“Fading” Fiscal Stimulus; Really?

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Fed Chair Jerome Powell and others have started a new narrative about economic “headwinds.” They think past rate hikes, slower foreign growth, and “fading fiscal stimulus” should slow the Fed’s rate hikes. But is fiscal stimulus really fading?

Powell and others think the growth benefits of both the 2018 tax cuts and increased federal spending are winding down. This is pure Keynesian analysis and we think it’s wrong. In our view it reflects a misunderstanding of both how tax cuts work and the actual path of federal spending.

The difference is between demand-side (Keynesian thinking) and supply-side thinking. Keynesians think demand drives growth. In other words tax cuts work by putting more money in people’s pockets, which increases consumption and, therefore, GDP. They say the first year of a tax cut boosts aftertax incomes and demand, but then, stimulus fades as this boost is removed and income falls back to the previous (slower) trend.

Keynesians also believe federal government spending stimulates growth because it, too, is part of demand. In fact, government purchases are a direct part of GDP accounting and so it appears like government spending is a stimulus.

By contrast, supply-siders think incentives for entrepreneurship and investment drive growth. It is the supply of new goods and services that leads to faster economic activity. Say’s Law says “supply creates its own demand.” In other words, the tax cut led to better incentives to invest, work, and invent. And, as long as tax rates remain low a “permanent” change in incentives has been initiated, which will boost growth rates permanently. There is no “fade.”

Before the tax cut, the corporate tax rate in the US was approximately a combined 40% (federal, state, and local). In 2017, Canada had a corporate tax rate of 26.5%. So, there was a 13.5% incentive to invest in Canada over the US. And, at the margin, more investment went to Canada (and other countries with lower corporate tax rates) than would have been the case if the US tax rate was not the highest in the developed world.

Now the combined U.S. corporate tax rate is approximately 27%, radically changing incentives. In other words, at the margin, as long as tax rates stay where they are, there is a

permanent incentive to invest more in the US. This does not mean growth will accelerate from where it is now (roughly 3% GDP), but it will not automatically revert back to 2%, where it was from 2010-2017.

The more curious and misguided argument is that fading government spending will slow and reduce GDP. We think this comes from a misunderstanding of the budget deal which was passed last year. Yes, that budget deal increased spending, but so far it hasn’t shown up as a boost to GDP growth.

In Fiscal Year 2018, nominal GDP rose 5.0% over FY2017, while total federal spending went up just 3.2%. Government purchases, which feed directly into GDP, rose just 4.0%. In other words, relative to the private sector, government demand grew more slowly.

On top of this, total federal revenue was up 1% in FY2018. While corporate tax receipts fell 22%, total individual receipts were up 6%. In other words, while it’s true that the federal government collected fewer tax receipts in FY2018 than it budgeted prior to the tax cut, it still collected more revenue than it did in FY2017.

The bottom line is that the entire demand-side basis for the fiscal stimulus argument has no data to support it. Government spending grew slower than GDP and actual tax receipts went up. As a result, any argument that there will be “fading” fiscal stimulus is based on a data that does not exist.

The reason growth has accelerated is because lower tax rates, and less regulation, increase entrepreneurial activity – a supply-side acceleration in growth, not Keynesian. Anyone waiting for slower economic activity as fiscal stimulus “fades” will be waiting in vain.

The one worry we have is the exact opposite of what Keynesians argue. A new divided government adds to pressure for bipartisan legislation. Bipartisanship often means more government spending. As supply-siders, we view increased government spending as a drag on growth, not a boost.

The more government spends as a share of GDP, the smaller the private sector. That’s how growth will really fade.

Consensus forecasts come from Bloomberg. This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

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Heartburn, Not a Heart Attack Heartburn, Not a Heart Attack

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Not long ago, many investors were kicking themselves for not investing more when the stock market was cheaper. But when stocks fall, like they did last week, many investors have a hard time buying for fear stocks may go lower still.

Who knows, maybe they’re right. We have no idea where stocks will close today, nor at the end of the week. Corrections (both small and large) happen from time to time. In hindsight, many claim they knew it was coming, but we don’t know anyone who has successfully traded corrections on a consistent basis – we certainly won’t try.

