Long-term trends don’t get the amount of coverage short-term stories do in this 24-hour news cycle we live in because they aren’t as enticing. However, long-term trends generally have a larger impact than short-term ones because they build up over time. Short-term trends are like mini speed boats. Long-term trends are like glaciers which are massive and barely move. The two trends I will discuss in this article are related. They are the trends of rising government debt and declining productivity growth.
In late-March, the Congressional Budget Office (CBO) released its 2017 budget forecast. As you can see in the chart below, the CBO is expecting the debt held by the public as a percentage of GDP to grow to 150%. This chart looks like one created by the doom and gloom websites.
In fact, the government itself is telling the world it is in dire straits. The projections are subject to changes in interest rates, GDP growth, Social Security and healthcare spending.
Here’s what the CBO stated:
Under current law, spending growth—driven by outlays for Social Security, the major health care programs, and net interest—is projected to outpace revenue growth.
There is a greater need than ever before to grow the economy and reform healthcare.
The high level of government debt affects monetary policy. The Federal Reserve holds $4.5 trillion of mortgage and treasury bonds on its balance sheet. If it were to begin to sell these bonds, interest rates would rise, which would then balloon the government deficit even more. The Federal Reserve is supposed to be an apolitical institution. There are always complex effects to Fed policy, but the current scenario is unlike previous ones because of the size of the balance sheet and the debt.
The stock market has been rallying since the 2016 election because of an expected fiscal policy boost which would likely come from deficit spending. This year the Fed is in the midst of potentially raising rates three times, according to rhetoric. Although the Fed raised rates once in 2015 and once in 2016, this is the unofficial start of the tightening cycle. This beginning of the tightening cycle has brought investors and economists to question when the Fed would start selling some of the bonds it bought since the purchases were said to be temporary. In a recent Fed Q and A, Janet Yellen, The Federal Reserve Chairwoman made the point that the Fed wouldn’t be unwinding the balance sheet as part of its rate hike cycle. It’s a possibility the Fed is worried about the ramifications higher interest rates, created by selling the bonds, will have on government deficits which are already high.
As mentioned prior, one of the factors which will determine what the actual future debt and deficits will be is the level of economic growth. As you can see from the chart below, the average annual growth from 2017-2027 is only expected to be 1.8%. That’s a slowdown from the level of growth from 1950-2001. It’s the growth rate the economy saw from 2002 to 2016 which is also when the debt increased. The chart breaks down the two drivers of growth which are growth in the labor force and productivity growth. The short-term economy is also driven by credit growth which is not considered here. When banks are willing to give out loans, growth can exceed the long-term trajectory and when banks are stringent about who they give out loans to, growth declines below the long-term average (recession).
Productivity growth fell 0.2% in 2016. This type of weakness has become the norm, as you can see from the chart below. Exactly what drives productivity growth is not easy to determine. One of the reasons productivity may have increased in the 1990s is because of the advancement of the internet. This is the most optimistic reason since there will likely be another technological breakthrough in the future which could improve productivity. One example of a possible productivity driver would be artificial intelligence. Many see the job-killing nature of artificial intelligence, but this is a faulty way of looking at the economy. Artificial intelligence will lower the cost of goods sold. Lower costs cause lower prices which will give consumers a larger disposable income. This increase in disposable income will increase demand for goods and services in the economy.
The more pessimistic potential reason for the productivity decline is the decline in domestic investment. As you can see in the chart below, domestic investment growth and GDP growth have been highly correlated. The reason this is a more pessimistic outlook is because there has been a long-term decline in domestic investment as a percent of GDP. While artificial intelligence advancements can come from a few firms, an increase in domestic investment would have to come from most firms; it would be a wholesale change in the way they operate. Advancing stock multiples have encouraged firms to buy back their stock instead of investing in new initiatives. Therefore, a decline in stocks may be necessary to get domestic investment higher. Low interest rates have spurred more mergers and acquisitions which do nothing to add to economic growth.
A final potential reason for low productivity growth lately is because businesses may be worried about the mountain of debt consumers have acquired over the past few years. As you can see from the chart below, the total consumer debt is $12.57 trillion. The previous peak of $12.68 trillion in Q3 2008 is about to be surpassed later this year. A consumer products firm who knows the consumer has too much debt may be hesitant to invest in new initiatives. Anytime a metric is comparable is near 2008 levels it is worrisome. The last cycle was driven by housing debt. This debt cycle is being driven by auto loans and student loans.
The government debt is set to explode higher, according to the Congressional Budget Office. As a result, this is effecting how the Federal Reserve decides monetary policy leaving little choice for it to reduce its balance sheet, which means that there is an increased likelihood of policy reversal to further easing in the near future, not tightening. GDP growth is one of the main factors which can make the debt more manageable because it raises the revenue earned from taxes and lowers spending on transfer payments. However, as the people of the United States become more indebted, this reduces their future purchasing power, as a result, naturally providing a negative headwind to GDP growth. The United States has an aging population, and without a secure work environment nor lack of debt, families ability to expand in the form of population growth becomes restrained as a growing number of millennials continue living with their parents into their 20s and 30s. As such, this leaves productivity growth as a key lever to improve the debt situation. Technological advancements, such as those of artificial intelligence could be the savior for the economy, not the enemy. At the end of the day, a car is faster than a horse and buggy.