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The US Urgently Needs the Tax Reform to Close the Recovery Gap

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The US economy expanded in the second quarter of 2017 by more than double the pace shown in the first quarter, reducing concerns about stagnation or even a forthcoming recession.

Gross domestic product rose at a 2.6% annualized rate from the previous quarter, while first-quarter growth was revised down to 1.2% from 1.4%. The biggest drivers of growth were consumer spending, the biggest part of the economy, which rose 2.8%, while non-residential fixed investment increased 5.2%, adding to growth. After years of no increase in capital expenditure, business investment in equipment rose 8.2%, while net exports also added to growth.

All these figures are relevant, but there is one that is significantly more important.

The recovery growth gap compared to other recoveries since 196o has been set at $1.67 trillion. That means the weakest recovery in recent history. The Federal Reserve expects 1.9% growth for 2017 going to 2% in 2018, the weakest relative to potential and previous recoveries.

All of this is after a massive $4.7 trillion monetary stimulus and $10 trillion in new debt (a fiscal deficit increase of $13 trillion at State, local and Federal level).

As such, the concern is that the economy is not doing what it could do in terms of growth, delivering on real wage growth and creating better jobs.

There is a clear cap on growth set from excessive taxation and high government debt. The US continues to suffer one of the highest corporate tax rates, and disincentives to investment persist.

The evidence of the positive impact on growth, jobs, and wages of lower corporate taxes has been published in many studies. The example of more than 200 cases in 21 countries shows that tax cuts and expenditure reductions are much more effective in boosting growth and prosperity than spending increases. The studies of Mertens and Ravn (The dynamic effects of personal and corporate income tax changes , 2012), Alesina and Ardagna (Large changes in tax policy, taxes versus spending , 2010), Logan (2011), or the IMF conclude that in more than 170 cases, the impact of tax cuts has been much more positive for growth.

You might think that the US is doing just fine with the current system, but that would be missing the enormous potential of the economy. Consumption is the largest part of the economy and would benefit from returning to taxpayers their hard-earned money after $1.5 trillion in new taxes in the past eight years. Additionally, we cannot expect companies to increase capital expenditure in the US to recover Capex investment and create better-paid jobs if the tax burden stands almost 10 points above the OECD average and it is almost impossible to generate a Net Return on Invested Capital above the weighted average cost of capital, now that interest rates are rising.

The two main components that will save the US economy from entering a recession due to the boomerang effect of incorrect stimulus and excessive debt will be consumption and investment. None of them can reach their full potential, and offset the inevitable slowdown in other components, without a tax reform aimed at supporting growth. Tax cuts and supply-side measures are badly needed after demand-side, high debt and government intervention have left such an enormous recovery gap.

An overly optimistic reading of these GDP figures misses the point. The US needs to grow closer to its immense potential or face the consequences when global forces negatively impact the economy.

The US needs to be prepared, and deliver more robust figures, before the Chinese slowdown, the backlash of European stimuli and the sudden stop in emerging markets affect its domestic economy.

The US cannot afford to be complacent with these growth figures because it needs to think of the future, and the only way to lighten the burden of debt that cripples the economy is by boosting growth and reducing spending.

Cutting taxes does not just make economic sense, it is social justice. The US  government needs to return to taxpayers the effort that they have made lifting the country from the depression.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google

 

Eurozone Growth Seems To Have Peaked

Global Economy, On the cover, Sin categoría
Old Europe continues to reveal its old problems: Overcapacity, companies in difficulties and an aging population that has more conservative consumption patterns

European PMIs for July in the eurozone have shown how difficult it is to continue to believe in the mirage of growth that has been sold to us by Old Wall Street after Macron’s victory in France.

It is important to highlight the difference between a modest recovery and excess optimism, and in the euro area markets have gone from the first to the second without calibrating real hard data.

Both manufacturing and service PMIs continue in expansion mode, but France shows the weakness to which we are accustomed in an economy that promises reforms and has delivered stagnation for two decades, similar to what happens with Italy. More importantly, data from Germany also indicates a slowdown in this expansion.

This graphic courtesy of Morgan Stanley is very revealing. It shows the relationship between PMI indicators and GDP growth, and how data peaked in the past months.

 

 

There are other interesting variables that confirm the modestly positive but not euphoric tone of the European economy. Gross capital formation growth of 6% is positive, but the level of overcapacity in the European Union continues above 20%, therefore investment is still well below 2009 levels.

The investment expectations of the non-financial sectors point to an almost imperceptible capital expenditure (capex) increase in 2017, and certainly not above the average depreciation rate, which indicates that companies do not see an attractive environment for investment despite ultra-low rates, and too much of capital goes to real estate, construction and capital recycling (mergers and acquisitions).

