real wages. They assume that the impact of fiscal policy and foreign trade performance will not change significantly. If that is the case, faster growth can only come from rising spending by households and firms. Since household balance sheets remain fragile, funding this spending via increased borrowing seems unlikely, and if it did happen, it would set the economy up for a new period of retrenchment leading to economic stagnation, or at worst another financial crisis and recession. Wage growth remains weak, but sustainable growth depends on its improvement.

Can Donald Trump fulfill his campaign promises to make the US (economy) great again? As the authors note, in his campaign he touched on all three of the constraints on growth described above: stagnant incomes among the working class, poor infrastructure which requires public investment, and the drag from the weakening foreign trade performance. But the proposed policies may do little to tackle these issues: largely regressive tax cuts and cuts to social programmes which favour the richest relative to the poorest; and tax-incentives for privately funded infrastructure spending rather than publicly funded investment. Protectionism could provide a temporary boost to demand by restricting imports relative to exports if other countries do not retaliate and the dollar does not rise as a result. But given the highly integrated supply chains which characterise much modern international trade, rising import costs could simply raise the price of exports, with little benefit overall.

Finally, the paper cites the possibility of a sharp decline in the stock market as the “Trump effect” wears off, or as interest rates rise. This could lead to private sector deleveraging and weaker growth or recession, and a much higher government deficit, even as the current account improves due to weaker import growth arising from slowing or falling growth in overall expenditure.

In short, recent optimism about the US economy may be misplaced, and policymakers should be aware of the possible future outcomes. Unless they can act on the three structural constraints cited here, any improvement in performance seems unlikely.

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