Every year the U.S. Bureau of Economic Analysis releases data on U.S. GDP and real GDP growth. It’s widely accepted as the leading metric to determine the growth or deterioration of the U.S. economy, and cited by publications and media to evaluate a president’s ability to create prosperity.
It’s interesting how most sources fail to reveal a second critical component of analyzing the U.S. economy– and it stems from the relationship of real GDP growth to this second component.
This article will describe that second critical component while also showing how each president fared over the last 40 years. The numbers may surprise you, and may help you shed some political biases and realize that oftentimes there’s more going on beyond what is commonly reported and shared. I don’t have a political agenda here, I just love looking at the numbers.
Here’s what everyone is missing regarding those numbers. While it’s true that GDP estimates the flow of goods and services pretty well, by itself it’s not looking at the entire picture.
What we all need to understand is how the fluctuations of the credit cycle relate to economic growth, as this is a more accurate representation of real economic prosperity.
What’s the Credit Cycle?
I won’t cover this too extensively as anyone could easily write a doctorate thesis on the topic. Like the economy and the markets, the impact of credit (particularly interest rates) is so widespread in its reach that it’s impossible to estimate with any certain accuracy.
Think about how the economy works for a second.
It behaves like a living, breathing organism. All parts have a butterfly effect on each other.
When customers flood into a business and buy a bunch of their products, this creates profits for the business. The business has a financial incentive to expand and grow, and must hire more workers to make that happen. As more workers get hired, more disposable income reaches the hands of the common man to allow for more spending at businesses and increased profits.
It’s a beautiful compounding cycle, when it is working well. Of course on the flip side, the opposite is true. When unemployment is high, disposable incomes shrink and businesses see less inflow to their bottom line. This makes them less likely to hire more with the possibility of needing to downsize their workforce.
The Benefits of a Low Interest Rate Environment
Now, the credit cycle has a major influence on these moving parts of the economy. The two ways for companies to have enough money to hire employees is through either profits or debt.
Most companies in the stock market have some level of debt. The amount of debt they are willing to carry oftentimes depends on current interest rates.
When rates are low, companies tend to borrow more because the interest they’ll have to pay isn’t as high.
When rates are high, companies tend to be more conservative in their leveraging because it becomes very expensive.
You see the effect of various levels of interest rates in the consumer world as well.
Low interest rates tend to result in more buying of houses, which causes prices to rise. In a low interest rate environment, consumers tend to refinance or be willing to take on a home equity line of credit (HELOC), which usually pushes more capital into the economy. Rising house prices tends to make owners feel wealthier and lead to spending more money. Other assets tend to rise in price along with real estate, again injecting more cash into the economy. The list goes on and on. The various ways that lower interest rates contribute to a booming economy are endless.
Disadvantages of a High Interest Rate Environment
On the other side, high (or even rising) interest rates can devaste an economy and slow spending and growth.
Again, companies usually borrow less because it’s more expensive, which means they usually have less money to spend. Hiring naturally decreases, which leads to less disposable income for the common man and leads to even lower profits.
On the investor side, higher interest rates mean more yield for less risky assets– like bonds (particularly government bonds, which are considered essentially “risk-free”). Instead of encouraging asset price growth, this can drain money from the stock market as investors hear the siren call of less risky assets available at higher yields.
So, stock prices as a whole can decline or at least slow down their growth, leading to less disposable income for employees who receive stock options– or reducing things like bonuses and raises.
Businesses not only are likely to borrow less, but many are likely to be more at risk at going bankrupt.
Not all debts are accumulated at a “fixed rate”. Both businesses and consumers have the option to borrow at variable rates, which means the interest they ultimately pay on the loan fluctuates as interest rates change. It may seem like a silly thing to do to the outside observer, but it often results in lower monthly payments (compared to a fixed rate loan) during a low interest rate environment.
This increases expenses at the worst possible time (when the economy as a whole tends to spend less), and can really put a strain on both a business’s or consumer’s finances.
A business that was too aggressive with leverage (borrowing) during the low interest rate environment could be unable to make their debt payments as profits and revenues decrease.
Even with a more conservative borrowing approach, demand could shrink so unexpectedly (leading to dangerously low revenues and profits) to really create a strain. A business may have to sell off assets prematurely and thus lose even more ability to create profits as time goes on.
On the consumer side, higher interest rates can greatly reduce the purchasing of houses and real estate, thus suppressing or depressing the real estate market. This can lead owners to be more conservative and less likely to borrow, spending less on things like renovations or home improvements. Again the list goes on and on and the repercussions span across all corners of the economy.
This relationship between interest rates and the economy is known as the credit cycle and is defined by two terms…
Low interest rates leading to more borrowing is described as “expansion of credit”.
High interest rates leading to less borrowing is known as a “contraction of credit”.
Just as the stock market goes through natural cycles of boom and bust, the credit cycle naturally contains periods of prosperity and hardship. Oftentimes these the credit cycle and the stock market cycles (bear and bull markets) are interconnected. Trying to deny the existence of either natural force is plain ignorant.
There’s no such thing as an economy that increases indefinitely, regardless of who the president is.
You see, a low interest rate environment can’t stay low forever.
No Free Lunch = Inflation
One other aspect of low interest rates is the presence of inflation. When the economy is flush with capital due to the expansion of credit, the price of assets rise. I talked about that above. But, that’s not the only thing that rises with the tide. Prices of other things also rise, including food, commodities, … Because the economy as a whole is spending more, the demand for various things rises.
