Where Goes The Economy?

   I am blessed with a generally positive disposition and that was true of my outlook for the U.S. economy in the coming year. I was, therefore, shaken when I read last week that Nouriel Roubini has predicted that the U.S. is about to fall into a deep recession and that the coming decade will be filled with bankruptcies and economic crises. While Roubini is not the first economist to predict that we are heading into a recession, he’s the first to contend that the economic dangers will be both severe and will stretch well into the future. While some may attribute these dire predictions to his well-known pessimistic outlook (he even characterizes himself as “Dr. Doom”), he’s someone whose views must be taken seriously. He last made the headlines when he was among the first to predict the collapse of the U.S. real estate market and the world-wide recession that ensued. That was in 2006, two years before Lehman Brothers closed and America’s financial system came to a standstill.

   My estimate was that at worst we’re only headed for a relatively mild and short-lived recession. This was based largely upon the fact that the U.S. has positioned itself to make a number of substantial investments that will help assure its future growth. Specifically, the Congress recently enacted badly needed and long overdue legislation to improve the nation’s infrastructure. It also approved investing in high tech industries which will keep the U.S. in the forefront of technological advances. As a nation with a high standard of living and high labor costs, maintaining leadership in the technology sector is, and will continue to be, critical to maintaining a thriving economy. The current administration’s determination to combat climate change has also led to the recent enactment of the Inflation Reduction Act which will help the U.S. regain a leadership position in harnessing renewable energy that will be critical to its economic growth over the next several decades. The Inflation Reduction Act also includes provisions for investments in our nation’s citizens, including programs that will reduce drug prices and expand Medicare benefits.

   Like all developed countries, the U.S. is now experiencing its highest rate of inflation since the early 1980s. This has largely been caused by supply chain disruptions emanating from the Covid pandemic as well as a labor shortage (roughly 11 million unfilled job openings) which has fueled an increase in labor costs with corresponding price increases. A third factor underlying our current rate of inflation is the trillions of dollars dispensed by the federal government during the Covid pandemic to keep the nation’s economy alive. That enabled many Americans to build up their savings which are now being rapidly exhausted. Accordingly, the impact of these three factors should be relatively short-lived allowing inflation to fall to a more sustainable level. Clearly more problematic is the increase of world fuel prices triggered by Russia’s efforts to weaponize its sales of oil and natural gas. That’s because the war in Ukraine could linger on and rising energy prices tend to affect the costs of a broad spectrum of products, including food prices. Therefore, unless the war in Ukraine ends soon, inflationary pressures could continue for some time.

   There’s relatively little our federal government can do to immediately combat inflation other than raise taxes, which currently is an unlikely prospect as it requires the cooperation of the U.S. Congress. Our administration is also not permitted to refuse to spend monies appropriated by Congress, an issue which the Supreme Court resolved during the Nixon administration. As a result, the job of fighting inflation is invariably relegated to the Federal Reserve Board. However, even the Fed has limited powers to fight inflation. It can raise interest rates and it can reduce the nation’s money supply. While these measure can prevent the nation from becoming trapped in an inflationary spiral (when the mere anticipation of rising prices begets further price increases), they are particularly blunt tools which can generate a number of unintended  consequences. Equally important, they tend to have a delayed impact so it’s difficult for the Fed to gauge to what extent and for how long they should be employed. Indeed, a miscalculation could transform an inflationary spiral into a recession. This is the situation the Fed is now facing.

   According to Roubini, thinking that the Fed is navigating our nation’s economy toward a “soft landing” is “delusional.” He asserts that there are just too many structural problems underlying today’s world economy that will result in continued high levels of inflation coupled with slow economic growth, a condition which economists have dubbed “stagflation.” This situation, which last occurred in the late 1970s, may prompt the Fed, as well as other central bankers, to keep interest rates high just as Fed Chairman Paul Volker did in the early 1980s. Those high interest rates, in turn, will force into bankruptcy individuals, companies and nations encumbered by high levels of debt. This prospect now stands as a strong possibility because global private and public debt as a percentage of global GDP has grown from 200% in 1999 to 350% this year.

  It is beyond question that those individuals and entities carrying high levels of indebtedness will be placed in jeopardy as interest rates are raised. It is also clear that inflation will likely spiral upward and out of control if it’s not checked now by increasing interest rates and tightening money supplies. This leaves central bankers with little choice except to take affirmative action and hope that any adverse consequences will not be too severe.  At least, one economist has said that the Fed has already gone too far in raising interest rates. While Roubini did not expressly address this issue, he thinks the coming recession will be quite severe. Just how severe will depend on the level of economic growth that will take place.

