U.S. Economic Policy: The Storm after the Calm

President Trump hasn't achieved much in major economic policies. The one thing on which all Republicans agree is tax cuts, but now is the worst possible time for cutting taxes. A column by Barry Eichengreen.

Barry Eichengreen
«A prideful president, just like the Congress, needs to show an accomplishment.»

This month we are celebrating, if that’s the right word, the first anniversary of Donald Trump’s election as president of the United States.  Trump’s first year has been nothing if not eventful, with the president tweeting on everything from «Crooked Hilary» to «Little Rocket Man» and issuing a blizzard of presidential decrees. But the one area where there has been little progress is major economic policy initiatives. This is surprising given Trump’s emphasis on «making the American economy great again.» But there was no repeal of Obamacare. There was no $1 trillion infrastructure package. There was no dramatic trade-policy initiative.

If this now changes, it will have more to do with the Republicans in the Congress than with president, who lacks the patience for detailed economic plans. Congressional Republicans understand that mid-term elections are coming in 2018. They understand that, with their failure to repeal and replace Obamacare or to accomplish much anything else of substance, their majorities in the House and Senate are at risk.

Hence they have coalesced around the one thing on which all Republicans can agree, namely $1.5 trillion of tax cuts spread over ten years. The problem being that this is the worst possible time for cutting taxes. The U.S. economy is running at capacity, with unemployment, at 4.1 per cent, near all-time lows. Compared to when Ronald Reagan engineered his historic tax cuts, federal government revenue is already down by a tenth (17 per cent of GDP now compared to 19 per cent in 1981).

New sources of revenue needed

The idea that cutting revenues will create irresistible pressure to cut expenditures runs up against the uncomfortable fact that non-defense, non-entitlement spending in the United States is already just 8 per cent of GDP. Hence the Republicans have no choice but to go after new sources of revenue: taxing university endowments, taxing tuition breaks received by Ph.D. students, and levying a one-time 12 per cent tax on repatriated cash held abroad by U.S. corporations. They have no choice but to eliminate deductions and exemptions – so-called tax expenditures – like the deductions for mortgage interest, state-and-local taxes, and interest on student loans.

But in doing so Congressional Republicans are getting themselves into the same bind as with their effort to repeal and replace Obamacare. To placate the hyper-conservative Freedom Caucus and get their bill through the Senate with just 51 votes (as required by the so-called Reconciliation Process, which frees them from the risk of a filibuster in the Senate), they have to limit deficits to the aforementioned $1.5 trillion over ten years. But raising taxes on students, homeowners and other members of the working class, by making the bill meaner, jeopardizes the support of more moderate members of their party.

On November 16th the House of Representatives passed its version of the bill on a strict party-line vote. But many additional steps still remain before something resembling it becomes law. Currently, one of the leading betting markets, Predict-It, shows a less than 50-50 probability of Congressional agreement that individual income and corporate tax rates will be cut by the end of 2017. Those estimates are way too low, in my view. Republicans in Congress have to show the voters that they’re capable of accomplishing something. But the punters on Predict-It remind us that tax reform is far from a done deal.

No surge of business investment to be expected

If tax reform happens, what will it mean for the economy? Perversely, the long-term impact on productivity will be strongly negative. Everyone, except perhaps for the Republicans in Congress, knows that education and training are the keys to productivity growth in the 21st century. But taxing university endowments, tuition breaks and interest on student loans, the Republican bill will make university education less accessible and affordable for the majority of Americans who will comprise the country’s future labor force.

Nor will there be a surge of business investment boosting productive potential. The cost of capital is already low, given rock-bottom interest rates. Expensing of capital expenditures will make little difference, since interest on debt issued to finance investment can already be deducted from profits. U.S. corporations are swimming in cash, so foreign profits repatriated as a result of the plan will go into share buybacks, not new investment. These are facts that Trump’s advisor Gary Cohn learned to his chagrin on November 15th, when corporate bigwigs attending the Wall Street Journal’s CEO Council, asked to raise their hands if they intended to increase their companies’ investment, sat silently in their seats.

And whatever additional spending does in fact occur will only drive up the dollar. With the U.S. economy already running at or near capacity, additional consumption of goods and services will have to come from foreign sources. The only reliable way of encouraging consumers to redirect their spending toward imports is, of course, by making them cheaper – that is, via a stronger currency. Moreover, if tax cuts make the Fed more worried about inflation, its faster interest rate hikes will only reinforce this incipient dollar strength.

Risk of strengthening the dollar

Bring us back to President Trump. A stronger dollar will frustrate the president’s efforts to bring back «good manufacturing jobs.» It will produce a larger trade deficit, Mr. Trump’s favorite indicator of unsolved economic problems. Since services are produced mainly at home, while manufactures can be imported, the additional imports will be disproportionately imports of manufactures, leading to a commensurate reduction in domestic manufacturing employment.

If all this happens, and U.S. growth fails to accelerate to 3 or 4 per cent, while manufacturing jobs fail to return, the president will look for someone to blame. Here, there are two plausible candidates. First, Trump can blame foreigners for unfair trade practices. So far, the president has been relatively quiet on the trade-policy front, aside from withdrawing the country from Trans-Pacific Partnership negotiations. But if the trade deficit widens, as it now will, we can expect him to move more aggressively.

A trade war with China is no longer in the offing. Trump was extensively flattered on his trip to Beijing, making President Xi his new best friend. More importantly, Trump understands that he needs China’s cooperation to solve his North Korea problem. This leaves NAFTA in the crosshairs.

Cancelling NAFTA would be fatal

U.S. business is lobbying to convince Trump that blowing up NAFTA would be a mistake. But a prideful president, just like the Congress, needs to show an accomplishment. Abrogating NAFTA would be a way for Trump to show his core constituency of disaffected voters that he is capable of accomplishing something. The most recent round of NAFTA negotiations was delegated to the technocrats. When national trade representatives next meet, things could be more explosive.

Trump’s other obvious target is the Fed. He can blame its higher interest rates for both the stronger dollar and the failure of growth to accelerate. While the accusation would be «fake news,» it would be an effective way of deflecting blame. Jerome Powell, Trump’s selection to succeed Janet Yellen, is a reasonable appointment. But it’s worth remembering that there are multiple additional openings on the Federal Reserve Board. If the dollar takes off because of the Republicans’ own policies, the president’s next appointees may not be so reasonable.