Economic Outlook

December 3, 2013

Macroeconomic Calm in the Midst of Fiscal Storms

BY JASON M. THOMAS

For the past three years, U.S. policymakers have proven unable to reach agreement on a coherent strategy to combine large, back-loaded fiscal consolidation with short-term policy support. There is no reason to suspect the House-Senate Conference Committee currently meeting to formulate a 2014 Budget Resolution will meet a different fate. With little probability of longer-term entitlement reform and no rational basis to seek further near-term deficit reduction, the current budget negotiations are likely to focus on providing relief from 2014 spending cuts mandated by sequestration. While an agreement could modestly boost economic activity in 2014, the main driver of the economy’s underperformance is an especially subdued pace of business investment, a problem which is not likely to be solved by short-term budget tinkering. Fiscal policy’s significance has waned as the debt-to-GDP ratio has been stabilized and last-minute budget agreements have become the norm. Since uncertainty regarding future fiscal policy changes likely depressed private sector spending in 2011 and 2012, the economic impact of the large tax increases and spending cuts that took effect in 2013 were less dramatic than many had feared. Both GDP and payroll employment growth have substantially exceeded estimates from the Congressional Budget Office (CBO) and many private forecasters. At the same time, the impact of political brinksmanship has clearly waned as investors and business managers have been conditioned to expect last-minute budget agreements to avert catastrophe. If U.S. growth accelerates in 2014, as many forecasters expect, it will likely be due to a sudden increase in business confidence rather than any change in fiscal policy. The nonfinancial business sector continues to be net lenders to the rest of the economy, which means businesses, in aggregate, prefer to increase holdings of cash and securities instead of reinvesting cash flow into new property, plant, and equipment. Either expected returns on new investment are negative – an unlikely result given returns on existing capital remain close to historic norms – or elevated levels of risk aversion continues

• The latest round of federal budget negotiations is unlikely to meaningfully impact the near-term economic outlook, whatever the outcome.

• Fiscal policy’s significance has declined now that near-term debt ratios have been stabilized.

• Data suggest that the “fiscal drag” from 2013 tax increases and spending cuts were significantly overstated, likely because the private sector incorporated its effects in prior years.

• The damage caused by debt limit crises has declined as investors and business managers have been conditioned to expect last-minute agreements to avert disaster.

• If growth accelerates in 2014 it will likely be due to an increase in business confidence unrelated to fiscal policy.

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to inhibit capital formation. These trends are not likely to be reversed by declining “fiscal drag” or a modest increase in near-term government purchases. Deficit Reduction and Fiscal Drag In the 2013 fiscal year, the U.S. federal government ran a budget deficit of $680 billion, or 4.1% of GDP, 38% less than 2012’s $1.09 trillion deficit.1 Federal revenues increased by 13.3% in 2013 due largely to the elimination of the 2% payroll tax holiday, higher tax rates imposed on income above certain thresholds, new tax surcharges enacted as part of the Affordable Care Act, and the increase in year-end 2012 capital gains realizations and bonus payments to avoid these higher tax rates. At $2.8 trillion, federal revenues were 8% above the 2007 pre-crisis peak. At the same time, federal spending declined by 2.4% to $3.45 trillion in 2013 thanks to a 6.6% decline in defense spending and $97 billion in dividend payments from Fannie Mae and Freddie Mac.2 At 20.8% of GDP, federal outlays equaled their average of the 30 years prior to the financial crisis (1977-2007). Based on current trends, CBO expects the deficit to fall by an additional 2% of GDP over the next two years and cause federal debt to fall as a share of the economy for the first time since 2007.3

Figure 1: Fiscal Impulse as a Percentage of U.S. GDP4

The 2013 deficit reduction was not only the largest since World War II, it came about almost entirely due to discretionary policy changes enacted by the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012. Discretionary policy typically accounts for a small share of the annual variation in the deficit, which is usually attributable to economic changes that generate automatic shifts in cyclically-sensitive tax receipts (personal and corporate income, capital gains) and spending (Medicaid, supplemental nutrition assistance, unemployment insurance). Figure 1 measures the net impact of fiscal policy on GDP after accounting for changes in economic growth, interest rates, and prices. The 0.6% discretionary fiscal drag in 2013 was the largest on record and represents a 1.4% of GDP swing from the record 0.8% discretionary fiscal stimulus of 2009.5 1 CBO. Monthly Budget Review, October 2013. 2 More commonly thought of as revenues, CBO scores these payments as a net reduction in federal outlays. 3 CBO. Long-run Budget Outlook, August 2013. 4 Carlyle Analysis of IMF 2013 World Economic Outlook data. 5 Using similar methodology, researchers at the Federal Reserve Bank of San Francisco estimate that the deliberate policy choices elective policy choices exerted a 0.8% drag on GDP in 2013. See Lucking, B. and Wilson, D. (2013), “Fiscal Headwinds: Is the Other Shoe About to Drop?” Federal Reserve Bank of San Francisco Economic Letter 2013-16.

