Extreme Partisan Division
I’d prefer to write about markets instead of politics. But the tone and pace of political news has become stifling in the last two years, and I believe our present political circumstances warrant some thought as it pertains to markets. Incidentally, an interest in politics is what led me to study economics, which eventually led to a career on Wall Street. In subsequent years I grew tired of the mind-numbing trench warfare that takes place between the two major parties. Studies show that partisan division has never been as extreme as it is now ( Pew Research: Partisanship), and it’s difficult to see it improving soon. The internet, social media, and the 24-hour news cycle seem to be exacerbating some of the worst instincts we humans possess. Rather than providing clarity with better information, we are drowning in a sea of data, which is polluted with half-truths and blatant misinformation. There is little attempt at bipartisanship these days. Short-term political gain is the primary motivation, and constituents only matter from poll to poll. In the 1990’s, there was often talk about the prevalence of “gridlock”. That is, the inability of congress to take any definitive action. The partisan divide of the 1990’s seems quaint by comparison, as evidenced by 16% approval rating for congress in Gallop polls.
Within the parties, there are various political positions which at times may act as “litmus tests” for party loyalty. For Republicans, restrictions on abortions (and possibly abolition), the right to bear arms, limited regulation, and adherence to free market principles are core principles all party members are expected to uphold. For the last few decades, the “Reagan Revolution” of the 1980’s has held a special place in GOP hearts. A dogmatic belief in the benefits of deregulation, and more importantly, lower tax rates, is paramount in Republican orthodoxy. Yet, this presents a problem in the Republican party of 2017. The forces that propelled Donald Trump to the White House have little overlap with the supply-side theory that was a cornerstone of the Reagan era.
Being a naïve undergrad in the 1990’s, I could not understand how Republicans could view the 1980’s as an economic golden age, while Democrats deplored the ’80s as a new dark age . As I said, naïve. The Mark Twain adage, “lies, damn Lies, and statistics”, applies as much to economics as anything else, and cherry-picking statistics to promote a favored view is a time-honored tradition in politics. The concept of “Supply-Side Economics”, is the epicenter of that debate, and my primary motivation for studying economics was to gain an understanding of why it was so controversial. Supply-side theory promotes the idea of spurring investment (supply) rather than demand through lower taxes and deregulation. Certainly, it was not a surprise that liberal Democrats disliked economic plans that aimed to give large tax cuts to wealthier people. However, what was surprising to me was that there did not seem to be a consensus on whether or not the “Reagan Revolution” had even been beneficial in terms of economic growth.
Why am I bothering to dredge this up now? In my previous post, Disruptive Donald Balks at the Fed , I invoked the specter of Reaganomics as a burgeoning element in the current political debate. The effort of Republicans to implement a drastic overhaul of the tax system is bringing supply side views to the forefront once again. The GOP is claiming that large tax cuts will lead to a faster rate of economic growth without expanding the deficit. From the beginning, this was the promise of supply side economic theory. Lower tax rates, particularly at higher income levels, promotes higher growth rates. Deregulation also has a role to play, but the focus has usually been on tax rates. Economists love to represent ideas with charts, and the simplest way to convey the idea behind supply-side economics is with the Laffer Curve (chart 1).
Chart 1: The Laffer Curve
By Vanessaezekowitz at English Wikipedia, CC BY 3.0,
Chart 1 shows three different Laffer curves each representing a different economy, with dotted vertical lines marking the optimal tax rate for that economy. Any change up or down from that optimal rate will result in a drop in tax revenue. If we were to assume our economy has a tax rate denoted by t*, then the red curve is the one promoted by supply-side theorists, where lowering tax rates results in higher revenue, and raising them makes revenue lower. The blue is a more traditional viewpoint with tax revenues rising and falling with the tax rate. Two issues should be readily apparent. First, there is no one tax rate. There are many different types of taxes, and marginal rates vary with the level of income. Second, even if we simplify the analysis by using an average tax rate for the whole economy, can we assume that the red curve is reality, and reducing taxes will lead to more revenue? This second part is the heart of the matter. Since the 1980’s Republicans have generally worked on the assumption that lowering taxes always boosts economic activity, and therefore, tax cuts can “pay for themselves”. But is that true?
Using real GDP data from the Bureau of Economic Analysis to compare the two decades is telling. The compound annual growth rate during the 1970’s comes out at 2.44% versus 2.16% for the 1980’s. I will admit to being shocked by this realization! A supply-sider might rightly argue that including the first two years of the 1980’s is not fair. The Reagan tax cuts had not been enacted, and there were two sharp downturns as Federal Reserve Chairman, Paul Volker, was hiking rates to combat inflation. If we compare the post-recession periods of the two decades, 1975-1979, and 1982-1989, we get CAGRs of 3.95% and 3.94%. Virtually no difference. And to drive the point home even harder, federal budget deficits in the ’82-’89 period averaged 3.87% of GDP, versus 2.42% in the ’75-’79 period. So no matter how you want to measure it, there is no evidence that the large tax cuts raised economic growth during the 1980’s. But federal budget deficits actually averaged an extra 1.5% of GDP. Bruce Bartlett, domestic policy advisor under Ronald Reagan, recently attested to this in a Washington Post article ( I helped create the GOP tax myth )
As I have illustrated above, the evidence shows that tax cuts do not pay for themselves. In reality, there are a multitude of elements that affect economic growth, and it is difficult to isolate one driver, since all of the elements are in motion over time. Personally, I believe that cutting certain taxes at the right time can have a positive effect on growth. Hence, the structure of the tax system is as important as the total amount of taxes paid. Incentives should be properly aligned to promote growth. But that’s not how it is generally presented. Republicans are selling the idea that tax cuts always accelerate growth. Much will depend on various alternatives are being discussed at present, and the end result is very much in flux. Regardless of what Republican plan ultimately emerges from the fray, you can bet Democrats will attack the plan as a typical Republican “tax giveaway to the rich”, and will likely oppose it unanimously. Given the narrow majority Republicans hold in the Senate, there is little room for Republican dissension.
