V-Shaped Recovery: Inflation Warning

As I explained last week, President Trump was entirely correct back in the spring when he predicted a V-shaped recovery for the U.S. economy. I also noted that we now have more evidence that the stimulus checks and unemployment bonuses blew out far more cash in the economy than was necessary under the artificial economic shutdown.

Now, though, it is time to issue another inflation warning. There are two mechanisms at work fueling the inflation fire. Both are caused by Congressional overspending, therefore both can be turned off with swift, responsible action by Congress.

If Congress doesn’t act, we are in for a rough ride in 2021.

In my second article on the V-shaped recovery I explained that this cash blowout

reinforces my previously expressed inflation concerns. We could be looking at a food-based surge in prices, which in turn could spread throughout the economy. It has been suggested that the artificial economic shutdown, with its disruptive effects on some supply chains, can be the origin of inflation. This is true only in theory: if we were to have permanent supply disruptions, such as in a centrally planned economy, there would be upward pressure on prices. At the same time, a centrally planned economy does not allow for market prices in the first place, so there is de facto no inflation there. Furthermore, the disruptive effects of the artificial economic shutdown in Q2 were almost entirely gone in Q3, suggesting that the rise in farmers’ earnings could be a sign of monetarily driven food-price inflation (transmitted by the aforementioned sharp rise in entitlement spending). Again, I am not suggesting that we are witnessing monetarily driven inflation. However, I see enough hints that it could be underway to suggest that the next Congress will have to make de-monetization of the economy its highest domestic-policy priority.

A closer look at the national-accounts data for the third quarter add more fuel to the inflation worries. My previous review was of annualized, seasonally adjusted numbers, which are good for analyzing long-term trends in the economy. However, they are not good for closer examination of short-term swings, especially when it comes to such extreme economic episodes as this year’s artificial economic shutdown.

For that purpose, the Bureau of Economic Analysis offers NIPA Tables 8.1.5 and 8.1.6, with quarterly GDP numbers that are not seasonally adjusted. These figures are as raw as they come, giving us one of the best street-level pictures of what is happening out there in the American economy (only surpassed by employment numbers from the Bureau of Labor Statistics).

Using these tables, we can see in closer detail what the V-shaped recovery actually looks like. We also get a not-so-happy picture of inflation numbers, one that we will return to in a moment. First, the recovery itself.

In current prices, third-quarter GDP was $5,318.3 billion. This is total spending in the economy in the three months July, August and September. It was a solid rebound from the $4,901.8 billion in Q2, but even more noteworthy is that it exceeded Q1 GDP by almost $73 billion. That may not seem to be much of a number to write home about – and it could change when the adjusted numbers are released in a few weeks – but it does show that the recovery is strong and our economy is resilient.

As I noticed in my first article on the recovery, we saw a strong come-back for American businesses. Capital formation – investments – rose sharply. In current prices,

  1. Equipment purchases increased 12 percent from Q2 to Q3 and are only eight billion dollars away from where they were in Q3 of 2019;
  2. Residential investments – home construction – increased by 16 percent from Q2 to Q3 and were 11.6 percent over their level from Q3 of 2019.

It is also important to note that businesses were back to increasing their inventories. In Q2 they reduced their inventories by more than $88 billion, the largest quarterly inventory decline on record. In Q3, they were back to increasing them again.

Changes in inventories are important. An expansion in inventories during a surge in economic activity is a sign of economic optimism. By contrast, inventory depletion in economic downturns (as we saw in 2009 during the Great Recession) is a way for businesses to liquidate future sales and stem losses.

The artificial economic shutdown was to some degree different. Many businesses were forced by government to cease operations. Albeit temporarily, they nevertheless had limited ability to respond to the demand they had from buyers. Depleting inventories was a way to bridge the shutdown gap.

