One of the policy commitments of the incoming Administration is reportedly to deliver a fiscal stimulus in the form of an unfunded upper-end tax cut and perhaps infrastructure spending program.
But the case for such “stimulus” is quite weak, because the US economy has already tentatively exited liquidity trap and is probably effectively at full employment. Moreover, a fiscal expansion now would have to be followed by a fiscal contraction later, in order to avoid an unhelpful acceleration of federal indebtedness. Depending on where the business cycle is when that fiscal contraction comes, having increased the need for it might actually raise the risk of return to liquidity trap.
It is hard to imagine that the GOP are not aware of these issues, which leaves me to conclude that the real purpose of the proposed fiscal measures is other than what it is purported to be. I would guess, but cannot prove, that the agenda is the usual political expediency of deficit finance plus a desire to reward the upper end for ideological reasons or to secure political support.
It is probably best not to weaken the argument by overstating it. A temporary run-up of the federal deficit might be a good idea if it were the only politically-feasible way to cobble together a coalition supporting a major infrastructure spending program.
Alternatively, one could make the argument that immediate reductions of upper-end tax rates funded with major longer-term reductions of the path of entitlement outlays would be a reasonable trade-off. I would not, myself, make that argument because I assign a high value to reducing – rather than aggravating – income inequality. But as a good liberal, I recognize that values calls are unavoidably controversial and that the ones I make are not universal. From a macro perspective, that would probably not be harmful.
The point of this note, however, is that intentionally raising the deficit in the current environment is probably not a good idea taken in isolation. Now is not the time for fiscal stimulus, per se.
The most compelling time to do fiscal stimulus is when the economy is stuck in liquidity trap, monetary policy has lost traction, and unemployment is needlessly being held aloft by an absence of aggregate demand. Those conditions held, roughly from 2008 through, let’s say, 2014.
And yet the GOP favored fiscal contraction over that entire period. Even with the economy in free fall, the Obama fiscal stimulus of 2009 received not a single vote from Republicans in the House, and the party agitated aggressively over the next few years for fiscal contraction. By threatening to default, they actually managed to achieve a fair degree of fiscal contraction after 2011. As it turns out, this did not deliver disaster, but it probably slightly delayed the recovery to full employment and was suboptimal in that regard.
However, you judge the GOP’s past approach to fiscal policy, utterly reckless (as in 2009) or not great (thereafter), it hardly seems as though the case for fiscal expansion has recently improved. For starters, the US economy has apparently exited liquidity trap, which means – among other things – that fiscal stimulus can now, as a first approximation, be expected to be fully offset by additional monetary tightening, at least in the short- to medium-term.
In fairness, the economy has not come roaring off the zero bound. Presuming the Fed goes in December, the funds rate will then be only 50 bps off its low. And the futures strip prices less than 100 bps more tightening over the next two years. The 10-year Treasury yield, similarly, is off its record lows but not signaling an all clear.
But unlike many, even among my liberal friends, I interpret that as a reason for fiscal caution here, not aggressive expansion. While the fiscal expansion is ongoing, the Fed will have to offset it with tighter monetary policy than would be required otherwise. And yet when the fiscal expansion ends, the equilibrium interest rate seems likely to fall at least to where it was before the fiscal expansion, for reasons I will get to below. As I read it, this is implicitly the signal from futures strip and bond market. The implication is that fiscal stimulus would do little to lift actual growth over the next couple years and would actually slightly exacerbate the issue of liquidity trap beyond that horizon.
This brings us to the second issue, which is that the US economy is now, for the first time in a decade, within range of full employment. Before getting to that, though, it may be worthwhile to linger over this issue of escape of liquidity trap, even if so far only tentatively. When the US economy entered liquidity trap during 2008, some pretty big rules of macro switched in a way that was counterintuitive to many people. At great risk of oversimplifying, the idea of scarcity went out the window and free lunches that are generally meant not to be available because so. It took a while for Wall Street, the media and some hidebound economists to cotton on to this.