Republican Civil War
This returns us to our fractious political environment. With Republicans in charge of both houses of congress and the White House, it would seem passage of tax cuts would be a sure bet, despite Democratic opposition. But today’s GOP is not the party of old. Donald Trump rode to the White House on a wave of populist anger. Stephen Bannon, Trump’s former Chief Strategist, promotes the view of what we might call the “Trump Republican”. These individuals are middle or working class people who feel they have been neglected by Republican leadership over the years. Paul Ryan, Speaker of the House, embodies the characteristics Trump Republicans hate. He is attacked for promoting policies that cause jobs to leave the country for cheaper labor destinations. Former White House strategist Stephen Bannon, now back as the head of Breitbart, the conservative news site, has openly targeted Ryan and other Republican leaders, which they label as “globalists” and “elitists”. Bannon’s vision is that the Republican Party be transformed into a nationalist workers’ party. Such a direction would be diametrically opposed to the goals of the Republican party over the last several decades. Extreme divisions do not just exist between the parties anymore, they exist within the parties.
Certainly, the Democrats are divided between the Democratic establishment and the Bernie Sanders supporters, but Democrats are not in charge now. Therefore, their divisions will play little part in driving current policies, and playing the opposition party will likely not hurt them. On the other hand, Republicans have shown themselves woefully inept at governing thus far, despite their advantages. The failure to repeal Obamacare through three separate attempts has been humiliating for the party. After seven years of promising repeal, they had no ready and viable plan. Republican leaders pushed to pass a plan that had an abysmal 17% approval rating (vs. 51% for Obamacare), and was widely panned by groups such as the American Medical Association and the American Association of Retired Persons. They also sought to ram through this legislation in a matter of weeks, with virtually no debate, and before the Congressional Budget Office could properly score it. It’s difficult to see how these actions can even qualify as good politics, much less good governance. Stalwart Republican Senator from Arizona, John McCain, said as much when after delivering the deciding vote in the senate he stated, “It’s time Congress returns to regular order.” Amen! But I don’t think any of us should hold our breath.
Desperation and Recklessness
Beyond tax cuts, the GOP has pushed the notion that a simplified tax code is in the country’s best interest. Without a doubt, our roughly 74,000 page tax code is absurd, and any valid effort to simplify it should be embraced. But this should be a bipartisan undertaking which properly weighs the pros and cons of various elements of the code. Unfortunately, the Republicans are now desperate to get a legislative victory this year, before the 2018 mid-term election cycle starts. They have also shown themselves not to be too picky about details, or the optics of how they proceed. With that in mind, it has seemed to be a good bet that something will get passed this year. However, in elections held last week, Republicans were beaten badly, which further erodes their rapidly shrinking political capital.
The last time we had a major overhaul of the U.S. tax system was the Tax Reform Act of 1986, which took two years. Republicans are attempting to accomplish something similar in a matter of months! While an array of options have been bandied about, there seems to be little consensus, and the outcome is extremely uncertain. Despite concerted effort by the GOP, and an admitted sense of desperation, a failure similar to the health care debacle is looking increasingly possible. Even if they do succeed, it is likely that whatever plan gets implemented would increase federal budget deficits substantially. Increasing deficits at a time when the economy is already on solid ground, and the labor market is tightening, could cause both inflation and interest rates to spike, as the economy moves toward overheating.
Market is Not Priced for Uncertainty
Market action in the last few months has been relentlessly bullish. To a great extent, this is likely due to a coordinated acceleration in global growth which began last year, and not coincidentally, continued QE implemented in Japan and Europe. The third pillar supporting this rally has been the hope of substantial tax cuts enacted in the U.S. With global central banks beginning to remove stimulus, it remains to be seen how stable the global economy will be without emergency level liquidity provisions (see Are We There Yet?). A failure of Republicans to get something substantial done on tax cuts would deliver a sharp blow to what is an extraordinary level of optimism. By the same token, a tax plan that widens deficits, causing inflation and rates to spike would not be a welcome outcome, as it would require the Fed to get more hawkish. Either way, we have an extremely overbought market, a VIX that has been near record lows for months, and sentiment indicators looking frothy. Nothing has shaken this market’s resolve for quite some time. But events are starting to coalesce that could give us our first meaningful correction since before last year’s election.