Does The U.S. Really Need A Fiscal Stimulus?

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The Book of Ecclesiastes teaches that there is a time for everything and a season for every activity under the heavens. In formulating economic policy, Donald Trump's economic team would be well advised to consider that this teaching also applies to fiscal stimulus. The time for fiscal stimulus is when an economy is faltering and when unemployment is high. It is not when the economy is recovering and when it is at close to full employment. It is also not at a time when the last thing that a fragile global economy can withstand is a sharp rise in U.S. interest rates or a sharp U.S. dollar appreciation.

While the new administration is yet to take office, there are already strong indications of its likely shift to a highly expansionary budget policy. Proposed fiscal measures being floated include a sharp reduction in the corporate tax rate to 15 percent and a decline in the top household income tax rate from its present 39.6 percent to 33 percent. It also includes a $550 billion increase in public infrastructure spending and large increases in the defense budget.

There might be merit in Donald Trump's proposal to slash corporate and household income tax rates. There might also be much merit in his proposals to substantially ramp up infrastructure and defense spending. However, there would seem to be no merit to his wanting to both slash tax rates and increase public spending at the same time. Such an approach is bound to impart a large fiscal stimulus to the U.S. economy at a time that it is close to full employment. It also risks opening up a large budget deficit and substantially increasing the U.S. government's already large debt burden.

Applying a large fiscal stimulus at a time when unemployment is now below 5 percent and when wage pressures are beginning to increase would seem to be a reckless policy approach. With the economy so close to full employment, a meaningful fiscal stimulus is bound to result in either higher inflation or else in a series of Federal Reserve interest rate hikes in an effort to stave off inflation. That in turn is also likely to lead to a further significant appreciation of the U.S. dollar particularly at a time when major central banks like the Bank of Japan and the European Central Bank are still in an expansionary policy mode.

Hopefully, the dangers of higher U.S. interest rates for the health of the global economy will not be underestimated by the new Trump Administration. This would particularly be the case at a time that the world economy is drowning in debt and credit risk is being grossly mispriced in world financial markets. As has all too often been the case in the past, rising U.S. interest rates risk both triggering a repricing of global credit risk and a bursting of the global sovereign debt bubble. In a highly integrated global economy, if that were to indeed occur, it would have important adverse ramifications for the U.S. economy and its financial markets. It would have such ramifications in much the same way as the global economy was impacted in 2008 by the Lehman banking crisis in the United States.

Yet another disadvantage of a shift to a more expansionary fiscal policy is that it is bound to lead to further U.S. dollar appreciation. It would so as the rise in U.S. interest rates occasioned by fiscal expansion increased the attractiveness of holding U.S. dollar assets. It is difficult to see how such a dollar appreciation could be reconciled with Donald Trump's repeated calls to improve the competitive position of U.S. industry in an effort to bring jobs back home.

Hopefully, a Republican Congress will substantially temper Mr. Trump's budget proposals and will adhere to its principles of budget responsibility and prudent debt management. If Congress fails to do so, we should brace ourselves for much turbulence in U.S. and global financial markets in the year ahead.