This piece was originally posted on Real Clear Markets on December 13, 2016.
One month after the election, a huge market rally shows stock-market investors like the changes Donald Trump will bring to the business world. At the same time, great uncertainty remains about the new Administration’s policies toward the Middle East, Russia, trade relations, and other matters of state and defense. But on the core issues of macro policies for the U.S. economy, he will propose a large fiscal stimulus package and the Republican Congress will gladly go along. Details are still unknown, but they are likely to include lower tax rates on corporate profits and most personal income brackets, a massive public works initiative to modernize the nation’s infrastructure, and regulatory reforms that will favor profits in some sectors.
Not only does the fiscal package promise to promote expansion, it comes at a time when the economy is doing pretty well even without it. Even before the election, the nation’s output was already growing quicker and the labor market was already getting tighter. In the third quarter, gross national output, an average of the income and product sides of the national accounts, rose at a 4.2 percent rate. And the unemployment rate declined to 4.6 percent in October, which was the average rate for 2006-2007 when the last expansion peaked. In this environment, some are alarmed that bond prices have tumbled since the election, seeing this as a signal of excessive deficits and rising inflation ahead.
So is adding fiscal stimulus in today’s environment too much of a good thing? Should Congress therefore balk at large tax or spending changes that add to deficits at this time? Many current economic models use an unemployment rate between 4 and 5 percent as full employment, taken as the rate that can be sustained without steadily accelerating inflation. The inference some will draw is that fiscal stimulus now risks overshooting into the inflationary zone with too low an unemployment rate.
There are two issues here. One is how fast aggregate demand can grow without being constrained by the economy’s potential output level, which recent estimates show to be growing only slowly. The other is whether the Trump initiatives will have important supply-side effects that would make the economy’s potential output grow noticeably faster than these recent estimates, thus permitting a faster growth in aggregate demand and output. Sound infrastructure improvements will improve productivity in the long run, but their effects are spread over a distant future. And as for changes in income and profits taxes, estimates of supply-side effects range from modest to negligible among professional economists and from zero to important among politicians.
Trump will sell his plans for taxes, spending, and regulation as measures that will grow productivity and raise the supply side potential of the economy. He is not reluctant to exaggerate. But even if, to be on the safe side, we assume supply side effects are negligible, it is being far too cautious to argue that we are too near full employment for a major fiscal stimulus now. Careful analysis shows that the labor market works most smoothly with a modest positive rate of price inflation. It also shows that there is no dangerous knife edge case with inflation hard to tame once it starts. The lowest annual unemployment rate since the late 1960s was 4.0 percent in 2000 and the core CPI inflation rate then was 2.6 percent. This was about the same rate that prevailed throughout the long expansion of the 1990s. So, although there will be lots of room to argue about aspects of Trumps’ program, an expansionary fiscal policy is the right macroeconomic policy today. And the sharp rise in government bond rates since the election should be seen as a return towards normalcy rather than as a signal of excessive deficits and inflation.
Going from growing the overall economy to helping manufacturing workers who have lost their jobs is a very different matter. When John F. Kennedy was selling his tax cut proposal as a needed fiscal stimulus, he remarked that “a rising tide lifts all boats.” He turned out to be right then, but would have had it wrong lately. The rising tide of the past two decades left some boats on the beach. And it is a tribute to Donald Trump’s stump skills that he won the presidency by appealing to the blue collar workers who were left behind. They lost their jobs through no fault of their own and restoring them is a worthy goal. But does he have a feasible plan for doing it? Interrupting Carrier’s plans to move some jobs to Mexico and threatening Boeing over its Air Force One contract were in Trump’s style, and it might well have some effect at the margins of firms’ decision making. But without legislation that changes incentives, it acts on too small a scale and puts the president’s prestige in opposition to market forces, which is treacherous ground.
Other Presidents have leaned on companies or unions outside public view, but few did so publicly or without clear authority. In the early 1980s, Ronald Reagan interfered with striking air traffic controllers by replacing them with non-union workers. This was a bold action, but one that was specifically within his powers. As for open confrontation with business, Kennedy again comes to mind because he brow-beat the steel industry CEOs into rescinding announced price increases on steel products. But these were the days of great market power by the steel industry and its unions, and JFK was reacting to what he saw as a breach of an understanding to contain inflation under the informal wage-price guidelines that he had introduced. This was a long way from managing how the companies would conduct their production and employment. Trump loves the bully pulpit and he should have some success in using it. And though narrowly aimed programs may have only limited effects, a steady aggregate expansion provides the needed environment for success. The good news is that is now a reasonable forecast.