The monetary consequences of the looming largely unfunded mega tax-cutting package will almost certainly trump all others. Its advocates make vital comparisons with the Reagan era. But they omit the key fact that fiscal shock then occurred within a rare episode of “hard money.” Paul Volcker, nominated as Fed Chief by President Carter in late 1978, was applying monetarist medicine to usher the US economy into a new era beyond the “Greatest Peacetime Inflation.” Even though the Volcker stabilization turned out to be deeply flawed and of short duration, its high tide coincided with the Reagan budget deficit explosion, holding in check any immediate build-up of inflation (in either of its two forms — goods inflation or asset inflation).
This Isn’t the 1980s
This time the budget shock is occurring far into another Great Inflation originating in the Federal Reserve, featuring prominently asset prices with goods inflation less obvious but present nonetheless. This is especially true if comparison is made with the downward rhythm of prices which would have prevailed under a sound money regime at a time of rapid globalization and economic weakness. The vast monetary experimentation has induced huge uncertainty. How deadly will be the end phase of this asset price inflation and what is the extent of potential goods inflation still to emerge in this cycle and future cycles? At worst the budget shock, by adding seriously to such uncertainty — in particular with respect to a possible late cycle emergence of strong goods inflation — would curb any possible stimulus even in the short-run.
Sound money advocates may consider an outbreak of virulent goods inflation a Good Thing on the basis that only this could bring a political climate favorable to an overhaul of the monetary system according to their prescriptions. Asset booms and busts on their own produce scapegoating of financial intermediaries and regulatory suffocation. Meanwhile, the monetary policy makers largely escape blame. Even so, all three occasions in modern US history when goods inflation break-outs have triggered monetary stabilizations (1919-20, 1951-3, 1979-83) have proved to be false dawns for sound money. The looming budget shock could set off a chain of monetary consequences which would end in similarly flawed reform.
The Chimera of the “Neutral Interest Rate”
The inflationary danger of budget shock resides partly in the fact that no one, not even the most talented Fed officials, can make a reliable assessment as to what budget shock means for the neutral level of interest rates. Yet present Fed policy making is predicated on the idea that the Fed’s bureaucrats can conduct a stability policy by steering rates along a path which is optimally positioned relative to the neutral level. But even at the most tranquil of times neutral is unknown with market rates tied to this loosely by trial and error together with market estimation.
Budget shock is the opposite of tranquillity. Commentators warn that if we discard the illusory “dynamic scoring” (which includes large tax revenues resulting from higher growth) the general government deficit in the US could expand from a present “full employment” level, of say 3.5-4%, to 5-6% of GDP. The influence on neutral rate levels depends crucially on how the private sector saves or dis-saves in response.
At one extreme, the boost to post-tax corporate earnings from the Trump fiscal package may be reflected in an equal jump of private savings as businesses use the tax relief to bolster their equity buy-back programs, share prices rise to reflect this, and households do not spend out of the related capital gains – perhaps out of caution about eventual big tax rises or an inflation pick-up. At the other extreme, anxiety about inflation would play little immediate role. There would be large wealth effects on spending and business investment could take off as economic activity returns to the US from previously lower tax jurisdictions abroad. The likely trigger to raised inflation fears — and these could be concentrated on the far-off future — is the scary arithmetic of the public debt.
Within a decade, the ratio of government debt to GDP might well grow to as much as 150% of GDP compared to say 110% without the tax cuts. Stabilizing the debt at that elevated level would be a daunting task in terms of necessary tax increases at that point (amounting to say 4% of GDP over a brief time span) and the temptation for the Fed and the government of the times as accomplices to “ease” the political shock via higher inflation would be great. That far off risk of a high inflation outcome could fuel asset price inflation further in the present as income famine and desperation for yield become even more prominent. That is, the eventual outcome to the present asset price inflation could be even more violent than otherwise.
As well as the raised inflation danger in the far-out future, there is the threat of increased monetary instability in the present due to the Fed following a false estimate of neutral interest rate. That danger was contained under the brief Volcker episode of monetarism where monetary base targeting replaced strict control of short-term interest rates as the key operating procedure of the Federal Reserve. This meant that interest rates were wholly market-determined (as is the case under an ideal gold standard) rather than heavily influenced by the Fed’s short-term interest rate signalling. That signalling has been a potent tool of both short and long-term interest rate management throughout the Fed’s history with the brief exception of the monetarist episode as above.
By the time the Fed realizes that its estimate of neutral is too low in the wake of the budget shock, inflation could have become much more virulent — both in the dimension of assets and goods. (Asset price inflation is measured by the power of irrational forces as unleashed by the monetary disorder, whether in the form of desperate investors frenzied by interest income famine and anxiety about future inflation danger searching for yield, or bold investors lulled by feedback loops from capital gains into to excess confidence about presently popular speculative narratives). And there is the ever-present possibility on top that a sudden dive in speculative temperatures could occur, marking the always impossible to predict onset of the end phase of a long asset price inflation.
The architects of the looming budget package and their supporters may indeed be sincere in their beliefs about the supply side benefits to come from mega tax-cuts concentrated on business profits and the potential for its America First slant to raise domestic investment and wages (which incidentally would likely go along with greater dis-saving as consumer spending would gain impetus). But in ignoring the key role of monetary discipline in holding back large potential negative consequences, they are underestimating the downside risks of the whole plan. In a classical liberal agenda, monetary reform would have preceded and constrained any great fiscal policy initiative. That was the Reagan way, at least to start with. It does not seem to be the Trump way.