Window of opportunity
2017 has started with a lot more uncertainty and optimism than 2016. Global stock markets are up significantly, leading Yale’s Robert Schiller to warn of “illusions”. By comparison, equity prices had plunged in the first weeks of 2016. In the U.S., the Dow Jones and the S&P are up 8% and 6% since Election Day — even after the correction of the last ten days, as investors refocused on the uncertainty.
Both the optimism and the uncertainty are closely tied to the U.S. Presidential transition. The new Administration brings a marked change in direction from the last eight years, and there is high uncertainty on the prioritization and the details of policies, with both upside and downside risks. Meanwhile, other major regions of the world economy have shown resilience but also increasing risks.
U.S. business and consumer confidence have risen strongly. Consumer confidence as measured by both the Conference Board and the University of Michigan is back at the record-high levels last seen in the heady days of 2006–07. Even more striking, optimism of small businesses is a lot higher than its previous peak, having jumped by close to twelve points since last September. Both consumer and business confidence have risen strongly since Election Day. This is a lot more meaningful than the surge in equity prices. Small and medium-sized businesses form the backbone of the U.S. economy and employ about half of the workforce. The surge in their optimism signals that there is ample room to improve business conditions.
The new Administration’s platform includes three potentially growth-enhancing sets of measures: tax reform, regulatory reform, and infrastructure spending. In the latest World Bank’s Ease of Doing Business report, the U.S. ranks at number eight overall, but comes in only 36th on taxes (just behind Mongolia) and 51st on the ease of starting a business (just after Côte d’Ivoire). The U.S. tax system is recognized as exceedingly complex, and a reform is overdue. The tax reform blueprint that is being discussed would include a significant reduction in the headline rate, changes to interest payment deductibility and investment depreciation, a VAT-style border adjustment, and a provision for profit repatriation at a one-off lower rate. The impact will depend on the exact changes that will be approved, but this is a long-overdue reform that could have an important positive impact on investment.
A simplification of the regulatory environment could be similarly beneficial. Can regulations make a big difference to economic growth? Stanford’s John Cochrane has some of the best expositions on the issue; I would highlight two 2016 blog posts where he (a) discusses an academic study finding that the cumulated weight of regulations has slowed U.S. growth by 0.8 percentage points per year since 1980; (b) shows a strong positive correlation between per capita income and the ease of doing business ranking. The latter chart, reproduced here, is quite persuasive evidence that a better business environment is good for growth. (per capita GDP in $ is shown in log scale on the vertical axis).
Infrastructure investment is also sorely needed: in 2013 the American Society of Civil Engineers estimated that $3.6 trillion would be needed by 2020. Here, however, it is the quality of investment that will make the difference to long-term growth. Repaving existing roads and modernizing ports and airports will help; but to move the needle on productivity growth, investment should also focus on new generation digital infrastructure in the power, transportation and communications networks, to accelerate the development of autonomous vehicles, smart grids and the overall digital-industrial revolution.
Trade policy is the biggest downside risk. Globalization is under siege and protectionism has been on the rise for several years. Global trade, which used to rise at twice the pace of global GDP, now barely keeps pace. Globalization has lifted one billion people out of poverty in the last twenty years, and delivered a more balanced global economy; but it has contributed to rising inequality within countries, fueling populism, nationalism, and anti-globalization sentiment. We are entering a new phase, a Globalization 2.0 where bilateral negotiations between national states will play a bigger role than multilateral organizations and treaties; and technology will play a bigger role in lending resilience and flexibility to global supply chains. The world is more interlinked than ever before — isolationism is not an option. The transition to Globalization 2.0 is necessary, but will not be easy — and things could go badly wrong. Heavy recourse to tariffs could escalate into full-fledged trade wars, which would harm economic growth and erode purchasing power.
The U.S. and global economy start 2017 in good shape. U.S. GDP keeps expanding at 2–2 ½ %; the Fed has now acknowledged that we are back at full employment, and wage pressures have gotten more noticeable (close to 4% YoY for continuously employed workers). Europe is enjoying robust growth, with the Eurozone expanding at over 1 ½ % per year compared to a potential growth rate of less than 1%. China’s growth remains on track at 6–6 ½ %. Nothing exceptional, but healthy. In fact, I would argue that the strong stock market gains since February 2016 are in large part a recognition that the doom and gloom of a year ago was unjustified. Commodity prices have partially recovered and then stabilized; this has helped cure the prevailing deflation-phobia, and the trend is now for moderate reflation with corresponding upward pressure on funding costs.
But the risks are mounting. Europe still needs to absorb the Brexit shock, which will test the EU’s institutional cohesiveness; elections in France, Germany and possibly Italy could bring new shocks in 2017. China’s rebalancing exercise becomes more difficult, and the steady rise in debt levels is an increasing concern. We have a precious window of opportunity to bolster the U.S.’s growth potential and start addressing global trade tensions, making the U.S. and global economy more resilient to shocks that could manifest themselves sooner rather than later.
