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Donald Trump’s fiscal stimulus probably won’t work

This was the right recipe for 2013 but it’s too late now.

President Elect Trump Continues His 'Thank You Tour' In Grand Rapids, Michigan Photo by Drew Angerer/Getty Images

Democrats have a deep, dark worry that they can’t express publicly. After long, frustrating years of trying and failing to get congressional Republicans to agree to do some fiscal stimulus to boost the economy, they’re worried that Trump is now going to get the cooperation they couldn’t. Enormous tax cuts will widen the deficit and stimulate the economy, and the cuts will be paired with a substantial infrastructure program that further boosts growth.

“Well, sometimes you have to prime the pump,” Donald Trump told Time magazine, explaining blithely how he plans to brush aside years of conservative anti-Keynesian rhetoric.

The hypocrisy here is truly stunning, though in a sense conservatives have consistently (since the Reagan Era) adhered to the view that big deficits are good if and only if there’s a Republican in the White House.

But, beyond hypocrisy, the bad news for America — albeit good news for Democratic Party politicians — is that it won’t work.

Which is too bad, because there is reason to believe stimulus could work and help raise wages and put a few million extra people back to work. It’s just that to make it work Trump would have to make some additional changes that there’s no indication he wants to make.

Trump has a Federal Reserve problem

Here’s the problem: Increasing the budget deficit can create jobs by putting money into people’s pockets, but it can also increase interest rates and “crowd out” other forms of economic activity.

Which one of those things happens depends crucially on the actions of the Federal Reserve. When the Fed is worried about deflation, as it was early in both the George W. Bush and Obama terms, then the Fed is likely to let rates stay low even as deficits rise. But if the Fed responds to fiscal stimulus with monetary anti-stimulus, you are just pushing activity from one sector to another.

And right now, the Fed is in the mood to raise interest rates.

They raised rates last year, they are poised to raise rates again in December, and, as Goldman Sachs chief economist Jan Hatzius explains, the stronger the economy looks in 2017, the more the Fed will raise interest rates to slow it down.

Indeed, Fed officials are signaling clearly that more stimulus will mean more rate increases. This is a little bit disguised by the fact that Fed officials are saying they welcome the idea of stimulus. But they aren’t saying stimulus will increase growth. They’re saying it will increase interest rates.

On November 21, Fed Vice Chair Stanley Fischer argued that more stimulus would allow for faster rate increases, which would be good because it would let the Fed cut interest rates in response to future economic problems.

On November 29, Jerome Powell, another Fed board member, argued that more stimulus would allow for faster rate increases, which would be good because it would curb speculation.

Patrick Harker from the Philadelphia Federal Reserve, who’ll be rotating onto the monetary policy committee in January, says he wants to see interest rates go up. Robert Kaplan from the Dallas Fed says the same thing.

Trumponomics will shift activity, not boost it

Given this Federal Reserve regime, there’s very little chance that we’ll see some kind of Trump boom next year. JP Morgan doesn’t think the Fed will fully offset Trump’s stimulus, leaving us with 1.9 percent GDP growth in 2017 plus inflation peaking above 2 percent in the second half of the year. My best guess is that the Fed is a bit more hawkish than that and will keep both growth and inflation a little lower.

But either way, in a war between fiscal policy and monetary policy, the central bank always wins.

Trump will end up giving us less private economic activity in interest-rate sensitive areas like homebuilding and car purchases, offset by more infrastructure activity and more consumption from the affluent beneficiaries of his tax largess. If Trump succeeds in convincing Congress to make child care costs tax deductible, for example, that will do nothing to help poor families struggling with affordability — but my wife and I will have a bit more cash on hand to go out to dinner.

If the infrastructure projects Trump ends up building are useful, that could be a good tradeoff in the long-run. Early indications are that they probably won’t be, in which case it would be a bad tradeoff. But to make that assessment we’d have to know more about the plan. In the short-term, it won’t change much of anything.

The Fed may be making a big mistake

I argued back in October that the Fed’s eagerness to raise interest rates is a mistake.

It’s true that the unemployment rate is now pretty low. But the share of people between the ages of 25 and 54 who have a full-time job is lower than it was in 2005 and way lower than it was in 1999. It’s certainly very possible that some of those labor force leavers are irredeemably unemployable or totally uninterested in a job, but it’s very likely that many of them would find their way back into employment if the Fed let the economy run hot for a year.

The only way to find out would be to try, and personally I think they ought to try. If we try and it doesn’t work, the cost — a year of 3 or even 4 percent inflation — would be fairly minor. But if it works, the benefit — millions of people pulled back into mainstream employment — would be tremendous.

But cutting taxes on high-income households is now and forever the Republican Party’s number one agenda item. They are going to do it come what may. Offsetting the potentially stimulative impacts of the gigantic tax cuts only makes a bad situation even worse.

Trump could fix this, but probably won’t

Thanks to Senate Republican obstruction, there are currently two vacant seats on the Federal Reserve Board that Donald Trump could fill with monetary policy doves who would make his stimulus agenda workable. And then in 2018, Chair Janet Yellen and Vice Chair Stanley Fischer will be stepping down, creating even more vacancies.

But while I’m quite sure Trump hasn’t been crashing deeply on monetary policy during his transition weeks, signs are that this is not the direction he is heading with his Fed picks.

Instead, he seems to be taking his cues from guys like House Financial Services Chair Jeb Hensarling (R-TX) and John Taylor, who feel the Fed has already been too lax and needs to be “reined in.” Now that various quantitative easing programs are over, it’s a bit difficult to say what exactly that means in practice, but it appears to indicate a bias toward higher interest rates than those favored by the existing team, not lower ones.

One might think that in crass political terms, at least, Trump would want a Fed that helps his tax cuts boost the economy. But the research into the interplay of economics and politics indicates that’s probably not the case. The 2020 election will be heavily influenced by the rate of GDP and income growth in 2020 but not by what comes before. So Trump’s stimulus will probably be a bust, and the fact that it’s a bust probably won’t matter. This means he has no particular reason to worry about the fact that it will be a bust — it will keep him in good standing with congressional Republicans, GOP donors, and the business community, and that’s good enough.