Despite the many uncertainties arising from this year’s presidential campaign season, there’s little doubt real GDP continues to exhibit weakness. In addition, there’s mounting evidence that Michigan’s dominant automotive industry has already planned for a modest break in its string of record-setting annual vehicle sales cycles.
Whenever the expansion phase of a business cycle shows its age — and the current, weary upswing has lasted seven years — it decelerates. This slowdown is quite apparent in most cycles. And this one (mid-year 2009 to mid-year 2016) is a classic example: Real GDP grew 2.7 percent in 2013, slowed to 2.6 percent in 2014, and stumbled to 1.9 percent in 2015. For the first half of 2016, growth fell to 1 percent.
True, this recent growth cycle has seven years to its credit, instead of the average three-and-a-half-year expansion. But real GDP growth has averaged a mere 2 percent, which is one-third below the normal pace.
This anemic performance explains subdued gains in U.S. income and employment, as well as the incomplete comeback of manufacturing, industrial output, and residential home construction. Thus, an outlook that further takes steam from a tepid recovery is fraught with negative consequences.
Economic forecasters recognize the natural progression of a slowing expansion. We also know from experience that even a lackluster economy can eke out a 12-month, last-gasp extension after a presidential election year.
In nearly all national election years, government spending (for political expedience) accelerates to carry along the other limping spending sectors (consumers, businesses, and exports). Such politically motivated policies will provide momentum to carry real GDP in positive territory for at least some of 2017.
This scenario seems to be unfolding on schedule. Indeed, it would be quite an aberration for the U.S. economy to slip into recession prior to mid-2017.
However, forecasting clouds gather thereafter. First, there’s little motivation to keep pushing the pedals of monetary and fiscal acceleration to the floorboard. According to chief economist Robert Dye of Comerica Bank in Detroit, there’s scant leverage left to exploit using federal spending, especially with the U.S. Treasury’s budget deficit ballooning between fiscal years 2015 and 2016.
Second, how quickly monetary and federal stimulation retrench after a new administration emerges is anyone’s guess. The economic policies of a new administration and a new legislature occasionally break radically from the past. Psychology and behavior can change correspondingly, and with short lead times.
In this case, with an economy that’s moving so sluggishly entering 2017, sudden shocks — one way or another — can significantly alter the outlook and performance of the 2017-18 economy.
Next 12 Months
Between mid-2016 and mid-2017, there are unavoidable dynamics that have already been forged into the U.S. financial system. For example, myriad federal and state welfare and pension programs have inadequate funding, and promissory benefits with fewer resources will challenge claimants.
Only a wholesale, sustained leap in real GDP growth in the coming decades might stave off the financial bankruptcy of these underfunded liabilities. Not only have these concerns proved to be recurring drags on the private sector, but they also erode optimism across the nation and the world.
So what’s the prospect for growth over the next 12 months? From the third quarter of 2016, the three most accurate predictive indicators flashed the following messages:
• Yield Curve: The shape of the yield curve has historically foretold expansion or recession, often more than six months to a year in advance of an economic turning point. The yield curve’s prognosticating powers reflect the cost of financial capital — the affordability and profitability of borrowing and lending activity, and the tightening or loosening of credit in the marketplace.
The shape of the yield curve is “positive” when long-term securities (e.g., 10-year Treasury bonds) yield more than short-term securities (e.g., 3-month Treasury bills). Positive differences are highly correlated with continued gains in real GDP.
Negative spreads, meanwhile, are associated with a recession that’s lurking in the wings. At mid-August, the long-term (10-year) Treasury bond yielded 1.5 percent, whereas the short-term (3-month) Treasury bill yielded a scant 0.3 percent. The mathematical difference is + 1.2 percentage points.
Michigan has managed to outperform most other states in economic and employment gains during recent years of this business cycle.
This positive spread foreshadows further real GDP advances for roughly 11 months — but the difference is slim, hinting at erratic and halting growth going forward. A two- or three-point differential would signal robust growth ahead.
