Proposed Policy Shifts Are Likely to Have Uncertain Impact, Despite Market Optimism
Donald Trump was elected on a platform that deviated substantially from traditional Republican economic policy. In place of trade liberalization and spending restraint, President Trump has promised to pursue a more protectionist approach and spend substantial amounts of money upgrading the infrastructure of the United States. Despite the uncertainty that many commentators predicted, US asset markets have reacted favorably, with the Dow Jones index topping 20,000 points for the first time in its history.
Additionally, yields on US Federal Treasury bonds have risen sharply, while the dollar continues to appreciate.
All of these developments suggest that investors seem to believe that the policy mix that President Trump promises to pursue is likely to lead to faster economic growth. However, despite the exuberant market reaction, it is far from clear that a policy regime built on the foundations that President Trump campaigned on will actually be successful. Amidst this financial euphoria, there is reason for both investors and the public at large to remain skeptical.
If enacted, the infrastructure program and tax cuts touted by the President will likely lead to a larger budget deficit as expenditures rise and tax receipts fall. No one is entirely certain about the overall cost of the package. During the campaign, President Trump altered his tax plan several times and cost estimates range anywhere from $4-trillion to $10-trillion over a ten-year window. Even if other areas of expenditure were reduced concurrently to lessen the fiscal impact, the sheer size of the tax cuts would make it difficult to prevent a rise in the fiscal deficit.
Moreover, no one can be entirely sure of the total cost of Trump’s infrastructure program. During the campaign, President Trump suggested that the package would total $550-billion over a five-year period. However, it is unclear whether the stated costs will be entirely financed through the normal congressional funding process. Since his election, the President has suggested that there might only be limited, unspecified federal funding, which, in conjunction with an 82% tax credit, will be used to encourage private investment in infrastructure such as roads. Given these ambiguities, it is difficult to estimate the direct burden the new infrastructure proposal would place on American taxpayers. However, if the Trump administration jettisons the tax credit approach for more conventional direct public spending, the infrastructure component of the Trump plan could exacerbate a budget deficit that is poised to explode because of planned tax reductions.
This more expansionary fiscal stance would likely be met with tighter monetary policy. Given that the US economy is close to full employment, the Federal Reserve would likely feel pressured to accelerate its tightening of monetary policy to contain inflationary pressures. Thus, any boost to national income driven by a relaxation in fiscal policy would be offset by higher interest rates and a tighter monetary policy.
President Trump also vocally campaigned against the US’ chronic trade imbalances. Yet in a cruel irony, the combined effects of proposed changes to economic policy could actually lead to a worsening of the trade deficit. As budget deficits rise, the value of the dollar is likely to increase as well. This is because a portion of the funds required to finance a larger budget deficit would come from abroad, requiring foreigners to sell overseas currencies and purchase dollars. Moreover, if, as many project, the Federal Reserve tightens monetary policy in response to looser fiscal policy, higher interest rates could attract capital inflows that would cause the dollar to appreciate against other major currencies.
A stronger dollar would make American exports more expensive to foreigners and make imports more attractive to Americans. The combination of loose fiscal policy and tight monetary policy under the Reagan administration in the 1980s fueled persistent current account imbalances. There is no reason to believe that the situation would differ under a Trump administration.
Thus, the changes envisioned to economic policy by the new occupant of the oval office may end up being self-defeating. As the US economy stands near full employment, expansive fiscal policy will be met with tighter monetary policy, possibly slow economic growth. Prospective shifts in both fiscal and monetary policy could further expand the US’ current account deficit.
Far from inducing optimism, Trump’s new policy shifts should give investors pause and instead induce caution.