Sometimes, academic economists are worth paying attention to. A recent paper published by the Hoover Institution provided one of the best summaries we have read of the current state of the U.S. economy, its recent history, its troubles and the reasons behind them, its future prospects, and the policy changes that will be necessary to realize them. Interested readers can find the complete paper here.
The authors include three economists linked to Stanford University and its associated Hoover Institution — Hoover fellow John Cogan, Stanford professor John Taylor, and Hoover fellow and former Fed governor Kevin Warsh — as well as the Dean of Columbia University’s business school, Glenn Hubbard. Warsh and Hubbard have both been mentioned in the press as possible candidates to take over the position of Fed Chair from Janet Yellen in the event that the President does not ask her to serve another term.
The authors take issue with the negative views of those economists who believe that the U.S. is stuck in a secular low-growth trap that can be blamed on intractable social, geopolitical, or demographic causes. Their analysis supports what we have argued for some time: that GDP growth is decisively influenced by capital investment, productivity growth, and labor force participation — and that these factors in turn are profoundly shaped not by nebulous and intractable processes, but by policies. Therefore, policy changes have the potential to reverse negative trends. In short, we are not doomed.
Below, you can see the long-term chart of U.S. productivity growth illustrates the point clearly.
The long cycles visible in these data seem to us — and to the paper’s authors — to correlate pretty clearly with large shifts in U.S. tax and regulatory policy. The nadir now being seen is near the bottom that was seen as the policy milieu of the 70s ran its course and reversed during the Reagan administration.
The authors write:
“Economic theory and historical experience indicate economic policies are the primary cause of both the productivity slowdown and the poorly performing labor market. High marginal tax rates, especially those on capital formation and business enterprises, costly new labor market and other regulations, high debt-financed government spending (largely to fund income transfer payments), and the lack of a clear monetary strategy have discouraged real business investment and reduced both the supply of — and the demand for — labor. The policy changes of the kind proposed by the Congress and the Administration, if enacted, would significantly improve the economy’s growth prospects.”
Chart shows five-year average annual growth rate of BLS business sector output per hourSource: Bureau of Labor Statistics
They make the case, based on an analysis of past trends, that taken together, tax reform, regulatory reform, and entitlement reform would allow the U.S. economy to make another long cyclical turn towards more robust GDP growth — by encouraging capital investment, drawing workers back into the labor force, and reducing the burden of excessive debt. All this in turn would deliver the growth in living standards that middle-class Americans have been missing for the past decade, and that they demanded in the 2016 presidential campaign by voting for insurgent campaigns such as those of Donald Trump and Bernie Sanders.
The critical question is simply whether the new administration can deliver the necessary reforms, or if the inertia of the status quo will prevail and deliver instead the continued anemic growth that the Congressional Budget Office has predicted.
Leaving aside the hyperbole of some of the new administration’s critics, the open question is simply whether it can muster the political skill and political capital necessary — or if the opportunity for reform will be lost. The sharp post-election increase in business and consumer optimism suggested that many Americans believed the new administration’s business experience could translate quickly into political effectiveness. Subsequent events — some directly due to the administration’s failings, others due to intransigent opposition which deems partisan victory more important than the country’s welfare — have called into question the administration’s capacity to move from business sense to political effectiveness.
Perhaps the demise of efforts to repeal and replace the Affordable Care Act will now give the administration the chance to move forward meaningfully on other reform efforts — especially regulation and taxes. In the meantime, markets wait with baited breath.
Investment implications: As much as we prefer to base our market views on economic realities rather than on political prognostications, there’s no way to avoid the current entanglement of economic and political reality. Investors therefore need to keep watching the administration’s progress towards its stated reform goals. We stress that this is not a matter of partisan judgment; it is a matter of assessing prospects for future economic growth in the U.S. — and therefore for future corporate profits and stock-market returns.