GDP growth rates: The trail of tears
The below graph reflects the ongoing deterioration in the real inflation-adjusted growth rate in the United States. The dotted line captures the trend in inflation-adjusted growth rates in the US (real growth rates). With real growth rates trending from 4.5% to 1.75% per year, it’s easy to see why the US is facing an economic crisis—and in fact a potential large-scale government shutdown. This series examines the specific components of the US economy over time and how each component has contributed to this “surprising” economic decline. Plus, we’ll examine specific economic policy measures, with special attention to tax rates, within the context of the Reagan Era to date, in order to provide investors with a framework for making an informed decision about the growing risks associated with investing in the US equity markets.
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Kudlow, Reagan, and the supply-siders
The first tax act put in place by the Reagan Administration represented a major shift in the economic and political ideological landscape of the US: supply-side economics. David Stockman, the Republican Congressman from Michigan, served as the Director of the Office of Management and Budget (OMB) from 1981 to 1985 under Ronald Reagan. The 1981 tax deal, known as “Kemp-Roth,” was referred to as a “Trojan Horse” by Stockman—with the goal to lower the top tax rate in the US. Essentially, “supply-side economics” was a more media-friendly description of “trickle-down economics.” In his famous interview with the Atlantic Monthly, Stockman commented that “none of us really understands what is going on with these numbers,” (which was used as a subtitle for the article). After being chastised by Ronald Reagan for such supply-side–insensitive remarks, Stockman quit in 1985, deeply troubled by the ballooning federal deficit, and went on to write The Triumph of Politics: Why the Reagan Revolution Failed.
Republican supply-siders versus democratic Keynesians: Two households, both alike in dignity
Stockman’s rebuff of Reaganomics seems to have been related to the rapid growth in government debt that was caused by the Tax Act of 1981. The Office of Tax Analysis estimates four-year average tax revenue loss of 2.89% due to this 1981 act. However, subsequent tax reforms under Reagan add back 1.94% of tax revenues recaptured, for a total net loss of tax revenue of 0.94% of US GDP under all Reagan-era tax reforms. In 1988, US GDP was approximately $5 trillion, so tax revenue impact may approximate $50 billion per year. On the other hand, consider the above graph: real GDP growth rates skyrocketed after this act passed.
Perhaps the stock market crash of 1987 put a temporary damper on this speculative economic momentum. However, the recovery got back on track just as Clinton was entering office—and skyrocketed again after Clinton cut capital gains from 27% to 20% in the Tax Act of 1997. While Stockman didn’t like the growth in the US debt levels, Clinton sure loved the revenue that supply-side economics delivered. As a result, it’s easy to see that, while the Democrats have a point on socially responsible budget commitments such as Obamacare, tax cuts appear to spur economic growth that pay for them. The question this series explores is, are the current levels of taxation, which are low by historical standards, optimal for creating optimal long-term growth?
Kudlow, “Ketchupnomics,” and a pound of flesh
During this time, Larry Kudlow worked as the Associate Director for Economics and Planning for the OMB. Meanwhile, a junior staffer at the Congressional Budget Office (CBO), G. William Hoagland, in an attempt to cut costs for the 1981 Reagan Budget, was apparently charged with the responsibility of squeezing a nickel out of federally subsidized school lunches. While Hoagland angered the meat lobby when he signed off on regulations allowing tofu as a substitute in order to accommodate Asian students, related classifications in the condiment section seemed to have categorized ketchup as a vegetable. The meat lobby jumped on this apparent mean-hearted attempt to cheat the average American student of his or her fair portion of meat, and paraded the classification of ketchup as a vegetable.
In fair Washington, where we lay our scene…
Hoagland had the misfortune of signing off on the new regulations, though apparently denies ever having classified ketchup as a vegetable. However, it’s possible that ketchup could have been classified as a vegetable condiment. Regardless, the media had a heyday with the spin, noting draconian budget cuts with student lunches while Nancy Reagan bought new china for the White House. Ronald Reagan took Hoagland and the CBO to the woodshed. Such is politics.
Kudlow: From ancient grudge break to new mutiny
Conservative commentators, such as Larry Kudlow, can point to the bad economic data as evidence of policy failures on behalf of the Obama Administration. From his perspective, the large-scale spending programs are inconsistent with financial prudence. As Kudlow points out in his article “Government Shutdown. So What?” on Creators.com, “But let me reiterate: Any budget deal should include some clear rules on budget-spending limitation. Several Republican senators, including Bob Corker and Mike Lee, want to limit federal spending as a share of the economy to around 20 percent. Today, it stands at 25 percent. If a proper spending-limit rule were put in place, strict budget-cutting penalties would be automatically triggered when the rule is broken.”
Plus, Kudlow’s views seem to focus on lowering tax rates, especially for the wealthy and large corporations, as the proper supply-side remedy for a weak economy. As Kudlow points out in the National Review, “Obama keeps giving us the same old, same old: End the spending-cut sequester, lower tax deductions, and raise taxes on the rich, all to free up money for infrastructure, green energy, ‘manufacturing innovation initiatives,’ and the teachers’ unions. Of course this would all come on top of Obamacare, which if it doesn’t fall on its own weight, will add so many new taxes and regulations that it will sink the economy even more.” Kudlow’s grudge seems to be that left-wing politicians will not allow the free market economy to perform its proper function. With the threat of default looming, it would appear that the Republican Party has declared mutiny on Captain Obama.
Reich: Where civil blood makes civil hands unclean
On the other hand, commentators such as Robert Reich point to regulatory issues that have led to the 2008 crisis, such as Bank Deregulation post-1994, which created banks that were too big to fail, and had to be bailed out by the public via the $700 billion Troubled Asset Relief plan. Robert Reich made his distrust of financial or banking regulation quite clear as early as 2007 in the Economist’s View in an article titled “When the Bushies Meet With Wall Street, Watch Your Wallets.” The left also has its grudge, as Main Street bailed out Wall Street post-2008 crisis, resulting in growing debt and associated future tax burden, which Main Street is held responsible to pay by the sweat of its brow. Regardless, even the left would have to acknowledge the Clinton Administration’s role in promoting the Community Reinvestment Act (CRA) reforms that contributed to the growth of the subprime housing market. Perhaps financial deregulation was the catalyst that exploited the CRA reforms.
Shutdown investing: Outlook
Should Congress and the President fail to make progress on budget discussions, investors may wish to consider limiting excessive exposure to the US domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by sequester-driven declines in consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution, and consider value and defensive sectors for investment.