But with the escape from liquidity trap, we have switched again, and the more conventional ways of thinking are once again likely to predict well. Resources are again scare. Free lunches are hard to obtain. And the homely rules often emphasized by conservatives actually apply. Don’t be fooled twice.
The most prominently scarce economic resource is labor. The unemployment rate has dropped
to within measurement error of slightly below its estimated natural rate, which means that a meaningful further reduction from here could be destabilizing, irrespective of the short run effect on underlying inflation. As I argued in this post, a decline of the unemployment rate of more than 50 basis points below the estimated natural rate has tended to be followed by trouble, although a couple years forward, rather than immediately.
The unemployment rate has already fallen more than 500 basis points from its high, so you might say that we are at least 10/11ths done with the desired decline. Certainly Fed officials do say – or indirectly imply — this.
So whatever threatens to steepen the rate of decline of unemployment is almost certain to generate a reaction from the Fed. How much the Fed would have to react to deliver the offset is an open question. I am in the camp believing less rather than more. But the point is that the end result would have to be to resist a further steep drop of unemployment.* So what then is the purpose now of fiscal “stimulus?”
The third issue here is that any fiscal expansion would probably have to be reversed at some point, in order to avoid an unhelpful steepening of rate of federal debt accumulation. For the sake of argument / illustration, we can imagine a $400 billion tax cut (2% of GDP) sustained for, say, two years. That would arguably lift aggregate demand growth for up to three years, give or take. But by then, the US economy may be “due” (on logical, not just calendar, grounds) for recession. So we would face the prospect of significant fiscal contraction, heading into recession, in an environment of presumably ongoing secular stagnation. That is obviously not a recipe for a quick and enduring return to the zero bound.
The obvious way to avoid that outcome is just to make the tax cut, if that is what it is, permanent. But let’s do the math to see how that works for the debt path. The CBO projects that the federal deficit will have risen from 3.2% of GDP in 2016 to about 4.6% in 2026. The persistent and widening deficit takes the federal debt / GDP ratio up from 77% this year to about 86% ten years out. These CBO estimates are notoriously unreliable, and yet a reasonable base case in a quite uncertain world. Goldman’s work has shown that, if anything, they tend to incorporate – by law – slightly optimistic assumptions regarding tax extenders, doc fixes and the like, although I will not get into that here. For now, let’s take these projections as good enough for government work.
If the Congress were to legislate a tax cut that were permanently to reduce tax revenues by 2% of GDP, then the path of the deficit and federal debt would steepen by just marginally under 2 percentage points a year, depending precisely on how quickly nominal bond yields rise towards nominal growth. (Measured relative to baseline, it does not matter much.) That would take the federal debt / GDP ratio up to near the record achieved in 1946 roughly ten years from now.
Reasonable people will disagree on the implications of that. I would characterize it as unhelpful and likely to be slightly contractionary, rather than alarming. And in this context, I would raise three specific points.
- First, absent meaningful entitlement program reductions, there is no reason to believe that the trajectory of the federal debt would naturally flatten after 2026. Between 1946 and 1974, the federal debt / GDP ratio got cut to a quarter. But that reflected an environment in which nominal growth was on average running 300 basis points above nominal 10-year bond yields and demographic/technological pressures on the entitlement programs were much more benign than they are now slated to be.
- Second, despite what the alarmists – to whom I will return in a follow-up post – have previously asserted, there is little reason to believe that the bond market would freak out over this particular debt trajectory. The recent experience in Japan has shown that the MMT crowd is probably right that the threat of the printing press can ward off the risk of the self-fulfilling fiscal crisis, even with the debt exceeding 100% of annual GDP. On the other hand, it is “quackery”, to use Ken Rogoff’s excellent term, to believe the MMT claim that magical accounting identities mean that we need never worry about the debt. People in the real economy would worry about the debt and would, I think, anticipate the macroeconomic implications of the policies required ultimately to stabilize it. They would forever be looking for tax hikes or spending cuts, the implications of which would be increasingly contractionary, although by how much dare not guess.
