It is difficult to forecast what President Trump’s fiscal legacy will be. He’s sought credit for a recent reduction in public debt, but pledged not to touch the entitlement programs which are its key long-term driver, while also cutting taxes. His team has talked of the need for high-quality infrastructure investment to boost productivity, but leaked memos suggest priority projects must be “shovel ready” and “direct job creators” – different short-term aims.
Anybody hopeful that the fiscal conservative lines of this muddled agenda might win out might want to think again. It looks as if Trump has “stimulus” rather than a supply-side agenda in mind. Here’s an interview excerpt from The NYT:
Trump seemed much less animated by the subject of budget cuts than the subject of spending increases. “We’re also going to prime the pump,” he said. “You know what I mean by ‘prime the pump’? In order to get this” — the economy — “going, and going big league, and having the jobs coming in and the taxes that will be cut very substantially and the regulations that’ll be going, we’re going to have to prime the pump to some extent. In other words: Spend money to make a lot more money in the future. And that’ll happen.”
Let us presume for the sake of argument that Trump is a Keynesian who believes that government spending can be used to re-inflate the economy from downturns. Let us also assume that this kind of agenda works as Keynesian theory predicts. We can still ponder: why does the U.S. economy need a fiscal stimulus now? Theory (even Keynesian) and evidence suggests it does not.
1. Theory would suggest fiscal stimulus is not effective when there is little “spare capacity.” Whatever Trump thinks about the veracity of the statistics, the US economy is close to “full employment.” The civilian unemployment rate currently stands at 4.7 percent, only slightly above the Congressional Budget Office’s estimate for the “natural rate of unemployment.” The job openings rate is now running above that seen pre-crisis, quit rates are about the same as they were prior to the crash. The U5 unemployment rate (which adds marginally attached workers to the official rate) and the U6 unemployment rate (which adds those who are part-time for economic reasons) are at levels seen in the middle of the 2000s and construction unemployment is lower than in 2007. In such an environment, any attempted macroeconomic stimulus through infrastructure investment would be highly likely to crowd out private sector activity.
2. Theory suggests fiscal stimulus will be offset by monetary policy. Given the Fed has begun to raise its target rate, Keynesian theory would suggest monetary policy would offset any expansionary fiscal policy. Paul Krugman spelled this argument out clearly when he wrote “spending can be withdrawn later on without hurting employment, because once you’re out of the liquidity trap the Fed can offset the contractionary effects of a fiscal tightening by holding off on the monetary tightening it would otherwise have pursued.
3. Evidence suggests that any effect of government spending is very small when countries are highly indebted. US federal public debt stands at 105 percent of GDP. The long-term outlook for the public finances is dire on unchanged policies, driven by rising entitlement spending given demographic trends and rising health care costs. The federal deficit is already projected to be 2.9 per cent in 2017, but if current policies remain largely unchanged, the Congressional Budget Office projects estimates the annual deficit would rise to 5 per cent of GDP over the next decade (even with tax revenues above their average over the past five decades). In such an environment, consumers are more likely to foresee future tax increases when the federal government borrows more, and hence rein in activity today.
4. The assumptions necessary for short-term spending improving the debt-to-GDP outlook are incredible. Trump talks about spending money now to make a lot more in the future, but Larry Summers and Brad Delong outlined back in 2012 the conditions under which short-term borrowing could hypothetically improve the longer-term debt-to GDP path. As I wrote at the time, “the paper does an important public service, however. It lays out in detail the scale of the assumptions required.” They presume fiscal multipliers are large, monetary policy does not work, and that absent short-term borrowing workers and capital will become much less productive. All of these conditions are even less likely now than they were in 2012. As the FT’s Chris Giles said: “you have to have a rather weird faith in the notion that raising capital spending a bit today provides a much more powerful boost than the hit that inevitably comes next year when that temporary support is removed.”
In sum, theory and evidence suggests more government borrowing at the current time is unnecessary and would have little effect on GDP but would worsen the debt-to-GDP ratio. Sure, there might be a case for some infrastructure investment for other reasons (maintenance, alleviating damaging congestion, enabling new transport modes etc.), which I will explore in future posts, but that is a very different rationale from the pump priming put forward by the President.