We’re also skeptical when analysts try to attribute corrections to a particular cause. It’s a basic logical flaw: post hoc ergo propter hoc. Because the correction happened after a certain event, that event must have been the cause. But important news and economic events happen all the time. Sometimes the market goes up afterward, sometimes down, and similar events at different times have no discernible impact.

Now some are blaming the Federal Reserve, and specifically statements from Chairman Powell, for the downdraft in equities. But, according to futures markets, the outlook for monetary policy has barely changed. The markets are still pricing in a path of gradual rate hikes and continued reduction in the size of the Fed’s balance sheet.

Let’s face it, fretting over the Fed is as old as the Fed itself. In recent years alone, we faced the “Taper Tantrum” and calls for a fourth round of quantitative easing. And remember when the Fed first raised rates and then announced it would reduce its balance sheet? Each time, analysts predicted the apocalypse was upon us – that a recession and bear market were right around the corner. How did those calls pan out?

Exactly, they were wrong, and this time looks no different. QE never lifted stocks, taking it away won’t hurt; and interest rates are still well below neutral. The biggest pain has been felt by those who followed the false prophets of doom.

The odds of a recession happening anytime soon remain remote, we put them at 10%, or less. And a recession is what it would take for us to expect a full-blown bear market. In other words, the current drop is just heartburn, not a heart attack.

We’ll publish a piece next week about our exact forecast for economic growth in Q3, but it looks like real GDP rose at about a 4.0% annual rate. Profits are hitting record highs and businesses are still adapting to the improved incentives of lower tax rates and full tax expensing for business equipment. Home building is still well below the pace required to meet population growth and scrappage (roughly 1.5 million units per year). Household debts are low relative to assets and debt service payments are low relative to income. These are not the ingredients for a recession.

That’s why we love Jerome Powell’s response to the recent gyrations in the market. Many pundits were calling for him to back off his tightening and his “hawkish” language, but he didn’t take the bait. He’s focused on monetary policy, and the economy and won’t be pushed around by hysterics or market gyrations. The S&P 500 fell about 6% from its intraday all-time high to Friday’s close. This isn’t earth-shattering, and the Fed shouldn’t respond. Investors need to stop obsessing about the Fed. Instead, they should focus on entrepreneurship and profits. The fundamentals are what matter.

Meanwhile, some investors are concerned about President Trump tweeting or speaking out on the Fed and monetary policy. If this were any other president, we’d be concerned, as well. But we all know Trump isn’t the kind of president to hold his opinions close to the vest on any topic. If he thinks it, he says it. Please take his comments on the Fed in that context. That certainly seems to be what Jerome Powell is doing.

The bull market in equities that started in March 2009 isn’t going to last forever. But we don’t see anything that’s going to bring it to a screeching halt anytime soon.

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The Growing Deficit

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

The U.S. federal government reported last week that it ran a deficit of $214 billion in August, the fifth largest deficit for any single month in US history.

The Congressional Budget Office thinks these numbers are consistent with a budget deficit of about $800 billion for Fiscal Year 2018, which ends September 30. If so, that would be the largest annual deficit in raw dollar terms since FY 2012. This deficit is roughly 4.0% of GDP, which would be the highest since FY 2013.

For many, this growing deficit is a dagger to the heart of the tax cut enacted in late 2017. They say the tax cut was irresponsible. However, economic growth has picked up because of the tax cut, and growth is the key to higher fiscal receipts down the road – in fact tax receipts are still hitting record highs.

Between 2010 and 2017, the U.S. passed two large tax hikes, yet the deficit was still $665 billion in FY 2017, which was not exactly a model of fiscal purity. As a result, we call “politics” on all those now fretting about deficit spending only when a tax cut is involved.

It’s important to recognize that the tax cut has, so far, reduced revenue compared to how much the federal government would have collected in the absence of the tax cut. But, total federal receipts are likely to end the current Fiscal Year up slightly from last year and at a record high. Next year, according to the CBO, revenue should be up 4.6% and at another record high.

In other words, the tax cut didn’t lead to an outright reduction in revenue, it just slowed the growth of revenue. Spending is the problem. Total federal spending will rise about 4% this year and is scheduled to rise about 8% next year. In spite of an acceleration in economic growth, government spending is rising faster than GDP.