  Roubini credits technological advances and globalization with keeping economic growth high and inflation under control over the past 40 years, thereby enabling the U.S. and other developed nations to avoid falling into the “stagflation” trap. However, he asserts that economic growth is going to decline in coming years due to a combination of the following factors:aging populations, climate change, supply chain disruptions, greater protectionism and the “re-shoring” of industry.

  As I have previously explained, population growth is an important contributor to economic growth. The more people who can perform productive work, the greater a country’s economic output. That explains why China and India, the world’s two most populous countries, had the highest GDPs prior to the industrial revolution.  While it’s true that the percentage of U.S. citizens over the age of 65 is growing, that doesn’t necessarily mean that the size of the U.S. workforce is shrinking. According to the Bureau of Labor Statistics the U.S. workforce grew by 0.5% over the past year. Although an aging population may account for slower growth in the workforce, it must be appreciated that most of our nation’s economic growth is derived from greater worker productivity (i.e., less people producing more good). Moreover, with more productive activity in the U.S not involving manual labor, even those over 65 can and do continue to contribute to the growth of our nation’s economy.

  There’s no disagreement among economists that the destructive forces unleashed by climate change have a distinctly negative impact on economic growth which will only accelerate if nothing is done to curb it. It’s estimated that climate change is currently reducing this country’s annual GDP growth by 0.2%. The Biden administration efforts to combat climate change will not only help to assure the habitability of our planet but will also enhance our nation’s economic output while reducing the negative impact on GDP growth caused by climate change.

  Supply chain disruptions, greater protectionism and the “re-shoring” of industry cited by Roubini are all related to globalization even though they each degrade it in a different way. Stated simply, globalization is the process of allocating the production of individual goods to the manufacturer with the lowest costs which frequently is a company located in a foreign country where labor costs are lower. The resulting process is sometimes referred to as “off-shoring.” An example of “off-shoring” is Apple’s practice of having most of its computers assembled in China. Another facet of globalization is to have various component parts produced abroad and shipped to this country to be included in a final product. This is the practice used by America’s automobile and airplane manufacturers.

  Globalization took off in the 1980s after the nations of Europe and Asia recovered from the ravages of World War II and began to compete with the U.S. for the production of goods. That started an era or relatively free trade with tariffs being reduced or abolished in an effort to achieve greater production efficiency. This led to the creation of supply chains used by producers of goods who would purchase their component parts, as well as their raw materials, from different companies located all over the world. Similarly, the producers of imported component parts would have their own component suppliers. In the case of complex items like railroad locomotives and warships any single chain of suppliers could include several manufacturers located on different continents.

  Although the use of supply chains allows manufacturers to produce their goods at lower costs, if a single component manufacturer fails to deliver its products on time, deliveries of the final product could come to a halt. Disruptions in supply chains might be caused by a wide variety of problems such as labor problems or interference by the government where a component part supplier is located. For example, the U.S. is currently prohibiting certain high tech products produced in the U.S. from being exported to Russia. Supply chain problems can be addressed in three ways: (1) by substituting another component part manufacturer, (2) by maintaining a surplus inventory of component part to overcome temporary disruptions, and (3) by resuming the manufacture the component part domestically, a process generally referred to as “re-shoring.” In each case, the end result is likely to be a higher production cost and price of the end product.

  Protectionism has been a feature of foreign trade for well over 200 years and usually consists of the imposition of tariffs on the importation of products manufactured in a foreign country. The objective is to make foreign products more costly and less price-competitive and thereby help domestic manufacturers to become more economically viable. Because tariffs increase the costs of goods, they reduce overall economic efficiency. Up until Trump took office, the U.S. had entered into numerous trade agreements, like NAFTA and TPP which eliminated (or at least reduced) tariffs among the trading partners. Trump, however, disavowed TPP and imposed tariffs on Chinese imports in an unsuccessful effort to coerce China to drop some of its unfair trade practices. These actions adversely impacted globalization and raised the costs of products the U.S. imports from China and other Pacific rim countries. It also prompted China to retaliate by limiting its purchases of U.S. agricultural products.

