For our weekly update, Dr Bob Gay*, our macro economist, provides his views on “A Trump Presidency”.
Donald Trump’s election victory is bringing forth a lot of speculation on the next administration’s possible economic policies and their consequences. These exercises are fraught with uncertainty in part because Trump as a candidate spoke so little about what his policies would be. A few themes are likely to remain intact now that election posturing is finished and so some thoughts are worth considering. Some of the main items on the agenda supposedly will include: renegotiating trade agreements including NAFTA, curbing immigration, health care reform (again), deregulation (notably for small businesses), repeal of Dodd-Frank, tax cuts and most significantly fiscal stimulus presumably in the context of infrastructure spending. Some of this agenda, however modified, is likely to move forward in 2016 because America has voted for ‘change’. Recall that each of the previous 8-year US presidents (Reagan, Clinton, Bush and Obama) was replaced with someone who was diametrically different in some sense from their predecessor, so the populous expects and Congress must deliver something new.
The Trump agenda is a mixed bag of supposedly pro-growth policies for the short run that unfortunately could have very negative consequences for the economy’s long term potential, so let’s divide the discussion into two phases – the short view and the long view.
The Short View
Not surprisingly, much of the market’s initial reaction seems to focus on the short view, especially the prospects for infrastructure spending. Markets have responded by raising inflation premiums on long term bonds. Although a growing consensus of economists now believes infrastructure spending is a viable anecdote for secular stagnation, some caveats are noteworthy.
When an economy is operating close to its potential, as is the case with the US economy today, an outsized initiative on infrastructure is ill-advised. The projects rarely provide jobs for the long-term unemployed or those who lack the requisite skills for such work. Moreover, the extra stimulus is likely to cause some inflation with a lag of about one year if it pushes the economy above potential. In a world where deflation still lingers, the risk is not so much a reversion to high inflation but rather the persistence of inflation from operating the economy ‘too hot’.
Congress will likely set restrictions on what projects would qualify, typically limiting the ventures to so-called ‘shovel-ready’ initiatives under the guise that the spending would not be a permanent feature of the government’s budget. The flip side of ‘shovel-ready’ however is that little thought is given to the long-term payback from projects or to what would be high priorities in raising the nation’s potential output. Only a small portion of the ARRA funding in 2009 was devoted to ‘greenfield’ projects which were next to impossible to accomplish within the two-year window of the stimulus package. The result often that most of the money is spent on pet projects, local road projects and transfers to local governments. This approach would be antithetical to the notion of remedying secular stagnation.
Waste is the Achilles’ heel of congressional legislation and infrastructure is no exception. Consider Japan’s ambitious building program of the 1990s that did nothing to augment potential growth but did implode the government deficit that remains today.
Apart from infrastructure, a Trump presidency also is perceived as more pro-business and hence good for growth. It is not clear what the transmission mechanism is however. Deregulation or repeal of Dodd-Frank and Obamacare supposedly would remove ‘shackles’ on businesses and health care providers and would allow banks to take more risk and lend. Neither of these themes is very convincing either as a short-term stimulus or a long-term boost to potential growth. It depends on what, if anything, replaces the old regulations and how reform is carried out. Mr. Trump is not known for his attention to detail and neither is Congress and, with regulations and health care, the devil is in the detail.
The Long View
A longer view is far more uncertain. The most controversial issues – namely, protectionism on foreign trade and restrictions on immigration – also are the most detrimental to the US long term growth prospects. Indeed, free trade – as opposed to globalization of production – and immigration including undocumented migrants from Mexico have been the most important engines of growth over the past two decades. Closing the doors the flow of goods, services and workers is one of the surest ways to raise domestic prices, undermine domestic demand and stifle competition that is the lifeblood of innovation. An aging workforce already has taken a huge toll on US potential growth which the Federal Reserve staff now estimates at only 1.8%. Because a nation’s demography changes very slowly absent immigration, a closed door policy in effect would doom the US to low potential growth for decades, not just during this incoming administration. The same, of course, could be said for Europe and Japan where demographics have played a major role in limiting the growth in domestic demand over the past 20 years. And demand is by far the most potent driver of business investment; bank regulations play a minor role by comparison.
*Dr Bob Gay is a consultant with the Fixed Income team and served eight years as Senior Economist with the Board of Governors of the Federal Reserve in Washington DC.