• Leading Economic Index (LEI): The Conference Board’s composite index of 10 economic indicators predicts movement of the general economy up to one year ahead. LEI includes monthly data series, such as the volume of housing permits issued and the number of overtime hours worked in manufacturing industries. Each series has its own stellar track record of accurately warning, months in advance, of improving or worsening conditions.
In July, the LEI stood at 123.7, compared with 122.8 a year earlier. This meager gain of just three-fourths of 1 percent reinforces the yield curve’s prediction of a weak 2017.
• Consumer Sentiment: The University of Michigan in Ann Arbor has compiled a monthly report on consumer sentiment dating back to 1966, and its rigorous interviews with consumers register household plans for major purchases and financings in the coming year.
Answers given by prospective buyers of large-ticket products such as vehicles, appliances, and furniture provide valuable signals as to optimism and pessimism, and distinguish exuberant expectations of household financial positions versus attitudes of ambivalence, caution, or retrenchment. The index thereby anticipates either rising personal outlays or individual movement to restore savings balances and pay off debt.
In August, the Sentiment Index stood at 90.4, compared with 91.9 in August 2015 — a year-over-year loss of 1.5 points. The negative reading warns of lower vehicle sales in 2017.
Still, the percentage drop in the index isn’t yet particularly steep or consistent. Therefore, whatever slack pervades vehicle sales in 2017 may still support a profitable year for the industry, depending on how nimble managements are at cost control, incentive pricing, financing, and new product innovations.
Traditional Outlook: 2017
In summary, we have a weak economic starting point for 2017’s forecast. Added to slackening momentum, our three best econometric forecasting tools ratify a “more of the same” anemic economy in the first half of 2017, precluding a real annual U.S. expansion averaging in excess of 1.5 percent for 2017.
Growth at this pace is inadequate for keeping payroll employment expanding at 2016’s rate, nor can it add robust pay gains, profits, or private residential construction activity.
Michigan’s experience under conditions of further national deceleration suggests that the state’s industries must work harder, smarter, and more productively just to match the average Gross State Product expansion of other states.
Comerica’s Dye reminds us that in 2017 Michigan will begin to grapple with recently announced plans by General Motors Co. and Ford Motor Co. to move low-profit product lines to Mexico. Further consideration, he notes, is needed to gauge implications for Michigan’s housing markets from changing size and preferences of millennials versus their baby boomer predecessors. Demographically, millennials (people born between 1982 and 2004) now equal or surpass the population cohort of baby boomers, yet millennials for the most part exhibit diminished enthusiasm for new homes — an auspicious development for many urban downtowns.
So far, Michigan has managed to outperform most other states in economic and employment gains during the recent years of this business cycle. In part, we owe this fortune to unparalleled financial subsidies targeting our auto industry — reflecting a once-in-a-lifetime policy stimulation from both the U.S. Treasury and Federal Reserve System. Seven years of flat borrowing rates represented costs so low that few can remember auto or home loans at such affordable levels during their lifetimes.
Hence, in assessing the last half of 2017, we must consider the likelihood of changes in monetary and federal spending policies beginning in the second half of 2016, as well as beyond the election.
In view of disappointing GDP growth and absent any troubling inflation reports, Federal Reserve Chairman Janet Yellen is highly unlikely to shift to tighter monetary policies over the next six months, as she’s proven to be risk-averse and eager to avoid a recession.
Regarding any new U.S. Treasury initiative, most changes in taxing, spending, and regulatory policies are on hold until 2017. Even with a new administration, changes typically require a full year to take effect or gestate with measurable economic impact. Essentially, this forecast assumes neutrality and exhausted leverage held by Washington, D.C.
The 2016 surge in urban crime, violent protests, and terrorism has been a serious impairment to economic advances.