  In recent years world order has deteriorated as a number of formerly democratic countries have been taken over by authoritarian regimes. Sadly, this trend has been fueled by increased dysfunction in our own government. One need only to look to the U.S. Senate to appreciate this fact. The problems currently vexing the U.S. government have not gone unnoticed by other nations and they are to be contrasted with the high level of growth that China’s authoritarian government has achieved in recent years. With this movement has come a growth in nationalism which tends to diminish globalization in the various ways discussed above. Even so, it's by no means clear that globalization is appreciably declining, if it is declining at all, because the need to be able to compete in world markets remains strong.

  The other factor which Roubini credits for having kept inflation in check over the past four decades is technological advancements. The widespread use of computers has given advent to the information age which has spawned new products, new industries and greatly increased the operating efficiency of existing industries. Not only has computer technology given rise to economic growth, it has also enabled machines to replace workers thereby keeping labor costs from rising. More to the point, there is no evidence that technological advancements are currently diminishing. Artificial intelligence is now moving to the forefront and will take economic growth to a new level.

  Nevertheless, Roubini’s prediction that the U.S. will experience a raft of business failures is a fairly safe bet and it has been voiced by other students of the economy, including Larry Summers, the former Treasury Secretary, and Jeff Bezos and Elon Musk, America’s two most successful entrepreneurs. There’s no question that business enterprises carrying high levels of debt are being placed in jeopardy by rising interest rates. The chances of a business being forced into bankruptcy, however, is a function of the extent of the business’ indebtedness (i.e., the percentage of its total assets funded by indebtedness), whether the higher interest will cause the business to operate at a loss and the length of time that condition persists. The extent of business failures that ultimately will be precipitated by the Fed’s increases in interest rates remains to be determined. If business failures do materialize they will have a negative impact on our nation’s GDP. So far, however, businesses have not suffered.

  Notwithstanding the U.S. government’s economic bailouts during the Covid pandemic, consumer debt has also risen to new heights. This means that individual Americans, like business enterprises, may also be facing bankruptcy if interest rates remain high for an extended period. Should this happen, consumer spending will decline and that will cause a reduction in economic growth and rising unemployment.

  A potentially more serious problem involves the impact of high interest rates on the U.S. government which may be forced to cut back on a number of its current investment programs designed to fuel economic growth. Our current national debt now stands at approximately $31.15 trillion. This is an enormous sum especially when you view it in relationship to our national debt in 1980 which was only $73 billion. Even when viewed as a percentage of GDP it’s still alarming (125.6% now compared to 34.68% in 1980).

  A nation’s level of indebtedness, however, is not an immediate problem as long as the annual debt service (i.e., the interest payments on that indebtedness) does not exceed 2% of its GDP. Accordingly, the current level of indebtedness did not seriously affect the level of federal government expenditures when interest rates were under 1% (the interest rate on 10-year Treasury Notes was 0.89% in 2021). However, the interest rate on 10-year Treasury Notes is currently up to 4.23% and still rising.  This will cause annual debt service payments on the national debt to increase to over $$750 billion as compared to annual interest payments of only $300 billion in 2021.  This is roughly 3% of annual GDP (which now stands at $24.8 trillion). This means that the nation’s fiscal deficit is now growing significantly faster than its GDP which could put the nation’s economy into a downward spiral. From any perspective it’s not a pretty picture.

The obvious solution is to reduce the nation’s deficit without significantly diminishing its economic growth. This can best be achieved by cutting government spending on those programs that only have a limited impact on increasing GDP and by raising corporate income taxes and taxes (including income, property and estate taxes) on wealthy individuals. Therein, of course, lies the rub. Getting the U.S. Congress to proceed on any program is tough and getting Congressional Republicans to support raising the taxes of their wealthy donors is close to impossible.

  What makes this even more alarming is that the Republicans are now poised to regain control over at least one of the two houses of Congress (most likely the House of Representatives). This problem was underscored last week when House Minority Leader Kevin McCarthy announced that his caucus would oppose any attempt to raise the national debt ceiling (which now stands at $31.4 trillion and will be exceeded in about three months) unless the Biden administration approves cuts to Social Security and Medicare, measures that will have a substantial negative impact on economic growth. McCarthy didn’t mention anything about raising taxes, but it’s fully understood that House Republicans would also oppose doing that. 

The bottom line is that even if the debt ceiling is raised, the current level of our nation’s deficit doesn’t leave our government with much room to deal with external events which might impair GDP growth such as wars and climate disasters. Equally depressing is the fact that the Congress is likely to squander what little maneuvering room the nation now has. AsWinston Churchill is reported to have said, “You can always count on the Americans to do the right thing after they have exhausted all of the other possibilities.” This seems to be one of those occasions which means that Rubini’s pessimism may well be justified.