Volatility returns to the global economy
The dramatic single-day fall in the U.S. stock market has raised a red flag, but reactions fall along predictable lines: Bears see dark clouds, while the bulls dismiss the correction as a mere bump on the road to higher stock prices. For the road ahead, analysis must include a nonmarket factor: a constitutional crisis that could overwhelm policy-making.
A correction was overdue, given the relentless rise of the market with low volatility and high valuations. Add the consequences of major tax-cut legislation, the need to lift the debt ceiling and the possibility of a trade war promoted by the Trump administration, and economic prospects look less balmy. The markets also are digesting the potential consequences of Robert Mueller’s investigation into Russian meddling in the U.S. presidential campaign and its alleged ties with the Trump election campaign.
At one point stock markets declined about 10% from recent all-time highs, but they’re still up about 20% from late 2016 and several times higher than during the worst of the global financial crisis in 2009. Many commentators have correctly pointed out that most major economies are likely to grow this year, corporate profits are strong and good news of job and wage gains probably played a role in stoking fears of inflation and interest rates rising. Investors wonder if the slump is a long-overdue pause in a surprisingly relentless upward trend, or if the market is signaling something more troubling.
Start with the major U.S. legislative action that took effect with the new year, the tax cut. Cutting taxes during a time of near-full employment and rising interest rates, as well as growing federal deficits, is not a usual step for rational economic managers. Some groups estimate that next year’s deficits will top $1 trillion during a period of full employment. While large deficits may help during periods of high unemployment, balanced or surplus budgets are typical when tax revenues are high because the economy is strong.
U.S. Treasury yields on 10-year debt jumped from 1.5% in 2016 to 2.8% recently, a huge move in a normally sedate market. Yields on 10-year bonds usually are close to the rate of nominal gross-domestic-product growth. For example, they were 4% to 6% in the decade before the 2007-2009 financial crisis led to huge purchases of debt by the U.S. Federal Reserve and plunging interest rates. If real G.D.P. growth and inflation are both about 2%, then normal bond yields would approach 4% — substantially higher than today’s levels. This would provide competition with stocks and put downward pressure on stock prices.
Stock bulls argue that corporate profits are high and growing, boosted by the recent tax cut. Adding demand at full employment shows some signs of driving up wages, however, which would put pressure on profits. Baby boomers, nearly 30% of the labor force, are retiring. Immigration, a major source of labor supply, is diminishing in response to aggressive enforcement of immigration law. These factors imply a labor scarcity going forward.
Corporate profits averaged 6% to 10% of G.D.P. from 1980 to 2005. Profits, now at a record 14% share of G.D.P., may struggle to achieve the projected growth of 11.6% per year as G.D.P. grows at only 5%.
Another argument from optimists: The tax cuts are also tax reform, expected to create higher growth and more tax revenues. Proponents argue that the Congressional Budget Office does not take sufficient account of such growth in its assessment. When the Atlanta Federal Reserve surveyed businesses, however, only 11% said that they would increase capacity due to the tax cut. Most cited a shortage of skilled workers as a major constraint. Labor-force growth is low, the educational levels that boost productivity are not growing much and productivity growth is sluggish.
Another source of policy uncertainty is President Donald Trump’s stance on trade. Trillions of dollars have been invested on the assumption that world trading patterns, or at least trading rules, would remain relatively stable. If tariffs and quotas are imposed on many products, that will lead to higher prices or shortages in importing countries, as well as to unemployment in exporting countries.
Disruptions to the North American Free-Trade Agreement or to U.S. trade with China could test the patience of America’s trading partners. The last time the United States tried a tit-for-tat response was in the 1930s, and the result was a collapse in trade, output and employment that produced the Great Depression. Most do not want to repeat this experience, but the Trump administration’s brinkmanship seems to accept that some retaliation is likely. No one knows how far the administration may go, but the risks surely give pause to trade partners and corporate investors alike.
Tax cuts during full employment, trade wars and rising interest rates with rich equity valuations are normally bad for stock prices, at least after the exuberance of extra demand wears off and society must confront the policy results. This is fairly standard economics. Another challenge looms, however: the possibility of a constitutional crisis.
The president used the word “treason” to describe the Democrats’ reluctance to applaud during his first State of the Union address. He also has encouraged Republicans in Congress to discredit the FBI and the Justice Department as they pursue questions about Russian influence on and collusion with his 2016 campaign. Reports suggest that Trump has considered firing Mueller and anyone else aggressively investigating these issues, and still wants to do so.
Republicans control majorities in Congress and, while some push back, no legislation protects the special prosecutor — and many indications suggest that findings of collusion involving Trump could become a partisan issue. The resulting constitutional crisis would reach far beyond tax policy.
Volatility in stock prices may simply signal a return to normal risks, signifying little in terms of the prospects for the real economy. On the other hand, the market could be recognizing global risks as a once-stable country transforms into a more dangerous and complicated place.
Risks do not imply inevitable crises, but they do raise red flags about problems that must be handled. A skilled group of leaders and policy-makers that understood the risks could reduce the probability of crisis, while a partisan group loyal to the president’s approval rating heightens it.
The market may be re-evaluating U.S. leadership and finding that the odds are not as good as it had once assumed.
(David Dapice is the economist for the Vietnam and Myanmar program at Harvard University’s Kennedy School of Government in Cambridge, Massachusetts.)
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