November 18, 2014—I’d like to carry on the theme from my recent article “Interest Rates Cannot Rise – Here’s Why” that garnered some discussion around the financial blog universe. I’m going to show that GDP is also in a trap of decelerating growth although I will state that unlike interest rates the prognosis is treatable for GDP.
However, it will require the Fed to admit its failure and for the government to pull its Keynesian head out of its aristocratic ass. Specifically, the Fed needs to end its market manipulation and corporate tax rates need to come down significantly in addition to offering incentives for hiring and fixed capital investment here in the US.
Let me start by showing that GDP growth has been decelerating for as long as many of us have been alive. If you can remember back to your calculus classes you’d see deceleration of GDP growth as the second derivative of the GDP function. Let’s see what this looks like in practice on the following chart (the data was exported from St. Louis Fed’s Fred in order to show the trend line).
I know many of you are already shouting, “of course, as the size of the economy grows it will naturally grow slower.” And while that sounds good it doesn’t pass the smell test. And by smell test I mean that’s BS.
I will grant that emerging from a developing economy to a full on modern industrialized economy there will be a shift from grand acceleration to moderate acceleration and thus some deceleration will naturally take place prior to settling in at a moderate but consistent level of growth. And 150 years on since the beginning of the second industrial revolution we are well past the point of settling in. Ok let’s move on to more interesting tidbits.
If we look at just the past 6 years we are beginning to realize that no matter how much money is injected into the system or how cheap borrowing costs are GDP does not seem to respond. Today I want to really dig into this issue and show why GDP growth is so anemic and unresponsive to loose monetary policy. If you listen to the hype about the economy one of the predominant arguments that we are headed in the right direction is that total earnings (income) are at all time highs.
This is a classic fallacy of affirming the consequent. Economic growth isn’t a function of earnings but a function of expenditures. And although we’ve been taught that these equate when it comes to GDP, it is not the case. The key difference between expenditure and income is their marginal utility. Our marginal utility of income is much higher than our marginal utility of expenditures.
So producers will continue to generate more profits far longer than they will continue to spend more profits. And so while GDP growth is a function of expenditures, expenditures is a function of both total earnings and earnings distribution. For expenditures to grow it may or may not be sufficient to have total earnings growth.
And I would suggest that we are currently in a scenario where total income growth has very little impact on economic growth due to a severe narrowing of income distribution. And so the argument that the economy is strong because total income continues to grow is a fallacy (and nonsensical given GDP growth rates). What has become necessary is an expansion of income distribution.
Let’s have a look at the heart of the problem. The following chart depicts the U3 unemployment rate (red line), the U6 unemployment rate (green line) and the differential between them (blue line). You can see the green line is actually higher than it has been since the early 1990s. This line represents what I call true unemployment. It takes into account those who have dropped out of the labour force and those who are working part time because they cannot find full time work.
The red line which is the U3 unemployment figure and the one you hear about when people generally talk about unemployment does not differentiate for people who replaced full time work with part time work and does not account for those who simply gave up looking for work because they could not find anything.
And so it becomes clear that, despite all the cheers of a fully recuperated job market, the state of employment in the US is actually quite dire relative to the past 25 years. I will show that the cause of such an ominous employment landscape is a misallocation of investment funds and the implications manifest as inadequate demand resulting in economic contraction.
If we look at median household incomes we find they have been declining for 15 years. So while total income has been growing, distribution of income has been narrowing. Today’s demand void is due to narrowing income distribution. That is, fewer people are receiving more of the bigger pie. Due to diminishing marginal utility of expenditures, less and less total income is being allocated or spent in a way the generates economic growth.
Those who are enjoying the lion’s share of the increasing total income, both corporates and individuals, are allocating it to financial investments which provide very little economic growth. The following chart depicts the reallocation of corporate earnings from effective economic assets to ineffective financial assets, a process that leads to a narrowing of income distribution (which I prove in an earlier article I wrote for Ron Paul’s Voices of Liberty that was reposted to ZH).
The chart simply shows that since 2000 corporate earnings are being reallocated from fixed capital investments (which widen income distribution) into financial investments via dividend payouts (which narrow income distribution).