Last Piece of the Puzzle
The final part of constructing the 2017 outlook is to examine events that will likely have a high probability of raising or lowering real GDP growth over the course of the forecast. Such events include “Brexit” (the British optioning out of the EU), U.S. electioneering and results, increasing violence and polarization within our principal cities, worsening fiscal conditions within the states, and political subdivisions.
Unpredictable military confrontations could worsen public sector budgets and deepen angst across the nation, as well. Some likely pluses and minuses from those events include:
• Brexit: The British election earlier this year was a bold move by voters. Pulling away from the EU’s high-strung policies of tax, spend, borrow, and regulation provides Great Britain with a Thatcher-esque opportunity to restore badly needed reforms and lift the U.K.’s private sector growth in order to thrive on realities of a rapidly-evolving, globally competitive marketplace.
In the near term, the move roiled foreign currency markets and caused the U.S. dollar’s value to soar compared with most of its trade partners. A stronger dollar hinders the price-competitiveness of U.S. exports and makes foreign imports more attractive. This will adversely affect the real GDP growth rates through the first quarter of 2017.
However, for the balance of 2017 and beyond, Britain’s exit from the EU will have many beneficial impacts on both U.S. and British GDP. For Britain, Brexit means that 44 percent of the country’s exports to the EU (beginning in 2017) will face an automatic 2 percent tariff hike because the nation is now an outsider.
The 17 percent of British exports that go to the U.S., however, can now compete more
favorably in our markets and enhance competitively-based choices of goods and services for America’s public. Brexit also frees Britain from Brussels’ trade and regulatory shackles, enabling more British-American bilateral trade negotiations with fewer economic barriers.
Brexit may also improve our economic and domestic security. The EU had 28 member nations with dozens of security agencies; such a structure inhibits sharing information quickly and retards a coordinated response to conflict.
Working directly with Britain on urgent and strategic matters should improve security networks via the cultivation of one-on-one communication. For example, Britain’s armed forces would no longer be subject to the EU’s proposed European military authority — a NATO redundancy. Furthermore, Brexit encourages U.S. and U.K. collaboration against terrorist threats that the EU’s legal system increasingly resists and impedes (especially in view of EU’s lenient courts).
• Electioneering: Four billion dollars is a lot of money — more than has been spent previously by the major contenders for the executive and legislative offices of the land.
Campaign funding comes from personal and corporate savings, payroll deductions, borrowings, and the imputed time of volunteers. Expenses covered by this funding include setups, takedowns, travel, advertising, media, extra security, food, lodging, mailings, and materials.
Considering the ripple effects of spending in all 3,077 county jurisdictions across the U.S., aggregate election-related costs are approximately $12 billion.
• Riots: The 2016 upsurge in urban crime, violent protests, and terrorism has been a serious impairment to economic advances. Threats to life and property, and the compounding of municipal debt to current and future taxpayers, are the costs of chaos.
Chaos also signifies a loss of consumer confidence and focus. The dispiriting economic impact, as reflected in the duration and depths of 1967’s urban riots, leaves the U.S. and Michigan considerably more vulnerable to recession by late 2017.
• Unfunded Liabilities: Despite decades of red-flag warnings over improper public pension accounting and disregard over funding reform for pensions and other payroll expenses, there has been little, if any, meaningful change anywhere in the system.
If honest pension funding were mandated, given the actual (rather than mythical) rates of return on investments, then today’s massive underfunding of public pensions would require as much as $8.5 trillion in financial resources to make whole the promises. Similarly, our nation’s Social Security system runs uncovered deficits that will, by 2024, demand another $1 trillion just to remain solvent, while unpaid student loan borrowing already threatens write-offs in excess of $1.2 trillion.
Worse, there is no rational estimate yet available for what could become the largest of all financial calamities: Obamacare, or the Affordable Care Act.
Although the financial ramifications of these daunting scenarios are mostly hidden from view during national election years, the inevitability and size of their economic impact on the well-being of households can no longer be disguised.