By doing this, they could essentially keep supply flowing. To again dispel the suggestion that supply disruptions have caused inflation, Table 1 shows that inventory depletion actually correlates with a decline in prices. In short: thanks to inventories there were no significant supply disruptions in the U.S. economy in Q2. Using the two aforementioned tables from the BEA, we can get an inflation estimate for the second and third quarters and see where the inflation pressure is emerging. The “Q to Q” columns report price changes from, respectively, Q1 to Q2 and Q2 to Q3. The “Y to Y” columns report the same numbers for a full year, i.e., from Q2 and Q3 2019 to Q2 and Q3 2020. The picture is quite telling:

Table 1: Inflation estimates

Source of raw data: Bureau of Economic Analysis

Starting with the quarter-to-quarter numbers, there was an almost universal decline in prices from Q1 to Q2. The decline in prices on consumer goods – which covers everything from groceries to automobiles – of almost a full percent contrasts sharply to the 1.28-percent increase during Q3. Since Q3 was the quarter when the economy opened up, we can conclude that this increase is related to the cash blowout in the economy – and to access to cheap credit.

The low cost of credit is noteworthy. It is a spin-off effect of the massive monetary printing that the Federal Reserve has engaged in for almost a year now. In other words, this money injects inflation into the economy through at least two venues: monetized deficit spending in the form of the stimulus cash blowout; and cheap consumer credit.

We see the price push even more clearly if we disaggregate consumer goods spending into so-called durables and perishables. The former are goods that last for more than one economic period, such as lawn mowers, computers and furniture. Here, prices increased by 2.31 percent in one quarter.

Looking at the year-to-year numbers, the rise in prices of consumer durables in Q3 was enough to wipe out the decline that took place in Q2.

There is another interesting source of inflation, one that will probably be even more important going forward. Prices on consumer services essentially stood still in Q2 and increased by less than one percent in Q3. However, the year-to-year numbers tell us that prices are rising by as much as 1.76 percent here.

Access to cheap consumer credit is less of a driving factor here. More than likely, what we are seeing here is instead a price effect from the labor market: thanks to the unemployment bonus that Congress created in the spring, when the economy opened back up again it was more profitable for people with low-to-moderate income to stay at home than to go back to work. In response, employers have had to significantly raise wages.

I predicted this a bit over a month ago. The numbers we see here are a reflection of how this cost-push inflation is now working its way into consumer prices.

This means, bluntly, that we have two different inflation forces at work: one monetary and one from cost increases. Interestingly, both originate with government. The monetary inflation originates with exorbitant Congressional overspending on stimulus bills; the cost-push inflation originates with exorbitant Congressional overspending on unemployment bonuses.

As of today, inflation is not an imminent threat to the U.S. economy. However, I maintain my warning of more inflation to come: with two sources of inflation at work we will very likely see higher rates in 2021. The only way to quell the drive in prices is for Congress to end its highly irresponsible spending spree.

V-Shaped Recovery: Trump Was Right

Never bark at the Big Dog. The Big Dog is always right.

The GDP data for the third quarter is out. The V-shaped recovery is a fact.

I predicted exactly this back in May. So did President Trump. We both did it in the face of bold, almost condescending forecasts from economists all over the country, the world even, who predicted a protracted recession that would last all the way to 2022.

Some of them, of course, wished for a long recession so Trump would not get re-elected, but those who thought they were just doing their job now have some new homework to do. Their stubborn reliance on econometrics for forecasting once again came back like those proverbial, roosting chickens.

I, on the other hand, work with theory and methodology from good old political economy. Over and over again, John Maynard Keynes, Friedrich von Hayek, Frank Knight, Arthur Okun, Paul Davidson, George Shackle and Armen Alchian prove their superiority.

Now that the gloating is done, let’s see what Trump’s V-shaped recovery looks like. According to the advance estimate from the Bureau of Economic Analysis (BEA), inflation-adjusted GDP increased by 7.4 percent from Q2 to Q3.* Private consumption roared back with an 8.9-percent increase. Most of that came in the form of durables, which ostensibly has to do with the windfall income from the stimulus checks.