- Third, by virtue of the first two considerations, there would probably arise at some point political pressure to actually deliver a fiscal contraction which would be, you know, contractionary. If the history of American politics provides any guide, the clamor for fiscal contraction would probably be very poorly timed. Once again the alarmists would clamor for fiscal contraction precisely when the economy was weakest.
For me, it is a high conviction view, then, that fiscal stimulus per se makes little sense in the current environment. Please recall the caveats mentioned above regarding the merits of an infrastructure spending program and the possible offsets offered by deep long-term entitlement spending cuts. We will see if either of these come to pass.
Beyond those caveats, you may find conservatives telling you that the “stimulus” from tax cuts has nothing to do with the logic of aggregate demand management and is just an inconvenient short hand for unleashing creativity, risk tolerance, the spirit of entrepreneurship, etc. The thing about such arguments is that they have little empirical support at the (low) tax rates near those prevailing in the US today. But if the new Administration and its allies in Congress believe otherwise, then they can make the case.
What I would claim to know here is that fiscal stimulus per se in the current environment would be kind of dumb. In a follow-up note, I will elaborate on my guess of why they are making the case for it despite this.
* Fed Chair Yellen has effectively made this argument, but I see Bloomberg View columnist Noah Smith pointing out that there is little empirical evidence to support the idea that fiscal deficits lead to inflation. The issue here is not that fiscal deficits directly create inflation. The issue is that a fully employed economy creates supply side constraints, which the Fed must respect to avoid inflation and the directly-destabilizing effects of undershooting the natural rate of unemployment. Separately, I would place a higher weight on macro stabilization and a lower weight on trying to game the interest rate cycle than Noah does.
Speaking of inflation
The inflation data in this morning’s income and consumption report for October were benign. Both the core deflator and its market-price-only component were reported up 0.11% on the month. This allowed the 12-month inflation rate in the former to make a marginal new high, so I guess we can still claim that inflation is renormalizing back to target. I think the Fed will want it above target by the end of this cycle. I hold this view with lower conviction post the election because I am not confident what the Autocrat’s approach to monetary policy might be, assuming he knows what monetary policy is. But that would still be my best guess. The practical implications of it seem to me to be less than they were, for reasons I need not reiterate here.
Update: Mankiw and Summers takes
Greg Mankiw makes roughly the same point, although through a different angle and obliquely, so as not to seem critical of the Autocrat. He says that if the Autocrat wants to “rev” up the economy, then he will have to accept — and not worry about — a wider trade deficit. If the Fed is effectively targeting nominal demand growth, then a wider trade deficit will be one of venting excess demand here overseas, to respect the supply side constraints and inflation objective I emphasize in my own take. Mankiw’s then, is the same argument, just expressed quite differently.
And with one caveat: when Mankiw speaks of revving up the economy, he appears to be blending together supply-side and demand-side considerations. In the short- to medium-term, the demand-side considerations dominate, which I think is to my point. But Mankiw might claim that simplifying the tax code will have supply-side benefits. No quarrel from me. Is Trump going to simplify the tax code to get rid of crony capitalism and free the entrepreneurial spirit? So far, he has made a point of introducing presidential whim into the tax code. We shall see. But that is a separate issue, and initial indications are not good. Larry Summers calls the carrier deal a threat to capitalism, which doesn’t seem good.
Weak, not stupid
It must be excruciating for Romney to be, in Josh Marshall’s words, a Trump dignity wraith. Having to come out of dinner and speak well of the Autocrat, and Jeff Sessions and that idiot who wants to destroy federal RomneyCare must be painful. I guess it helps to be a vacuous moral zero in such cases. Even with that, though, you can see the pain on his face in the photo.
Having said that, check the video. He speaks in full sentences, very coherently, under pressure and without notes. He is obviously not stupid, which of course just makes his utter moral collapse worse.
All I want for Christmas are liberals who know how to fight to win. This is not that. Guy was total dork, could not spin peace and prosperity into a win, and now expresses what must be the most reliably-biased opinion conceivable. Right next to: Turkey opposes Thanksgiving. Thanks for keeping me up on these important thoughts.