The Trump administration’s first CEA report

Greg Ip, reviewing the Trump administration’s first Council of Economic Advisers report, finds credible its claims that Barack Obama’s policies, particularly in his second term as president, materially slowed economic growth, even though Mr Ip acknowledges that the CEA’s claims as to magnitudes are probably exaggerated.

The CEA’s thesis is that a wave of tax and regulatory policies reduced both workers’ incentives to work and businesses’ incentive to invest, leading to slower economic growth than would otherwise have been achievable. I am sympathetic to arguments of this type, having often observed that “business confidence is the cheapest form of stimulus”. And I would be the last to argue that every regulatory intervention of the late Obama years was salutary.

I would also note that much of what the Obama administration proposed (for example, more infrastructure spending and responsible tax reform) would have triggered even greater economic growth but never came to pass, largely due to congressional roadblocks. There was certainly more that could have been done.

But at least three broad features of the economic landscape make the CEA’s view an unlikely explanation for disappointing economic growth.

First, the dominant reason for slow growth has been what economists label slow total factor productivity growth. That is, the problem has not primarily been a shortage of capital and labour inputs into production, but rather slow growth in output given inputs. After growing at about 1.75 per cent a year between 1996-2004, the TFP growth rate has halved since 2005.

While TFP has fallen off rapidly, there is no basis for supposing that levels of labour input or capital are less than one would expect given the magnitude of the financial crisis. In fact, labour force participation rates in 2016 lined up closely with Federal Reserve researchers’ 2006 predictions. This suggests the unimportance of the various factors adduced by the CEA’s report.

Second, perhaps the biggest surprise of the last few years has been the remarkably low rate of inflation even as the unemployment rate has reached 4 per cent.

Year after year, consensus and Fed forecasts of inflation have fallen short of what was forecast. If, as the CEA believes, our slow economic growth is a result of too little supply of labour and capital one would expect surprisingly high rather than surprisingly low inflation as demand growth collided with constricted supply. This is the opposite of what we observe. On the other hand, the secular stagnation hypothesis which emphasises issues on the demand side would predict exactly the combination of sluggish growth, low inflation and low capital costs that we observe.

Third, the essential idea behind the CEA’s thesis is that capital has been greatly burdened in recent years by excessive regulation, high taxes and a lack of availability of labour. This idea is belied by the behaviour of the stock market and of corporate profits. Over the course of Mr Obama’s second term, corporate profits increased by nearly 20 per cent and the S&P 500 grew by over 50 per cent. This hardly suggests a period of excessively increasing burdens on capital.

The observation that share buybacks appear to be the largest use of the proceeds from the Trump tax cuts points in the same direction. It has not been costs of capital that has held back investment in the US in recent years.

If the Obamasclerosis theory does not fit the facts of slow growth in recent years, what are its likely causes? This will remain a matter for active research. But my guess is that key elements include hysteresis effects from the financial crisis and associated recession, reduced application of innovation in the economy in recent years and possibly the adverse effects of rising monopoly power and diminishing competition in a range of markets.