It remains to be seen exactly what people spent their money on, but it is reasonable to expect a combination fo windfall consumption and the advantage of cheap credit. The part of the stimulus checks that did not go toward paying down debt was likely used for home electronics: phones, computers, flat-screen TVs. In other words, items that did not come with long-term installment payments.

On the other hand, once the recovery was underway and people got their jobs back, extremely cheap consumer credit appears to have stimulated car sales again. We should have a better grip on the details in late November.

Another big, good news item in the Q3 GDP numbers is gross fixed capital formation, or business investments. Up 16.3 percent from Q2, America’s businesses are once again putting their money into the Trump economy.

The biggest improvement in investments, 14.2 percent, came in the form of equipment purchases. This covers everything that can be put into a factory or an office for the purpose of business operations, as well as things needed for shipping and deliveries. Think of “equipment” as everything from delivery trucks and wrenches to computers and assembly-line robots.

Another show of commitment to the Trump economy comes in the form of housing. Investments in residential dwellings rose more than 12.3 percent over Q2. In fact, home construction was 6.6 percent higher in Q3 than it was in Q3 2019!

Home construction intersects business confidence with consumer confidence. If people buy homes, they believe in their own financial future. If businesses build those homes, they believe in the local economy.

But wait – we are not done with the good news. While fiscal conservatives rightly criticized Congress for its stimulus checks, government consumption – spending that pays people to do work – was down more than 1.1 percent in Q3 over Q2. Non-defense consumption by the federal government was down a healthy 4.9 percent; the equivalent for states and local governments dropped a minute 0.8 percent.

At the same time, defense spending rose by three quarters of a percent. Again, a good priority by the federal government. Unfortunately, the annual numbers for federal spending do not look as good: from Q3 in 2019 to Q3 this year, federal non-defense consumption is up almost 4.2 percent. Hopefully, the restraint shown in Q3 over Q2 will be extended into Q4.

Speaking of annual numbers: U.S. GDP in Q3 was $18,584 billion in inflation-adjusted numbers (base year 2012). This is 2.9 percent below where it was in Q3 last year. If this V-shaped recovery continues, it is not impossible that real GDP for the whole year will be positive. It is a tall order, requiring an unlikely 3.6-percent increase for Q4, but if Trump is re-elected and Biden’s ominous tax plan withers away, this growth number can actually materialize.

Again, the latest numbers from the Bureau of Economic Analysis are all good news. The not-so-good news is in the hints of inflation in these numbers. A simple subtraction of real GDP from current-price GDP – a crude inflation estimate – suggests a price bubble in Q3. By this calculation, prices on consumer durables rose 2.4 percent from Q2, a remarkably high price increase.

It is worth noting that the same prices dropped by only 0.8 percent in Q2. This could all be attributable to the aforementioned windfall spending, but I would not rule out that we are seeing the first hints of a monetarily driven spike in inflation. Let us keep in mind that Q3 was the first quarter when the Federal Reserve’s new MMT-style money printing made its first full appearance in the economy.

I hold it for unlikely that the money-to-prices transmission mechanisms have already kicked in with the force needed to spike prices, but I do not rule it out. Let us not forget that the velocity of money has dropped below 1 for the first time on record. This is dangerous: ultra-cheap liquidity always finds its way out somewhere in the economy. First it flows into equity markets – hence our stock-market boom – then it finds its way into consumer markets via cheap credit and government handouts.

We saw the first combination of that this year. The brunt of the handouts was temporary, which means that part of the transmission mechanism from money to prices has been turned off again. However, if Congress persists in its plans for another stimulus bill, the inflation outlook may change very quickly.

The BEA also published some interesting numbers on personal income. We will have to return to those later. Enjoy the rest of your day!

