Focus Forward – The Growth “Mask” Will Likely Shrink

July 6, 2020
Focus Forward – The Growth “Mask” Will Likely Shrink

The world has been focused, rightfully so, on the pandemic. The shutdown and the shape of the economic recovery have been on investors’ minds as the main events over the last four months. It’s hard to believe it was only four months ago when we all still lived our daily lives without masks and social distancing. But perhaps that is one of the lessons we’ve learned from this trial – that bad times seem to drag on, longer than reality would suggest, while good times come and go in seemingly lightning-speed fashion.

We have been suggesting that the shape of the economic recovery from the pandemic will resemble a Nike swoosh rather than a “V” or some other form. The swoosh form suggests an economic recovery pace which, while positive, is somewhat slower and more protracted than the “V” form.

The swoosh script kind of goes as follows: As the economy reopens, we will see increased infection rates (this is occurring), which leads to anxiety about reopening (this too is happening), which leads to “backing and filling” of economic activity. All of this supports our view of the Nike swoosh shape of recovery. We continue to expect to see gross domestic product (GDP) growth to have contracted by 5% year-over-year by the fourth quarter this year.  We expect to see positive GDP growth quarter-over-quarter starting in the third quarter of this year.

Longer Term View – Government Influence to Build

What of the longer term? With increased reliance on government spending, which is designed to soften the government-mandated economic shutdown, what can Americans expect going forward as the economy regains its footing and the next period of economic recovery/expansion occurs?

The world has changed. I think life, and the economy as we knew it, isn’t going to be the same going forward, even if a vaccine to eradicate the uncertainty of the coronavirus is forthcoming. During good times, many turn to capitalism’s forces and ride the positive wave. During bad times, some turn to the government to save us from the malady that has been thrust upon us. During bad times, many become more socialistic in their approach toward economic and social issues. Federal government spending, as a percent of GDP, has ballooned to above 35% (from a long-term, normalized level of 20% – 30% per Ned Davis Research), government reach has accelerated. I believe some politicians won’t easily let this newly found reach and power go. This shift to an even-greater governmental-led economy creates:

  • A government with a growing presence in all our personal lives. 
  • A Federal Reserve with a reach and influence on global economic events that is much more pervasive than in the past (if that is possible).   
  • The age-old push and pull of capital allocation shifting more toward government control, either through outright government spending, or through new, governmental control as a result of regulatory oversight.
  • Higher tax rates for many, if not most, Americans. 

This all leads to the view that economic variables limit economic friction and tend to be more efficient in generating high-growth and economic opportunities. When added interference is introduced to capital allocation decisions, those decisions tend to be less effective and efficient. This is the environment that I see the world has entered, and specifically, that U.S. economic growth will be hobbled going forward, as compared to our longer-term secular growth profile. Combining this change with the ever-aging level of the U.S. population base, leads us to the view that, yes, indeed our longer-term GDP growth rate is probably going to average somewhere between 1% and 2%, instead of the historical normal average rate of 3.1% (data per NBER).

Government Leads the Way to Lower Growth

Both history and current evidence shows that as governments become an ever-larger portion of the economy, economic growth has suffered.

Are we able to compare the historical U.S. economic growth with other mature countries where government spending and influence has been higher than our own country? Yes. Below, find information for the eight larger, more developed democratic economies (non-emerging) showing economic growth and government spending. 

5-Year GDP Growth & Government Spending
GDP Growth Compared to Government Spending

As can be seen, in both the tabular data and the depicted chart, economies with higher government spending tend to show slower overall economic growth over the last five years, according to IMF data. I’ve conducted a more thorough, 50-country study of this data in the past. This study confirms the relationship noted above, which suggests as government spending becomes a larger portion of economic activity, overall economic growth tends to slow (U.S. government spending is federal spending along with local and state spending). 

A valid question to be asked: “Is a high level of government spending the cause or the result of slow economic growth?” I don’t know the answer, but even with that thought, the point is still clear…a high level of government spending has not coincided with rising economic growth.

Current Situation – The Government Will Reverse Course and Cut Spending, Right?

With the virus still prevalent, and unemployment plus business failures accelerating, recent federal government spending has ballooned to an annualized rate of $6.8 trillion, according to a report from the AP. This represents an increase of $2.8 trillion from 2019’s federal spending rate. At $6.8 trillion, federal government spending represents about 31% of overall national GDP. Add in state and local government spending, and total government spending is now a little more than 50% of overall GDP, similar to levels we currently see in Italy, Germany and France.

Some suggest the historically high level of federal government spending we are now witnessing will shrink once the health pandemic recedes. I wouldn’t count on it. Over the last 70 years, annual federal government spending has only declined five times, averaging 3.2% reductions. For reference purposes, the average annual change in federal government spending over that 70-year period has been +7.2% per year, a period when nominal GDP growth averaged 6.4%, according to the St. Louis Federal Reserve.

Even if government spending recedes from its current high levels, history tells us that politicians tend not to reduce spending dramatically, rather, they tend to slow spending only moderately, to be followed eventually by even higher levels of increase.   

We come back to the longer-term view that overall economic growth will probably remain slower than we have experienced in the past. Some ask why this is a problem. The people of slow-growth economies may be basically happy with their lives. I suggest the trade-off of economic growth and government spending is the age-old trade-off between economic opportunity and economic security. With all of the recent social upsets, many Americans believe economic security has become more important, while economic opportunity has become less so. Perhaps this is the case. If so, I find this a disheartening development. 

Why does increased government control of the economy necessarily mean lower overall economic growth? The answer lies in the efficiency of capital allocation and the income multiplier effect. 

Summary and Closing Thoughts

If we are right, the scene is being set for the U.S. economy to grow more slowly over the long term than has been the case of late. When the economic growth pie is expanding at a significantly lower level than many expect, capital allocation and spending decisions become more challenging. Growth tends to mask bad decisions. I think that mask is becoming smaller.

Next month, we will focus on the upcoming election – not to make any predictions, but simply to look at historical data and see how the U.S. economy has performed when one party or the other has been in power. Should be interesting and perhaps surprising to some. 

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