After 2016’s election, severe stress on government finances will emerge as never before, and may be highlighted by desperate calls for national assistance from heavily indebted states like Illinois and California.
Resorting to additional taxation for restitution will compound the problem, causing a major national recession. The timing of the next recession is tricky, but the certainty of this outcome is no more difficult to forecast than was the inevitability of the bursting of the bubble (2007-09) that followed years of mounting fluff-credit in our residential housing markets.
For the U.S. economy, 2017 is shaping up as a marginal year, with possibly 1 percent real GDP growth. Average growth for the balance of 2016 might well be below the first half. With real output expanding at one-third the normal pace, there is neither the income growth nor the confidence to expand jobs sufficiently to sustain the auto sales records of recent years. Michigan’s economy, therefore, will see sector retrenchment compared with 2016 in housing, large-ticket durable goods sales, employment, and income. Two building blocks of Michigan’s better-than-average expansion — the rise in the stock market and the rise of home prices (both being wealth effects) — will be more difficult to exploit in 2017 and 2018.
In turn, Michigan is less vulnerable to major shock or financial impairment than in other setbacks occurring since the 1970s. Matt Elliott, Michigan Market president for Bank of America in Troy, offers several reasons for this hopeful observation.
He notes that banking clients have very good credit quality, an excellent sign, while OEMs and myriad suppliers have already built softening trends and adaptation strategies into their operations, including overtime reductions. Supplier chains also are exhibiting better balance in costs, pricing, and inventories within the auto industry.
Elliott adds that there’s no shortage of investment or working capital. His concerns going into 2017 revolve around health care costs, integrity of infrastructure, and immigration. Perhaps his longest-running frustration is with the shortage of quality workers in vital positions across the spectrum.
Much of Michigan’s commendable growth is predicated on persistent Federal Reserve policies of easy money and low interest rates. Political exigencies, while likely to restrain major upward adjustments to these borrowing costs, will run into urgent realities of unmet needs — including fiscal, infrastructural, and the rebuilding of the military and homeland security.
After years of rock-bottom capital costs and weak growth in output and income, the U.S. economy has become supersensitive to any perceived tightening in monetary policy.
As a result, wary firms and individuals are increasingly motivated to adopt protective and defensive postures in their investments, inventory-building, incentive structures, and purchasing behaviors. Typically, this caution targets 2018 as a probable recession year.
Regardless of the date of the next downturn, how best might we transition from recession to growth by incurring the least amount of time and pain? Essentially, how do we restore a stable foundation for intergenerational growth?
Epilogue: Least Pain, Most Gain
Donald Trump and Hillary Clinton presented nearly polar opposite tax and regulatory platforms at their early August appearances in Detroit. Here’s an impact analysis for the national and Michigan economies, based on the economic proposals that have been revealed.
The heart of the Trump tax plan calls for a major reduction in marginal tax rates on firms and individuals, in addition to vastly simplifying the number of tax brackets in the tax code from seven to three.
In addition, his proposal for boosting the existing $6,300 personal income deductions on the 1040 tax form to $25,000 per individual and $50,000 per couple is so dramatic as to be largely without precedent. In fact, the amount of stimulus, in terms of saved income from such a change in the IRS code, would mean that more than half of America’s workers would annually pay no federal income taxes at all.
The three effective brackets would carry marginal tax rates of 12, 25, and 33 percent. During the Obama years, the top bracket was nominally at 39.6 percent. However, this top rate underestimates the adverse impacts on capital formation, saving incentives, and entrepreneur ability to begin businesses or spend on expensive goods and services, such as a college education.
It is grossly misleading for the simple reason that during the final term of Obama’s administration, most households faced higher marginal tax rates resulting from three sources: an extremely intricate Alternative Minimum Tax on interest and dividend income, a punitive Estate Tax, and a 3.8-percent Medicare surcharge. Under Trump’s proposed reform, these last three taxes would be repealed.