*) Normally I do not discuss quarter-to-quarter numbers, but due to the exceptional nature of the swings in the economy this year, it is merited to make an exception.

Government: Size Matters

The Bureau of Economic Analysis has published private-consumption numbers by state for 2019. There is quite a bit of spread between the states, a spread that shows how different fiscal policies visibly shape the economy. States where private industries gain ground vs. government have seen a stronger trend in household consumption than states where government has grown.

First, let us take a look at the growth numbers for household consumption. Figure 1 reports annual averages for 2015-2019:

Figure 1: Household consumption growth, current prices

Source of raw data: Bureau of Economic Analysis

Spending by households accounts for two thirds of our economy, on average. It is the driving force behind economic growth; no capital formation takes place in an economy where consumers do not spend money. Therefore, the variations between states are significant for how the economies of those states fare generally.

Next, the growth in consumer spending is compared with changes in the private sector of the economy. Figure 2 reports a comparison between two annual averages:

a) The private sector of the economy as a share of total GDP; when the share declines, government grows; and

b) Household consumption growth; when the growth rate falls, it suggests that consumer finances are tighter.

These two averages are then compared for two time periods: 2005-2009 vs. 2015-2019. States where the private sector is bigger in the second period get an index number above 100; states with a smaller private sector score below 100. Likewise, when the average growth rate in consumer spending is lower (higher) in the latter period than the former, a state scores an index below (above) 100.

As Figure 2 explains, the message is clear: in states where the private sector shrunk over time, household spending also tapers off.

Figure 2: Trends in GDP, comparing 2005-2009 to 2015-2019

Source of raw data: Bureau of Economic Analysis

There is one interesting piece of information from Figure 2 that is independent of the balance between the private sector and government. Consumer spending growth has tapered off everywhere; the national average has fallen from 5.7 percent per year in current prices in 2005-2009 to 3.9 percent per year in 2015-2019.

Breaking down this growth trend by state, Figure 2 tells us loud and clear that wherever government expands relative the private sector, consumer spending also takes a beating. The decline in consumption growth is simply bigger in states where government has expanded.

Wyoming is the most extreme example. In 2005-2009 consumer spending grew at 8.5 percent per year; in 2015-2019 that rate was down to 2.2 percent (again in current prices). That is the largest drop of any state. During the same period of time the private-sector share of the economy declined more than in any other state: the index number for Wyoming is 95.76, worse than in any other state, even Alaska (albeit by a razor-thin margin).

It is hardly surprising that states with a growing government have weaker consumer-spending trends. Government depresses the economy in two ways. First, it socializes sectors of the economy, including segments of the labor market, depriving it of market competition. This weakens growth by stagnating economic activity; under competition, doing more with less means more economic resources from one year to the next. Government eliminates that process in sectors it takes over. As a result, the bigger government gets the more slowly the economy grows.

Secondly, government needs to pay for itself. The bigger it gets, the higher its taxes, fees and other charges. Even where taxes don’t go up, fees and charges tend to rise, making government chip away at household finances and weaken the economic strength of businesses. Less money remains in the private sector, where growth slows down and consumers have smaller margins to spend from.

In short: it pays to keep government limited.

Laffer Curve: Use with Caution

There is a tradition among Republicans to try to fix budget deficits with tax cuts. Three times in the past 40 years they have deployed this strategy, each time with largely the same results: a solid rise in tax revenue but no budget balance.

Now there are rumblings about an even bolder plan. Steve Moore, an economist with President Trump’s economic recovery task force, has suggested that Congress suspend federal personal and corporate income taxes for 2021. By 2022 taxes would revert back to their normal levels.

As with the Reagan, Bush and Trump tax cuts, the idea is to exploit the Laffer effect, according to which the initial loss of tax revenue from a tax cut is made up for with growth in the tax base. As a result, government collects more tax revenue down the road than it would have done at the initial, higher rates.

