Within days, Donald J Trump will be the forty-fifth President of the United States, and his economic team will be charged with the task of translating an economic manifesto into actual policy.
As a passionate supporter of free trade, I have problems with The Donald’s America First trade policy. But when I look at the rest of his economic policy commitments, I have to admit a frisson of excitement.
Sure, we don’t as yet know how much of his manifesto will translate into actual policies, but the potential supply-side gains of full implementation could be huge. In my book, if you’re going to get a supply-side behavioural response in the economy to tax changes, you need to implement big changes. Small tweaks don’t change behaviour. And one thing is clear, The Donald likes things big. His proposed fiscal stimulus has halved since the primaries, but is still double the George W Bush tax cuts.
With regard to fiscal policy, there is the possibility of: (1) A reduction in the rate of corporate tax from 35 per cent to 15 per cent. (2) A reduction in the number of personal income tax brackets from seven to three with rates of 12 per cent, 25 per cent and 33 per cent. (3) The “Penny Plan” with a reduction in non-defence, non-safety net spending by 1 per cent of the previous year’s total – reducing spending by $1 trillion over 10 years. (4) A one-off repatriation tax of 10 per cent on profits brought home from overseas by US companies. (5) A $0.5 trillion surge in infrastructure spending.
Throw in a revolution in energy policy, radical deregulation and scepticism on man-made global warming, and free market economists and financial markets are getting excited. The cyclically adjusted price earnings ratio (CAPE) is at levels only exceeded in 1929, the dot.com boom and the 2007 housing bubble.
Financial markets are taking the view that the fiscal stimulus will cause an acceleration in aggregate demand in the short term and aggregate supply in the long term – economic nirvana. Moreover, the interaction of stronger economic growth (and interest rate expectations) and supply side gains, is expected to push the dollar higher.
The political dimension is also seen as permissive for two reasons. First, there is Republican control of both the Senate and the House of Representatives. Second, rule changes will make unfunded tax cuts easier to pass.
Of course, there are potential downsides as well. Unemployment is around 4.6 per cent, with the US economy at the point where any acceleration in growth is likely to trigger higher interest rates by the Fed – due to capacity constraints and inflation. In other words, any fiscal easing could be offset by tighter monetary policy.
Twin deficit problems are likely to emerge. Even with dynamic supply-side gains, the budget deficit will head higher, possibly from 3 per cent to 6 per cent of GDP. Those most doubtful of supply side gains, estimate the deficit could reach 10 per cent of GDP. On top of this, faster growth is likely to lead to a higher current account deficit.
There are potential supply-side difficulties to consider, most notably in the case of protectionism, if there was a slide towards a trade war with China. If the US deported illegal immigrants on a large scale, there would be a serious hit to the size of the labour force as well. A much stronger dollar would also create serious problems for those emerging market economies that have acquired huge amounts of dollar denominated debt since the financial crisis.
So much could yet go wrong and thus far financial markets seem to have taken on board all the positives while ignoring the negatives. Time will tell how wise this is.