One of the basics of economics 101 is that the price of anything is defined by the relationship between supply and demand. When demand is higher (i.e. the economy is spending more), the price naturally increases. That’s unless the supply also increases by the same amount.
But across many different parts of an economy, you tend to see price rise more than the supply does– and so the price of most things tends to increase. There’s no free lunch. Like many things in life, there’s an upside and downside to a thing. Ying and the yang.
Excess capital and credit leads to economic growth, but too much at too quickly of a pace is likely to lead to higher inflation. Higher inflation leads to higher prices, which then can slow the economy once again if it slows spending.
Because there’s so many moving parts, it’s impossible to micromanage the economy to find that perfect balance between growth of an economy and the suppression of inflation. That’s why credit must naturally cycle between a boom and bust period.
A good balance of economic growth and limited inflation is defined as “real GDP”.
Real GDP is the growth of the economy (GDP growth) adjusted for inflation. A high GDP growth can still result in a low real GDP growth (and thus a less beneficial impact to the economy) if inflation rose up too much as well. This subtle, hidden force can deceive people trying to evaluate a president’s economic success if they analyze it based on GDP growth rather than GDP growth.
Which leads to the data I present for you here. It spans back to 1977, representing 40 years of economic and presidential data.
In the first table I will show you both the real GDP growth of each year and the percent change of the Federal Funds Rate in that year.
The Federal Funds Rate is the driving force behind all interest rates in the U.S. It can give us further insight into whether a real GDP growth was actual economic progress, or if it was just a good time in the credit cycle that a president was able to take advantage of. It can also indicate a time period where the economy grew but at the expense of low interest rates, which as we know now can’t last forever.
Now I’ll include a 2nd table to help us really analyze this data. It’s simply the average of real GDP growth and the percent change of the Fed Funds Rate for each president. I realize that taking an average might be less descriptive than taking a CAGR, which is a little more advanced.
For the purposes of this discussion we will be keeping it simple, while taking it a step further than the mainstream media tends to do. I’m strictly trying to present data here, without manipulating the data to make one political party look better than the other.
This is a website about finance and investing, not one with a political agenda. If you wish to take this research further, by all means do so. I won’t bore you with that kind of analysis and so I will keep these numbers simple. With that out of the way, let’s look at that second table.
The results are very intriguing.
It appears that Reagan (R) and Clinton (D) were the two presidents most successful in growing the economy in a meaningful way over the last 3 decades.
The numbers also indicate that Carter (D) did a great job of managing economic growth despite a large increase in interest rates and an probable contraction of credit. On the other hand, Reagan seemed to benefit from an expansion of credit while not being the worst offender in that regard.
Obama’s economy doesn’t appear to have done well, while Trump’s has started on a strong footing.
Everything I just typed is solely based on just one analysis point, the relationship between real GDP growth and interest rates. This article attempted to explain why such a relationship is an important part of analyzing economic growth from year to year.
But, I want to reiterate that a single economy is unbelievably complex and impossible to precisely analyze by anyone. There’s too many moving parts even within country borders itself; once you include the impact of other global economies the complexity increases even more.
Not only that, but there are so many other factors that influence these results outside of who the president is. You have to consider what type of situation a president inherited, what the political environment was in regards to the house, senate, and otherwise, who the chairman of the Fed is and was, and the list goes on…
It’s just an interesting way to put economic data released by the Bureau of Economic Analysis in perspective. Hopefully you’ve learned something, and have gained an ability to more pragmatically look at the economy and the market.
The question now becomes… how should we adjust our financial approach with this new information?
I think it should be clear that it makes sense to be conservative with our personal capital during a credit expansion because a credit contraction is inevitable. It should make sense that our investment capital is likely better utilized in companies that are also conservative during credit expansion and show indicators of real rather than debt powered growth.
We can do this with metrics like the debt to equity ratio and its relationship with net earnings.
Finally, we should deduce that the common fundamental principles that normally craft a prudent investing approach are even more critical to follow.
Diversification mitigates much of the risk of an inevitable credit bust and allows us to stay invested long term– which is absolutely essential if you expect to participate in the profitable spoils of a credit expansion. It’s hard to stay long term invested when a significant portion of your capital disappears from a bankruptcy.
Diversifying and staying invested long term goes hand in hand with one last critical principle: dollar cost averaging.
This is the idea of putting money into the market as a consistent habit. Because we don’t know who the next president will be, or if the current administration will make the right choices for the economy, or if we timed the credit cycle right, or if we timed the stock market cycle right… the best way to remain unaffected by these forces is to always be investing.
This is a saving habit you should have anyway, but it allows you to buy more stocks when they are down and actually keeps you from buying too many when stocks are up. A consistent habit like this coupled with a long term holding period is the best way to profit from the economy as a whole as it goes through its various cycles.
The average citizen can create personal prosperity as real GDP grows by being an investor. The great thing is that you don’t need much money to get started, and the concepts aren’t terribly complicated.
But you do have to get educated if you want a chance.
This website is all about making it simple; don’t over-complicate it but still be smart about it.
You’ll find plenty of articles and resources on here, and hopefully it can take you from a passive observer into an active participant. That way, instead of bemoaning a president who did this or that, you can objectively analyze it, smiling as your own money grows and compounds all the while.