As the US enters the mid-term election season, pundits have returned to the question of who deserves credit for the economy’s strong performance – President Obama for laying the foundation for the recovery, or President Trump for reviving animal spirits with policies that include tax cuts and deregulation? Indeed, both the former and current presidents have inserted themselves into this discussion recently in an attempt to energise their party faithful ahead of the mid-terms.
For Republicans, there is much to boast about – the unemployment rate has fallen below 4% for the first time since 2000; real median household income as reported by the Census Bureau appears to be breaking out of a prolonged slump; and business investment spending has accelerated.
Still, much of this misses the bigger picture about evaluating President Trump’s economic policies. Specifically, the true benchmark is whether an administration puts in place policies that are conducive to higher potential growth. Then-candidate Trump, campaigning to “Make America Great Again”, implicitly ran for the presidency on a promise to raise trend growth, with 3% or even 4% annual GDP growth often cited as the objective.
Reason for scepticism
However, there is reason for scepticism that the suite of the administration’s economic policies will have a meaningfully positive impact on the economy’s potential. In fact, there are aspects of the policy suite that will prove damaging if sustained over the longer run, even after setting aside protectionist policies that will increase resource allocation to portions of the economy where the US no longer enjoys a competitive advantage.
Improving an economy’s potential essentially comes down to two broad thrusts:
– improving productivity (through capital investment as well as by developing a workforce to use the product of such investment effectively)
– increasing the number of workers.
The current administration will likely have at most a modestly positive net impact across these two areas. Tax cuts and deregulation could certainly boost investment on a sustained basis and lay the groundwork for higher productivity. Business fixed investment has indeed picked up since the election, and for the first two quarters of 2018 has reached levels last seen during the 1990s investment boom.
Exhibit 1: Average quarterly business investment contribution to GDP growth during selected periods
Source: Bureau of Economic Analysis, data since 1983
Pick-up in investment is patchy
Whether this investment surge will be sustained, or is simply a one-off impulse from the implementation of corporate tax reform and repatriation of profits held off-shore, remains to be seen. The details of the investment data do not clearly suggest a sustained improvement in the investment outlook.
On the one hand, it is positive to see a meaningful pickup of investment in intellectual property products, which had been lacking earlier in the expansion. However, investment in structures remains highly concentrated in the oil and gas sector, with little evidence of a broadening out to other sectors such as manufacturing.
Tellingly, equipment investment has also shown no signs of a breakout in recent quarters, and remains notably below levels seen in the 1990s boom. This is important because the designers of corporate tax reform trumpeted the full and immediate expensing of equipment investment as a key provision for boosting business spending and overall growth. The evidence instead suggests that changes in tax policy have had little effect on business decisions on equipment investment.
Immigration policies will limit labour supply and restrain output
While a permanent pick-up in investment spending would boost productivity, the administration’s immigration policies will most likely push potential growth in the opposite direction. Restrictions on legal immigration and increased deportations of undocumented immigrants will only serve to limit growth in the labour supply and restrain output.
In addition, a generally less hospitable environment, including uncertainty about the stability of the H-1B visa programme under the Trump administration, could lead higher-skilled workers from other countries to pursue opportunities elsewhere. Other countries sense this vulnerability and will continue to strengthen their recruitment of high-skilled foreign workers at the expense of the US.
Biggest legacy could be a marked worsening of the debt profile
Without a meaningful improvement in trend growth, the Trump administration’s most enduring economic legacy will likely be a marked deterioration in the country’s debt profile. According to the Congressional Budget Office (CBO), federal debt held by the public will reach 95% of GDP by 2028. This reflects the CBO’s own scepticism that trend growth will rise meaningfully in the years ahead. The bad news does not end there. The CBO’s baseline does not assume a recession at any point over the next year, or major changes in fiscal policy.
In reality, however, both Democrats and Republicans have an incentive to extend beyond 2019 the recent agreement to increase discretionary spending. As seen in the chart below, with this assumption of maintaining the spending increase over the entire projection horizon, publicly-held Treasury debt outstanding will approach 100% of GDP by 2028. In addition, if the temporary provisions of the tax cuts are made permanent – an option that Republicans are already discussing – the debt profile worsens slightly further.
The truly adverse impact on debt sustainability comes with the reasonable assumption that the economy will experience a recession at some point over the next 10 years. The example herein demonstrates that even a short-lived recession that is accompanied by modest fiscal stimulus will take the debt-to-GDP ratio to almost 115%.
This assumption of stimulus in the next recession may seem to run counter to the argument that higher deficits now reduce fiscal space later, but it reflects the political reality of elected officials making the short-term decision to increase spending when faced with a recession that threatens their hold on office.
Exhibit 2: Publicly held debt as a percentage of GDP under different scenarios
Source: CBO, author’s calculations
Over time, higher levels of public debt relative to GDP will raise interest rates and crowd out private investment, which could have implications for productivity gains and trend growth. The extent of this crowding out is difficult to predict. The US still enjoys a tremendous advantage from its dollar being the world’s primary reserve currency, meaning that global savings can be readily accessed to fund deficits.
But at some point, global investors could become increasingly concerned about the US fiscal profile, especially if the ensuing years show no progress on entitlement reform, an extension of current fiscal largesse, and additional stimulus in the next recession.
 The US H-1B visa is a non-immigrant visa that allows US companies to employ graduate level workers in specialty occupations that require expertise in specialised fields such as in IT, finance, mathematics, science, medicine, etc. H-1B visas are subject to an annual visa cap each financial year and are heavily over-subscribed. Current immigration law allows for a total of 85 000 new H-1B visas to be made available each government fiscal year. This includes 65 000 new H-1B visas available for overseas workers in specialty (professional) level occupations with at least a bachelor’s degree.
 Specifically, discretionary spending as a percentage of GDP is maintained at the 2019 level for the entire projection horizon.
 Specifically, the recession scenario assumes that nominal GDP growth slows from 4.0% in 2020 to 2.3% in 2021, and then rises back towards trend over the following three years. In addition to automatic stabilisers, the Federal government responds with a two-year fiscal stimulus programme of 1% of GDP in 2020 and 0.5% of GDP in 2021. The scenario also assumes lower interest rates (and a lower cost of financing the stimulus), as the Federal Reserve responds to the recession with easier monetary policy.