While this is a long-term problem, it will not turn the U.S. into Greece overnight. No fiscal crisis for the nation is at hand. Last year, net interest on the federal debt amounted to 1.4% of GDP. The Congressional Budget Office projects that net interest will hit 2.9% of GDP before some of the tax cuts theoretically expire in the middle of the next decade.

That is a large increase, but net interest relative to GDP hovered between 2.5% and 3.2% from 1982 through 1998. The U.S. paid this price and the economy still grew more rapidly than it has in the past decade. The U.S. didn’t become Greece.

Compare two economies of equal size. One spends $500 billion, but with zero taxes, the other spends $2 trillion, but taxes $1.5 trillion. Both have $500 billion deficits, but the first economy would be more vibrant and could finance the debt more easily. It’s not that deficits don’t matter, but deficits alone are not a reason for investors to run for the hills.

And when deficits are partly caused by more federal spending on interest payments you know who will hate it the most? The politicians.

Here’s why. Politicians like to deliver things their constituents are grateful for, things that make voters more likely to vote for them rather than someone else. Tax cuts help politicians get more votes, at least from those who actually pay taxes. Government programs can also help incumbents corral votes. Pass out government checks and you can get more votes, too. But bondholders have no gratitude for politicians when they receive the interest they’re owed on Treasury securities.

Higher net interest payments will eventually “crowd out” future tax cuts and government programs, making it tougher for incumbents to get re-elected. As net interest payments rise, more politicians will start obsessing about the deficit again, just like in the 1980s and 1990s.

The true threat to long-term fiscal health is spending. If left unreformed, entitlement programs like Social Security, Medicare, and Medicaid will take a ceaselessly higher share of GDP, leading to a larger and larger share of American production being allocated according to political gamesmanship rather than individual initiative, in turn eroding the character of the American people.

Unless we change the path of spending, last year’s tax cuts - and the boost to economic growth they’ve already provided - risk getting overwhelmed in the long run. But, for investors, this isn’t an immediate problem. After all, deficit fears have been around for decades and equities still rose. Stay bullish, for now.

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California Ramps Up Privacy Protection

A new law may spur other states—or the feds—to give you more control over your online data.

By Lisa Gerstner, Contributing Editor
August 30, 2018
Kiplinger's Personal Finance

Kiplinger’s spoke with Aleecia M. McDonald, an assistant professor at Carnegie Mellon Univer­sity’s Silicon Valley campus who researches internet privacy and security. Read on for an excerpt from our interview:

California’s new law, which goes into effect in 2020, is supposed to improve online privacy for consumers. What are the key points? Consumers will be able to know more about the information companies have collected about them, request that companies delete that information, and download or transfer the data for their own use. Consumers will also have the right to know when their personal information is being sold to a third party, such as an advertiser, and to opt out of that sale in many cases.

Will opting out be free? Companies can’t refuse service to customers who exercise that right, but they can charge customers the amount of money they would have collected from third parties for selling the data. The law applies to large companies and data brokers, so your local dentist or pizza shop could still sell your unlisted cell-phone number without notice or without allowing you to opt out.

Will other states follow California’s lead? It is entirely plausible that other states will either adopt the California law or modify it slightly. I wouldn’t be surprised if a state such as New York, which has an attorney general’s office with a strong consumer focus, passed a law like this one. And privacy is not a red state or blue state issue, so Montana and Vermont, for example, could easily pass privacy laws in a single year. Facebook and Google have reportedly been meeting with federal policymakers to talk about developing a privacy law. But a federal law may be weaker than state laws and may preempt them.

What changes will consumers see? Some companies may provide notices on their websites to everybody—not just Californians—about the personal information they’re collecting. It’s easier to write the code that way. California will require a button on websites allowing you to opt out of your personal data being sold. Non-Californians may see the button on some sites, too.

How else can consumers protect their privacy online, regardless of where they live? Look for privacy-friendly alternatives to the tools you use. DuckDuckGo is a fantastic search engine that doesn’t collect or share your personal information. The Privacy Badger browser add-on blocks advertisers and other third parties from tracking your activity—and you don’t need a PhD to figure out how to install and use it.