Donald Trump has won the US presidency with a campaign that broke all the rules. Is the stage therefore set for America’s economic policy to take off in an equally unprecedented direction? And should the rest of us be fearful or elated?
These questions cannot yet be answered with any certainty: so far, not much is known about who will take the most important economic posts in the new administration, nor what detailed policies they and the president-elect advocate. But we know enough from Trump’s campaign pledges and the Republican Party’s better-known conventional platform to make some educated guesses.
Fiscal policy – the scale of government spending and the tax rates it imposes – is the one area where the path seems reasonably clear. As in the UK, austerity and restraint are likely to give way to higher public investment spending and tax cuts, adding up to a potentially significant dose of fiscal stimulus. In isolation, and in the short term, reflating US growth through public spending will be a positive for the rest of the world, giving hope for more vibrant activity in what is still the largest economy and largest export market in the world.
But fiscal policy does not operate in a vacuum. Whether its impact on the broader economy is supported or offset by monetary policy and the exchange rate is just as important. Much less certain than the direction of the administration’s fiscal policy is the question of how the US Federal Reserve and the currency markets will respond. I see three main scenarios.
The first is that not much changes. Janet Yellen, the Fed’s dovish chair, remains in post beyond the end of her current term in February 2018 and the rate-setting board of governors maintains its cautious approach. Trump’s tax cuts and spending splurge cause them to accelerate interest rate hikes a little, and the dollar plies a steady course. This scenario would probably create the fewest ructions for global finance and trade. Unfortunately, it is also highly unlikely. In May, Trump said he would “most likely” replace Yellen if he were elected, because she is “not a Republican”. Not quite a “You’re fired” from the star of The Apprentice, but still a reminder that in the United States, the president appoints the governor of the central bank, and that the new administration will not be shy to exercise its prerogative.
Two scenarios in which US monetary and exchange-rate policy takes a significantly different turn from now on are therefore worth considering. One is that the mainstream of the Republican Party, which favours an end to quantitative easing (QE) – creating new money for use in an economy – and a return to orthodox monetary policy, starts to exert more influence. This could lead to a Trump fiscal stimulus accompanied by much more rapid tightening of monetary policy and a more hawkish Fed. US interest rates will rise and the dollar will probably strengthen. Dollar borrowers abroad and in the US itself will feel the pinch.
The biggest question, in this scenario, will be whether the US economy can cope. If reflating the US economy and normalising interest rates were as simple as flashing a bit of government cash and reversing QE, it would have been done five years ago. But tax cuts and increased spending will inevitably lead to higher public debt, which already stands at more than 100 per cent of GDP. So higher interest rates will translate into much higher interest payments – which in turn will eventually require higher taxes to fund them. As a result, the combination of loose fiscal and tight monetary policy may simply be self-defeating. The deadweight of expensive debt will stall the economy before it reaches escape velocity.
There is also a third scenario to think about. It is the least likely and the most outlandish – but after Brexit and Trump’s victory, who bets against surprises any longer? This is that Trump defies Republican Party orthodoxy and diverts monetary policy on to an even easier course than at present, even as he primes the fiscal pump.
In the short term, the US economy will fly under the influence of simultaneous fiscal and monetary stimulus. A famous Fed chairman past once characterised a central bank’s job as taking away the punch bowl just as the party gets started. This scenario would be just the opposite – an invitation to an epic all-nighter with the kegs thrown in for free. If it sounds too good to be true that’s because it is: this scenario in fact carries the greatest risks for the global economy. The reason is its effect on the foreign exchange market, the channel whereby US monetary policy most directly affects the rest of the world. Boosting the US economy by abandoning austerity while allowing interest rates to rise and the US dollar therefore to strengthen would be a recipe welcome in Japan and Europe. Higher demand in the US, coupled with a weak euro and yen, would finally offer these troubled economic zones a path out of their near-permanent slumps.
But opening the spigots of fiscal policy while keeping US interest rates low, and the dollar thereby weak, would have the opposite effect. It would be the most blatant economic unilateralism, helping the US out of a hole while condemning Europe and Japan to yet more years of uncompetitiveness.
For the first time in nearly 50 years, the economic priorities of the US and the rest of the developed world would be nakedly opposed. Not since Richard Nixon’s pliant Fed chairman Arthur Burns accommodated his president’s rampant spending on the Vietnam War would the US have dared such a self-interested policy mix. Nixon’s experiment brought about the collapse of the Bretton Woods regime, which had underpinned the Western economic order since the Second World War. Trump’s version would have consequences no less momentous.
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This article appears in the 16 Nov 2016 issue of the New Statesman, Trump world