Newspaper readers are smarter than politicians. Several readers have queried me about a key issue to which Congress and the White House seem to be ignoring: What will happen if GOP tax cuts stimulate the economy, but the Federal Reserve, with an economy at full employment and years into a recovery, accelerates interest rate increases?
Will higher interest rates simply offset tax cut stimulus ? And will higher rates increase the exchange value of the U.S. dollar? That always slams U.S. manufacturing and agriculture. Is this government at cross-purposes?
The issue was hot this past week because the GOP had gotten tax bills through both houses, but faces a difficult reconciliation. Meanwhile, the Fed’s key policy setters, the Federal Open Market Committee, met on Tuesday and Wednesday, opting for the expected quarter point increase in its target rate to 1.5 percent.
Central bank policy makers properly did not reference the tax bill at all, but in stating, “in determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions” the FOMC reminds us all that if the economy speeds up too much, too fast, the Fed will raise rates faster and potentially farther.
But in discussing the tax bill, Congress, the administration and the pundit world pretty much ignore the Fed. What are we to make of all of this?
Start with some history. Economic activity long had varied with availability of money. When abundant for whatever reason, economic activity was brisk. Also, when government spending rose, as had been the case in the Civil War, economic activity also was strong. And there often was a slump when such spending was decreased.
Until the Great Depression, these were deemed as side-effects of sound policy. But British economist John Maynard Keynes argued the government-hands-off policy economists favored was wrong. Governments could and should, he argued, stabilize overall economic activity by conscious management of taxing, spending, the money supply and hence interest rates.
In recessions, government should spend more and tax less. Central banks should expand the money supply to lower interest rates. If the problem was instead inflation, the reverse applied.
Keynes did not argue that such policies could change long-term growth, but only return a slack or overheated economy to sustainable full production.
Keynes’ prescription dominated policy for 40 years. But there were problems. Legislative branches never would keep the bargain. They loved to cut taxes and spend more, especially in the run-up to elections, but would never do the reverse.
Moreover, central banks, particularly those like the nationalized Bank of England or the politicized Fed of the ’70s headed by Nixon crony Arthur Burns, liked to keep interest rates low rather than ward off inflation. The result in many countries by the late 1970s, was “stagflation,” a combination of stagnant growth in output and employment plus high inflation. Economics had failed.
The discipline responded in two new approaches. The overwhelmingly dominant one was “rational expectations,” an abstract explanation of why Keynesianism was flawed. Another was “supply-side economics,” which had a tiny following among economists, but was adopted wholesale by the Republican party and continues to this day.
Supply-side eschewed the short-term manipulations that Keynes intended to increase or slacken overall demand by households and businesses. Instead it focused on fostering investment in new plants and equipment boosted long term growth.
The way to do this was cutting the high marginal income tax rates on high income people. These had the discretionary income for high savings. And taxes on business should also be lowered and streamlined. Regulation should be reduced and rationalized.
On this, many economists, even Keynesians, were in general agreement. Income tax rates could be lower if loopholes were closed. Regulation should weigh economic consequences and should retard output as little as possible.
But supply-siders went a step further, arguing that a cut in tax rates would so spur the economy that tax revenues would actually rise. Few economists bought this, and some prominent economists most respected by Republicans, like Milton Friedman and Martin Feldstein, disagreed vehemently. Hence old GOP hands like George H.W. Bush snorted at “voodoo economics.” Nevertheless, this became the centerpiece of the Reagan administration and a credo of younger GOP office-seekers. Democrats clung to Keynesianism even as economists largely moved away, at least for 30 years.
Fast forward to the present. Big donors to the GOP want cuts in tax rates that affect them. The Republican base has promised “tax reform.” Virtually no other major legislation has emerged from Congress since the inauguration. So a tax bill has passed both houses, without any hearings, position papers or input from economists. There has been no give and take except politically, inside a fractured GOP.
The bill is being sold on a bastardized amalgam of Keynesianism and supply-side. Tax cuts for households will spur their spending and goose the economy. That is pure Keynes. Lower rates for rich people will cause them to save and invest more. That is pretty pure supply-side. Lower corporate rates, without any closing of loopholes, will impel businesses to invest in new plants and equipment, thus expanding output and employment — and raising revenue. That is a mix of the two schools.
This is against a backdrop of an economy that is eight years into a recovery, however tenuous initially, after a historic recession. Output growth and unemployment are at levels most economists would call full capacity. Wages are finally rising. Europe is finally getting back on its feet. The world commodities boom is over, but Asia remains strong.
Yet no one pays attention to the Fed. It has promised to slowly return the short term rates it controls to more usual levels — read, higher. This is subject to keeping inflation around a goal of 2 percent, a target undershot so far.
Will a tax-cut push somehow come to Fed-tightening shove? If the legislation eventually passes, and I suspect it will, that will become a key question for the next couple of years. The answer depends on which economic view is most applicable.
If supply-side is correct and lower rates on the wealthy increase their savings and thus their investment, businesses might indeed spend more on plants, equipment, R&D and employee training and, yes, wages. Productivity may rise and with it output and employment. People now out of the labor force may be pulled back in, increasing job numbers despite the fact that unemployment rates are already low.
If Keynesianism is correct, lower taxes on the rich may result in their spending it on luxury goods that cause little employment and with no effect on productivity. Lower taxes on corporations will result in them investing the savings in stock buybacks and dividends, not on new workers and plants. We are already awash with capital. Few corporations suffer a lack of funds for new plants. Fiscal stimulus against a full-capacity economy will result in excess demand with inflationary pressures.
If the supply-side is true, the Fed’s task is easy. If productive capacity increases, the Fed can continue to ease rates upward. There will be no threat of inflation and little of recession.
If the second is true, pushing on already-utilized capacity will create pressures that induce the Fed to increase its pace of monetary tightening. Higher rates will offset any increased savings by the rich and raise the price of physical investment by businesses. Higher rates will suck money toward our country from abroad, pushing up the value of the U.S. dollar and thus thumping U.S. farmers and manufacturers over the head. Imports will be cheaper, blunting any revival of U.S.-based manufacturing employment.
Precious few economists see the first happening at a significant degree. Only a few noted ones, including George W. Bush Bush adviser Greg Mankiw, have spoken in favor of the bill. Most don’t see big output increases, none see lower tax rates boosting revenues.
Yet few warn of the second danger, that of the Fed soon hitting the brake pedal just because of the tax bill. Some, including Minneapolis Fed president Neel Kashkari, oppose any rate increases now because inflation remains well below targets.
The question of how all of this will affect the exchange value of the dollar is perhaps the most important for Minnesota. Agriculture, particularly corn and soybeans and the high-tech manufacturing sector, are particularly sensitive to a stronger dollar. And agriculture is already in a silent crisis from a past land boom overhang and currently dismal prices.
Over the last 12 months, broad indexes of the exchange value of our currency have actually dropped by 5 percent of so. A stronger Europe means money flows back there, further reducing upward pressures. Yet all other things equal, higher U.S. rates mean a pricier dollar. So if tax-cut induced stimulus does force the Fed’s self-perceived hand these recent trends could reverse.
There are other scenarios. Economists should never predict asset markets. But I’ll say that the Dow at 24,000 is unsustainable, as are southwest Minnesota farmland prices at $7 million a square mile. How these may come down I do not venture. But to paraphrase Robert Burns, the best-laid expectations of tax and interest rate changes “gang oft a-gley.” Or “often go awry.”