There is a fair amount of evidence to support the Laffer effect. However, it does not apply in Steve Moore’s case, and the reason is simple: temporary tax cuts have no lasting effect on economic growth. The only effect of Moore’s proposal would be an even bigger deficit hole in the federal budget.

With the experience that Moore has, you would have expected him to have kept this in mind while designing his proposal. As it is now, his tax holiday would only result in a massive increase in our already oversized money supply. No sane investor is going to lend even remotely enough money to the Treasury if it expands an already-gargantuan budget deficit by temporarily giving up 55 percent of its tax revenue.

More than anything, Moore’s proposal would accelerate us into an acute fiscal crisis. At that point, anything can happen – even Republican tax hikes.

In other words, the Laffer Curve is not to be taken lightly. You cannot throw it around like candy and hope for the best. That said, there is no doubt that the curve exists. Figure 1 reports data from 30 European countries from 1996-2019.* Two time series are compared:

  1. T/GDP, i.e., the ratio of total tax-revenue collections from all levels of government to GDP. Both variables are in current prices.
  2. T Growth, i.e., annual growth in current-price tax revenue.

The variables are paired by year, by country, then organized as two time series based on the second variable. The red-gray columns represent growth rates in tax revenue, while the green curve is a polynomial trend line for the tax-to-GDP ratio (representing 719 observations for T/GDP). Behold the Laffer Curve:

Figure 1: Euro-Laffer

Source of raw data: Eurostat

It is worth noting the up-sloping segment of the curve, giving the impression that it is good to raise taxes. That is not the case, however: the upslope is associated with declining tax revenue or revenue growth rates that are tepid at best. This indicates that we are looking at economies in recession; tax revenue only plummets during recessions or in the first year of a Laffer-driven reduction in taxes. Europe has seen practically nothing of the latter, so the cause of this decline is to be found in the former.

But why, then, is there an upslope in the Laffer curve? Simple: during recessions the total tax collection from the economy declines faster than GDP. In almost every mature welfare state – of which there is plenty in Europe – the tax burden is disproportionately placed on higher incomes. Those are the first to take a beating when the economy tanks. Therefore, at constant tax rates the tax-to-GDP ratio falls in a recession and rises as the economy revs up again.

Once the economy is out of a recession, however, high taxes stifle economic growth. This is visible in the peak of the Laffer Curve; the only way to increase the annual growth rate in tax revenue is to actually cut taxes.

To see how the Laffer Curve works in practice, let us take a look at one of the worst examples of bad tax policy in modern times, namely Greece in the aftermath of the Great Recession. Figure 2 reports the same variables as in Figure 1, though the T/GDP ratio is reported as actual data, not a trend line.

During the austerity episode after the 2008-2010 Great Recession, the Greek government raised taxes significantly. As a result, the average growth rate in tax revenue almost ground to a halt:

Figure 2: The Laffer Effect in Greece

Source of raw data: Eurostat

To summarize the two periods in the Greek economy:

If the Greeks did the opposite now, returning taxes to pre-austerity rates, they would spark a significant rise in GDP growth. Tax revenue would surge in the backwater of that growth. However, it would have to be permanent tax cuts, not some silly one-year holiday.

There is another side to the Laffer Curve, of course. If government does not cut spending in tandem with the tax cuts, but if entitlement programs are allowed to continue to grow, then the rise in revenue collections will be inadequate and fail to fully fund the welfare state. Therefore, the Laffer Curve must not be used as a simple go-to solution when deficits get out of hand; it is an instrument that should only be applied as part of a structural transition from a big welfare state to a small government focused on its core functions.

On the other hand, when used properly, the Laffer Curve works just fine.

*) All raw data numbers are sourced from the Eurostat databases on national accounts and government finances. The countries are: Belgium, Bulgaria, the Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Croatia, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, the Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, the U.K., Norway and Switzerland. For Switzerland, data is only available for 1996-2018.