Another prominent feature of Trump’s plan deals with business tax liabilities. He proposes slashing the current 35 percent corporate tax rate to 15 percent.
It is essential to understand that these rollbacks in tax rates are contingent on eliminating many current special deductions currently taken by middle- or high-income taxpayers. Those filers in current low tax brackets (10 to 20 percent brackets) would generally continue benefiting from all, or half, of the existing tax code’s deductions, respectively. Deductions currently available for taxpayers in the 25 percent bracket and above would be substantially limited.
The key to evaluating the growth potential of Trump’s plan is to recognize that it must be viewed “dynamically” and not “statically.” What this means is that people are energized by economic incentives that put more money in their pockets and are discouraged by forces that reduce income, thereby impairing discretionary spending or saving capacity.
Most Washington policymakers choose to analyze tax policies in static terms only. They’d consider Trump’s plan a “revenue-loser” because it cuts taxes without raising revenue by some means other than reducing the use of deductions for higher-income filers.
However, the “dynamic” approach is more in alignment with economic and psychological reality. That is, humans are motivated to vigorously earn money, hire workers, innovate, and risk their capital when they know they’ll be keeping more of their earnings or earn higher rates of return on investments.
We know this because expanding economies create prodigious amounts of new tax revenue — not just for Washington, but for state and local units of government, as well.
The American experience testifies repeatedly to the efficacy of “dynamic scoring” techniques in tax-revenue forecasting. The most powerful proofs are found in the bipartisan policies pursued during the years of John F. Kennedy and Ronald Reagan.
Those presidents slashed capital gains tax rates on investments, which led to tsunami waves of extra capital-gains-derived revenue from private and public coffers. Moreover, U.S. history illustrates magnificently the memorable 1962-65 prosperity of the Kennedy-Johnson tax cuts and the exceptional 1983-88 expansion following Reagan’s tax cuts.
Hillary Clinton’s proposals target middle- and higher-income firms and individuals. She advocates raising tax rates, with the stated objective of redistributing captured income tax revenue to fund up to $2,500 in annual college costs along with reducing tuition at state universities for taxpayers with incomes up to $125,000.
In addition, portions of new taxes would fund child care and health care benefits.
Clinton also advocates that business taxes be hiked on fossil fuel firms, namely those in the coal, oil, and gas industries. Banks having assets in excess of $50 billion (which today includes most regional banks like Comerica, up to international giants like Bank of America) would pay considerably more each year.
In stark contrast to the Trump plan, Clinton’s program would reduce the current $5.5 million estate exclusion to $3.5 million, regardless of the erosion effect on values of past, present, or future inflation. She would also raise the current 40 percent estate tax rate to 45 percent.
Besides hiking taxes on saving and capital accumulations of families and firms, Clinton’s tax agenda would discourage stock market investors, as well as damage the government’s ability to raise revenue from stock transactions and sales.
Here’s why: Currently, most owners who sell stocks they’ve held for less than a year pay 39.6 percent marginal income tax rates on gains, plus a 3.8 percent Medicare tax, for a total tax rate of 43.3 percent. Clinton would keep that rate, but add a severely restrictive element. Rather than taxing stocks held over a year at the current 23.8 percent rate, she would require six full years to attain this more favorable long-term capital gain treatment. In short, the top rate of 43.4 percent would be owed on assets sold within two years, locking investors into a very inflexible investment strategy.
Overall, the Clinton economic program would assure more rapid growth of government’s share of a weakening economy that would be focused on redistributing income, according to Washington’s “fairness” philosophy. Trump’s plan would begin returning a greater share of a growth-oriented economy to the productive private sector.
As it stands, in simple economic terms, a pro-growth plan that lowers taxes and opens new avenues of productivity is more favorable to our future prosperity than a program that calls for higher taxes, more handouts, added regulations, and a redistribution of wealth into the hands of idle workers.