The next chart shows that a decline in real median incomes (narrowing distribution) leads to a decline in total real expenditures despite all time high earnings. It also shows that money velocity is plummeting which is a function of requiring ever more debt (made available through increased money supply) to simply support the current menial economic growth rate.
Note that despite the pundits raving about highest ever total earnings, the growth rates for real median incomes (green line) and real personal consumption (red line) have been declining since around 1998 when they peaked (note that regressing these relationships we find statistical significance and explanatory power).
This is perfectly supportive of our proposition that strong total income growth does not equate to a strong economy. The growth rate of consumption has fallen from around 4 percent in 1998 to about 1.3 percent today. Prior to 2000 the base level growth for consumption was around 3 percent so we are less than half the base level growth rate from just 20 years ago. I won’t dig too deep into here but do be cognizant of the role that official inflation rate plays on these trends.
If we were to use the original CPI from the early 80’s or the second CPI from the 90’s we would see a much steeper decline in incomes, expenditures and GDP. And while you can fudge the official number you cannot fudge the economic impact so the real implication is likely much worse than even what these charts depict. And because of this we require ever increasing amounts of debt to support the resulting demand void from the narrowing income distribution, which is what we see happening today.
However, because debt consumption (consumption from borrowed funds) only replaces either current or future consumption it is not a true growth factor. Remember debt consumption is very different from debt investment as it has no return but does have a service which detracts from current and future consumption. Essentially by filling the demand void today with debt consumption you simply create a wider void tomorrow that must be made up with even more debt than today. This becomes evident in the next chart. Household debt is 150% higher than it was just 15 years ago when income distribution started narrowing significantly.
While this period depicts a huge increase in household debt to bolster spending (made available by excessive money printing) it also has the sharpest deceleration of GDP growth (refer to the first chart above). Now let’s look at the ‘growth’ we’ve had since 2008. Much of the growth we’ve seen has come by way of increases to consumer debt or social assistance (both which show up in consumption) as evidenced in the next chart.
Here I’ve charted just change in student loans + change in auto loans + change in government transfers and took the summation as a percentage of change in GDP . Here’s what we get (note where GDP growth was negative I defaulted to 100% and where debt growth was negative I defaulted to 0%). The data was sourced from St. Louis Fed’s Fred.
We see how important debt consumption has become to GDP growth. Interestingly even before the last crash in 2008, loans and social assistance were growing as a percent of GDP growth (refer to the blue trend line) which means this phenomenon wasn’t a result of the crash but something else. That something else is the severe narrowing of income distribution that was taking place since the late 1990’s. And if we look since the very bottom of the recession in April 2009 increases in student and auto loans plus increases in social assistance make up about 45% of all GDP growth. That is a significant but not surprising figure. In fact, it was necessary just to maintain the disappointing economic growth we have achieved.
The point is clear when we look again at the first chart. And it is that as bigger pieces of the growing pie are being distributed to only those on top (this means both wealth and income) which has been the case for many decades now, we will continue to see a deceleration in GDP growth and at some point a steady contraction of GDP as we’re seeing in incomes. Extrapolating from the first chart above it will be in 2023 when our trend line hits 0 percent. So the point is that while we hear lots of moral and ethical arguments about income inequality (a term I hate by the way because many people deserve to get less), morality and ethics are irrelevant to the real problem.
The crux of the matter is not a moral or ethical one but one of mathematics. There is a critical point of income distribution below which, economic growth becomes impossible regardless of the amount of money injections or duration of costless borrowing. The economy then requires endless additions to household debt (eventually leading to another period of mass defaults) and Federal debt as government spending must make up the shortfall. A clear, very recent example of this was in Q3 GDP. The boys in DC went full retard on ISIS in order to get public support to spend an additional $30 billion on defense just in the nick of time to meet Q3 GDP estimates (without which we would have come in .2% below consensus). However, that too leads down a dangerous road of negative interest rates (as I discussed in “Interest Rates Cannot Rise..”). Narrowing incomes and zero return on savings are destroying this nation from the middle out. I dare say we are getting very close to the edge. Those almighty aristocrats might be wise to put both the righteous and nonsensical banter away for a period whilst finding a solution or even they will suffer, of that I’m certain. For it is gravely difficult to enjoy one’s day with his head on a stick and I expect demand for pitchforks has an inverse relationship to GDP.