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Assessing Fiscal Policy’s Economic Impact in 2013 CBO estimated that the combined effects of tax increases and sequestration would slow GDP growth by 1.5% in 2013 and slow payroll employment growth by more than 60,000 per month.6 While counterfactuals cannot be disproved, CBO seems to have overstated the impact of fiscal tightening in 2013. Rather than decelerate sharply, GDP and payroll employment growth continued to grow in 2013 at the same moderate pace of the prior two years. Through the first three quarters of 2013, U.S. GDP expanded at a 2.2% annual rate, slightly faster than the 2.0% growth rate for all of 2012 (measured Q4-2012 relative to Q4-2011). To believe deficit reduction slowed 2013 growth by 1.5% of GDP, one would have to believe the economy would have otherwise accelerated to a 3.5% growth rate, despite growing at an average annual rate of 1.9% since 2010 and never having grown faster than 2.8% in any year since the Great Recession (again, measured Q4 to Q4). Estimates of the impact of fiscal policy changes depend critically on assumptions about the private sector’s likely response to the change. It is relatively easy to measure the decline in disposable personal income caused by a tax increase; it is more difficult to estimate what impact that decline will have on household spending, which is determined by many factors beyond current period income. As shown in Figure 2, real household spending in 2013 has been essentially unchanged relative to 2012. Households responded to the tax increase by reducing savings from an average of 5.3% of disposable income in the first nine months of 2012 to just 4.4% in the same period of 2013.7 At the same time, consumer credit utilization increased in 2013, with outstanding credit volumes growing at an average annual rate of 6.1% in the first nine months of 2013 relative to 4.9% average growth over the same period in 2012.8

Figure 2: Real Personal Consumption Expenditures, Annual Trend Growth Rate9

Similarly, payroll employment has grown at almost precisely the same rate in 2013 as it did in 2012. While month-over-month changes in total nonfarm payrolls are extremely volatile and hugely influenced by seasonal adjustment factors that can be 20x larger than the reported monthly job growth, year-over-year changes have been remarkably consistent. Since January 2012, year-over-year changes in employment have averaged 184,000 per month and varied by more than 9,000 jobs above or below this average on only four occasions (Figure 3). The data – and apparent modest acceleration in payrolls since sequestration took effect in March 2013 – suggest either CBO’s estimate of 750,000 job losses from sequestration is overstated or the

6 CBO. Long-run Budget Outlook, August 2013; Edelberg, W. (2013), “Automatic Reductions in Federal Spending,” CBO. 7 Bureau of Economic Analysis, Personal Income and its Disposition. 8 Federal Reserve, G.19. 9 Carlyle Analysis of BEA data.

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U.S. would have otherwise experienced a sudden 34% increase in monthly payroll employment growth were it not for the automatic spending cuts. Unless one is willing to believe that relatively modest automatic spending cuts are inhibiting the economy from returning to late-1990s employment growth, it seems likely that the anticipated reduction in government purchases impacted hiring decisions in prior years, resulting in little net impact in 2013.

Figure 3: Net Change in Year/Year Payroll Employment (Monthly Rate)10

The relatively muted response of economic variables to the fiscal drag of 2013 is consistent with most academic macroeconomic models, which emphasize the role expectations about future income, tax rates, business conditions, and product demand play in current decision-making. Since 2011, both the President and Congressional leaders have conditioned households and business managers to expect a large fiscal adjustment in the form of increased taxes and reduced spending. With the precise form of the fiscal adjustment left unspecified, risk-averse investors and business managers were left to prepare for worst-case scenarios, increasing the discount rates applied to risky future cash flows, deferring fixed investment, and increasing the marginal value of cash on balance sheets. This diminished the effectiveness of the “loose” fiscal policy of 2011-2012 and blunted the impact of fiscal tightening in 2013. Declining Impact of Fiscal Brinksmanship Perhaps the biggest surprise concerning the recent government shutdown was not the shutdown itself, but rather the absence of the sell-off on Wall Street anticipated by most Washington opinion leaders and elected officials, including President Obama. Instead, investors and business managers have not only proven able to anticipate future fiscal policy decisions, but also the manner in which those policies will be made. Whereas the 2011 debt ceiling crisis caused significant economic and financial dislocation, the most recent standoff generated little-to-no collateral damage. Between April and August 2011, the S&P 500 fell by nearly 18% and the implied volatility on the stock market (VIX index) rose nearly four-fold.11 Business managers responded to the uncertainty by slashing production schedules and meeting final sales by drawing down inventories. When the situation was resolved without any permanent damage to final demand, businesses had to restock, leading to a huge increase in the volatility of output. As shown in Figure 4, after declining steadily since mid-2009, the annualized standard deviation of the quarterly change in GDP increased three-fold between December 2010 and December 2011. While data on Q4-2013 GDP will not be available until late-January 2014, available evidence suggests that the economic damage from the recent stand-off was contained to the employees and contractors directly 10 Bureau of Labor Statistics, CES. 11 Bloomberg.

