Trump unveiled his tax plan yesterday. Part of his agenda calls for a reduction of the corporate tax rate from 35% to 15%.
It’s unclear at this moment what the final result will be after all the negotiations and political horse trading that will inevitably take place.
It’s very likely Trump planned to enter negotiations at 15%, fully expecting a compromise bill resulting in a demonstrably higher rate.
It’s the art of the deal.
But it doesn’t seem particularly well thought out.
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It’s difficult to project the impact the tax cuts will have on the economy, of course. But without offsetting spending reductions or making up the revenue somewhere else, a tax cut could balloon the deficit.
Estimates vary, but a 15% tax rate without offsets could cost the government trillions of dollars in lost tax revenues over the next decade.
But Trump advisors believe they can avoid a debt crisis through higher than average growth. This is mathematically possible but extremely unlikely.
The Trump team hopes for nominal deficits of about 3% of gross domestic product (GDP) and nominal GDP growth of about 6%, consisting of 4% real growth and 2% inflation. If that happens, the debt-to-GDP ratio will decline and a crisis might be averted.
Again, this outcome is extremely unlikely. Deficits are already over 3% of GDP and are projected by the Congressional Budget Office (CBO) to go higher.
CBO estimates that both inflation and real GDP will each grow at about 2% per year in the coming ten years. This means that nominal GDP, which is the sum of real GDP plus inflation, will grow at about 4% per year, not the 6% the Trump team envisions.
The debt-to-GDP ratio is projected to soar even under the Trump team’s rosy scenarios.
CBO projections show that deficits will increase to 5% of GDP in the years ahead, substantially higher than the hoped for 3% in the Trump team formula.
Since debt is incurred and paid in nominal terms, nominal GDP growth is the critical measure of the sustainability of U.S. debt.
Why is that important?
Because retiring Baby Boomers will soon be making large demands on social security, Medicare, Medicaid, Disability payments, Veterans benefits and other programs that will drive deficits higher.
But there are numerous problems even with the CBO projections.
They make no allowance for a recession in the next ten years. That is highly unrealistic considering that the current expansion is already one of the longest in history. A recession will demolish the growth projections and blow-up the deficits at the same time.
CBO also makes no allowance for substantially higher interest rates. With $20 trillion in debt, most of it short-term, a 2% increase in interest rates would quickly add $400 billion per year to the deficit in the form of increased interest expense in addition to any currently project spending.
Finally, CBO fails to consider the ground-breaking research of Kenneth Rogoff and Carmen Reinhart on the impact of debt on growth. I have discussed the 60% debt ratio danger threshold before. But there is an even more dangerous threshold of 90% debt-to-GDP revealed in the Rogoff-Reinhart research.
At that 90% level, debt itself causes reduced confidence in growth prospects — partly due to fear of higher taxes or inflation — which results in a material decline in growth relative to long-term trends.
Meanwhile, the U.S. debt-to-GDP ratio is currently at 105%, and heading higher. Under any standard, the U.S. is at the point where more debt produces less growth rather than more.
There’s almost no way Trump’s tax cutting or infrastructure policies can supply the stimulus the market is pricing in.
As for growth, we are now in the eighth year of an expansion — quite long by historical standards. This does not mean a recession occurs tomorrow, but no one should be surprised if it does.
Productivity has stalled out in recent months. Economists are not sure why. It could be due to lack of investment by business, or that workers are not being trained in useful skills, or that everyone is spending too much time on social media. Whatever the cause, productivity is flat.
Fourth-quarter 2016 GDP came in at 1.9%, below expectations — the final chapter on the worst year of U.S. growth since 2011 when the economy was still healing from the global financial crisis.
First-quarter 2017 growth is even slower. The Atlanta Fed estimates today that the economy grew at just 0.2% (seasonally adjusted), down from its April 18 projection of 0.5%. That’s stall speed essentially.
The strong dollar has a major headwind to growth, along with flat labor force participation and weak productivity growth.
Growth in a major economy is simply the sum of increases in the labor force plus increases in productivity. Think about it. How many people are working and what is the output per worker? That’s it; that’s all there is. The reality is that the workforce is not growing.
These headwinds practically insure that the Trump growth projections are wholly unrealistic. With higher than expected deficits, and lower than projected real growth, there is one and only one way for the Trump administration to reduce the debt ratio — inflation.
If inflation is allowed to rip to 4% and Fed financial repression can keep a lid on interest rates at around 2.5%, then it is possible to achieve 6% nominal growth with 5% deficits, which would be just enough to keep the debt ratio under control and even reduce it slightly.
Can Trump pull-off this finesse? Are his advisors even analyzing the problem along these lines?
I have my doubts.
But today’s stock market is priced for perfection. The Dow’s once again up around 21,000 — a good 12% higher than election night.
Either growth will rebound based on “animal spirits” and the Trump stimulus working better than expected or markets will collapse once they realize the growth is not coming. By “collapse,” I mean a violent stock market correction, a falling dollar and major rallies in bonds and gold. I expect the latter.
Financial crises are not mainly about the business cycle. They’re about investor psychology, sudden shocks and the instability of the financial system. Right now investors have been lulled into complacency. But numerous shocks are waiting to happen and the system is highly unstable due to overleverage and nontransparency.
Despite Trump’s best efforts and positive policies, a collapse could happen any day unless radical steps are taken to prevent it — such as breaking up big banks and banning derivatives.
I’ve been warning about this for a while, but now mainstream economists see the danger too. Nobel Prize winner Robert Shiller, for example, sees a stock market crash coming that could be worse than 1929 or 2000.
I hope he’s wrong.
For now, investors should not stand in front of a moving train. Keep cash ready and be prepared to move into gold, bonds and the euro. In fact, it’s not too soon to leg into those positions now.
Instead of watching the tape or short-term trends, my advice is to stay focused on the long-term trends.
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