The euro zone increase in consumption and credit growth are decent but modest, yet well below the growth of the money supply, at least a third less. Not surprisingly, with 1.2 trillion euros of excess liquidity in the eurozone, markets have opted for aggressive multiple expansion of stocks, well above the growth of adjusted real profits. That is why we must pay attention to the macroeconomic reality, to avoid falling into the trap of euphoria.

The latest Bank of America data reminds us that in Eurostoxx 600 almost 9% of companies can be considered “zombies”, ie their generation of operating profits does not cover the cost of interest payments, despite historically low-interest rates and huge liquidity. With a banking system that continues to accumulate almost 900 billion euros of non-performing loans, this is a combination that investors should not ignore.

Old Europe, therefore, continues to reveal its old problems: Overcapacity, companies with difficulties and an aging population that has more conservative consumption patterns. That is why we maintain our expectations for Eurozone growth unchanged for 2017 and 2018, and we expect confirmation in corporate earnings of a guidance for moderate improvement in margins and balance sheets.

Economies that are betting on structural reforms are leading growth, but we cannot ignore the fact that two of the largest economies in the eurozone, France and Italy, face enormous challenges that are unlikely to be solved betting that monetary policy will solve everything.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google

The Rise of Zombie Companies, And Why It Matters To You

Global Economy, On the cover, Sin categoría

The Bank of International Settlements (BIS) has warned again of the collateral damages of extremely loose monetary policy. One of the biggest threats is the rise of “zombie companies”. Since the “recovery” started, zombie firms have increased from 7.5% to 10.5%. In Europe, Bof A estimates that about 9% of the largest companies could be categorized as “walking dead”.

What is a zombie company? It is -in the BIS definition- a listed firm, with ten years or more of existence, where the ratio of EBIT (earnings before interest and taxes) relative to interest expense is lower than one. In essence, a company that merely survives due to the constant refinancing of its debt and, despite re-structuring and low rates, is still unable to cover its interest expense with operating profits, let alone repay the principal.

This share of zombie firms can be perceived by some as “small”. At the end of the day, 10.5% means that 89.5% are not zombies. But that analysis would be too complacent. According to Moody´s and Standard and Poor’s, debt repayment capacity has broadly weakened globally despite ultra-low rates and ample liquidity. Furthermore, the BIS only analyses listed zombie companies, but in the OECD 90% of the companies are SMEs (Small and Medium Enterprises), and a large proportion of these smaller non-listed companies, are still loss-making. In the Eurozone, the ECB estimates that around 30% of SMEs re still in the red and the figures are smaller, but not massively dissimilar in the USD, estimated at 20%, and the UK, close to 25%.

The rise of zombie companies is not a good thing. Some might say that at least these companies are still functioning, and jobs are kept alive, but the reality is that a growingly “zombified” economy is showing to reward the unproductive and tax the productive, creating a perverse incentive and protecting nothing in the long run. Companies that underperform get their debt refinanced over and over again, while growing and high productivity firms struggle to get access to credit. When cheap money ends, the first ones collapse and the second ones have not been allowed to thrive to offset the impact.

Low interest rates and high liquidity have not helped deleverage. Global debt has soared to 325% of GDP. Loose monetary policies have not helped clean overcapacity, and as such zombie companies perpetuate the glut in many sectors, driving down the growth in productivity and, despite historic low unemployment rates, we continue to see real wages stagnate.

The citizen does not benefit from the zombification of the economy. The citizen pays for it. How? With the destruction of savings through financial repression and the collapse of real wage growth. Savers pay for zombification, under the mirage that it “keeps” jobs.

Zombification does not boost job creation or buy time, it is a perverse incentive that delays the recovery. It is a transfer of wealth from savers and healthy companies to inefficient and obsolete businesses.

The longer it takes to clean the overcapacity -whcih stands above 20% in the OECD- and zombification of the economy, the worse the outcome will be. Because, when the placebo effect of monetary policy disappears, the domino of bankruptcies in companies that have been artificially kept alive will not be offset by the improvement in high added-value sectors. Policy makers have decided to penalize the high productivity sectors through taxation and subsidize the low productivity ones through monetary and fiscal policies. This is likely to create a vacuum effect when the bubble bursts.

The jobs and companies that they try to protect will disappear, and the impact on banks’ solvency and the real economy will be much worse.

Avoiding making hard decisions from a crisis created by excess and overcapacity ends up generating a much more negative effect afterwards.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google

(Data BIS, Moody’s, S&P)