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impacted by the lapse in federal payments. The S&P 500 actually rose by 3.1% during the 16-day government shutdown to close at a then-record high. Rather than being liquidated in anticipation of a potential disaster, business inventories actually grew by $86 billion during the quarter, adding 0.8% to GDP (annual rate). October payrolls grew by an estimated 204,000, defying expectations of a slowdown in hiring, and bringing the three-month moving average to its highest level since April 2013.

Figure 4: Stock Market and Macroeconomic Volatility, 2009-201312

Current Problems Not Likely to be Solved by Budget Tinkering With federal debt stabilized relative to GDP over the next decade, the Conference Committee will likely seek to enact a deficit-neutral “fix” for sequestration over the next two years. The most likely scenario would involve some increase in discretionary spending (both defense and nondefense) in exchange for some increase in user fees, postal reforms that reduce subsidies, and revenue-generating spectrum sales. The economic impact of any such “fix” is likely to prove quite modest. The key problem confronting the U.S. economy continues to be a dearth of fixed investment, which is not likely to be solved by short-term budget tinkering.

Figure 5: Nonfinancial Businesses Current Account Balance as a Percent of GDP13

12 Bureau of Economic Analysis; Chicago Board Options Exchange. 13 Federal Reserve, S.2.

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Figure 5 measures the cash flow relationship (current account balance) between nonfinancial businesses and the rest of the economy (as a share of GDP). In normal times, nonfinancial businesses run a deficit with the rest of the economy, as they borrow from households and financial institutions to transform savings into fixed capital: factories, equipment, telecommunications infrastructure, etc. Since Q3-2008, nonfinancial businesses have been running record cash flow surpluses with the rest of the economy averaging 2.7% of GDP. Instead of borrowing to fund fixed investment, nonfinancial businesses have been net lenders to the rest of the economy. This financial surplus has not been necessitated by the need to repair overburdened balance sheets; nonfinancial corporate leverage is well below the levels that prevailed in the mid-1990s prior to the investment boom.14 Nor does the cash accumulation appear tied to a dearth of investment opportunities, as estimates of the economy-wide return on capital and earnings yields on the book value of corporate assets remain at record levels relative to real interest rates.15 Whatever the origin, businesses’ desire to lend rather than invest has created a surplus of savings that is the key driver of the decline in equilibrium rates of return.

Figure 6: U.S. Real Fixed Nonresidential Investment16

As shown in Figure 6, nonfinancial businesses’ cash surpluses has pushed real fixed investment about $500 billion below the level consistent with the 2000-2008 trend. The economy’s inability to transform savings into fixed investment has persisted for so long that it may have permanently reduced the economy’s productive capacity and potential growth rates.17 If true, slower growth could persist for some time, even after the economy fully absorbs the effects of the 2013 fiscal tightening. While increased government spending could potentially catalyze investment by creating expectations of higher future inflation and reducing real interest rates,18 there is no evidence any party to current negotiations advocates such a strategy.

14 Federal Reserve, B. 102. 15 The return on capital is the marginal product of capital as estimated from data found in Penn World Tables Version 8.0. The earnings yield is the ratio of aggregate ebitda to the book value of assets for all constituents of the Russell 3000 Index. 16 BEA, NIPA Tables. 17 Reifschneider, D., Wascher, W. and Wilcox, D. (2013), “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy,” Federal Reserve Board of Governors. 18 This is the primary channel through which government spending increases output in New Keynesian models. Cf. Christiano, L., Eichenbaum, M. and Rebelo, S. (2011), “When Is the Government Spending Multiplier Large?” Journal of Political Economy; and Woodford, M. (2011), “Simple Analytics of the Government Expenditure Multiplier,” American Economic Journal: Macroeconomics.

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Conclusion Over the past four years, U.S. fiscal policy has swung dramatically from accommodation to austerity: in 2009, discretionary fiscal policy expanded the deficit above previous peacetime records; in 2013, tax increases and spending cuts delivered the most sizable deficit reduction since World War II. While many forecasters anticipated similarly large fluctuations in output and employment, the economy has remained on roughly the same slow-growth trajectory throughout this period. The current negotiations are unlikely to meaningfully impact the current outlook, as prior actions have stabilized the near-term debt-to-GDP ratio and entitlement reforms appear to be off the table. The main problem plaguing the economy is especially weak business investment, likely due to elevated risk aversion in the face of ongoing macroeconomic uncertainty. While much depends on external factors like banking union in Europe and economic rebalancing in China, the ebbing significance of U.S. fiscal policy should contribute to ongoing declines in volatility, which should further reduce risk premiums in financial markets, support asset prices, and hopefully contribute to a faster pace of business investment in 2014. Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts. Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information. This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Contact Information:

Jason Thomas Director of Research Jason.Thomas@carlyle.com (202) 729-5420