Economic history teaches us that major macroeconomic policy blunders have serious, long-run economic consequences.
This has proved to be the case in Europe where the misguided adoption of the euro as a single currency for a disparate group of European countries in 1999 contributed to a European lost economic decade some 10 years later.
This is also bound to be the case in the United States with the Trump administration’s adoption of a recklessly expansive budget policy at a time that the U.S. economy was close to full employment.
{mosads}There is presently much concern that the Trump administration’s $1.5 trillion unfunded tax cut over the next decade, together with a $300 billion increase in public spending over the next two years, will lead to a large and sustained increase in long-term U.S. interest rates.
It might do so by swelling the size of the budget deficit to an average of at least 5 percent of GDP over the next few years and by placing the U.S. public debt on a path to soon well exceed 100 percent of GDP.
It can be argued that the widening in the budget deficit at a time that the economy is close to full employment will force the Federal Reserve to raise interest rates to prevent a pickup in inflation.
It also might be argued that it could become increasingly difficult for the U.S. Treasury to fund itself at low long-term interest rates since, at the very time that its funding needs would be rising because of a larger budget deficit, the Federal Reserve would be reducing the size of its U.S. Treasury bond holdings by some $50 billion a month.
Strong as these arguments might be, it is more likely to turn out that at least over the next few years, a sustained rise in long-term interest rates will not have been the right reason to have been concerned about the highly inappropriate U.S. fiscal policy stance.
Rather, the real reason to have been concerned will turn out to be that it will have led to a widening in the U.S. trade deficit, an escalation in international trade tensions and acute stress in global financial markets that could very well precipitate a global economic recession.
As we should have learned from our experience in the 1980s, a sharp increase in the budget deficit is very likely once again to lead to a twin deficit problem in the U.S. — simultaneous large budget and trade deficits. It will do so in part by reducing the country’s savings rate.
It will also do so by inducing a dollar appreciation in response to Fed interest rate hikes that a higher budget deficit will require to prevent inflation. A higher dollar in turn will make our exports less competitive and our imports cheaper.
Should the U.S. trade deficit indeed widen as a result of public-sector profligacy, there is every likelihood that the Trump administration will double down on its shift toward trade protectionist policies. That in turn would risk taking us ever further down the road to a damaging full-blown world trade war.
More disturbing yet, by forcing U.S. interest rates and the U.S. dollar higher, a higher U.S. budget deficit could hasten the bursting of the global asset and credit market bubbles that have been spawned by many years of ultra-easy monetary policy by the world’s major central banks.
Since the start of this year, we have already seen a reversal of emerging market capital flows in response to higher U.S. interest rates and a strong dollar that has seen currency depreciations of around 20 percent in countries like Argentina, Brazil, South Africa and Turkey.
There is the real danger that if U.S. interest rates are indeed forced higher, we could see the present troubles of the emerging market economies spreading to a systemically more important country like Italy as well as to other high-risk credit markets like the U.S. high-yield market.
Yet one more reason to regret the Trump administration’s ill-advised fiscal policy is that it will put us in a very much weaker position to respond to the next U.S. economic recession.
With the next recession likely to cause the U.S. budget deficit to blow up from the already high 5 percent of GDP forecast under a good economic scenario, we will find that we will have used up the room for fiscal policy maneuver to counter the next recession.
That would carry with it the risk that once again too much of a burden for getting the economy moving will have to be placed on the Federal Reserve. Sadly, that in turn could once again lead to the distortion of global asset and credit markets and set us up for yet another global boom-bust cycle.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.