Monetary policy insurance from the Trump tax cut / Corbyn splurge

Jason Furman, former Chair of the Council of Economic Advisors under Obama, lately lamented the lack of a macroeconomic justification for the Trump tax cut.  This tax cut, as he and others have observed, has many flaws.

Notable are:  the manifest intent to redistribute to the wealthy who need it least;  the accompaniment of this with amateurish appeals to Laffer-curve notions that it would somehow provide for a new era of much enhanced growth;  and the mendacity of the publicity around the tax cut which hides its redistributive intent away from lower-income households.

A macro justification can be salvaged, though not one that would clearly warrant what has actually passed.  As the stimulus takes effect, and assuming that the new Fed Chair Powell adopts a seamless interpretation of the Fed’s mandate, it will lead to higher interest rates, as the Fed seeks to counter the unwanted short run effects on inflation.  This would provide for more room for a future interest rate cut in the event that were a recessionary shock over the next few years.

Of course, this is insurance whose beneficial effects will not last, and will at some point in the future have to be reversed, but there is nonetheless some benefit.  One might very well wonder why the fiscal stimulus isn’t saved for the rainy day, rather than spent on a day when the weather is improving [when the US is either at or heading to full capacity].  In a situation where there was a well-functioning and rational Congress, implementing evidence-based policy, there would be no great defence to this argument.  But in current circumstances, when there is no guarantee that the argument for counter-cyclical policy would hold sway, that argument has less force.  Though this argument also applies to the expected efficacy of the compensating fiscal tightening later on.

This side of the Atlantic in the UK, the Labour Party, currently in opposition, has as its stated policy a large program of public investment.  As I remarked at a TUC roundtable on the motivations for such a program today, the argument for a fiscal stimulus on grounds of business cycle policy are, in my view, very weak.

The economy is approaching or at full capacity, and the effects of any stimulus would largely be offset by tighter instrument settings by the Bank of England’s Monetary Policy Committee.  Even if you did not buy my own take on the business cycle, you would have to concede that this is the BoE’s take too.  However, just as with the Trump tax cut, there would be the temporary benefit of having, for a few years, a different mix of monetary and fiscal policy that allowed monetary policy to respond more forcefully to the next recession.  This might be argued to be even more beneficial for the UK as we might yet face the prospect of difficulties extricating ourselves from the European Union.

The case is less clear when we recall that central banks have allowed themselves the option of doing quantitative easing when they run out of room to cut interest rates;  and there are those like Miles Kimball and Martin Sandbu who think there are no significant obstacles to stimulating the economy with negative central bank rates.  However, most central banks have eschewed negative rates;  and none support very negative rates of the sort that would have done during the 2009 crisis when desired interest rates were perhaps as low as -8%.  And there are also plausibly diminishing economic benefits and also political constraints on significant further QE.

The UK stimulus proposal differs from the US program in a major way in that it stands on its own merits.  At current very low [perhaps even negative] real interest rates, there must surely be a very long list of public investment projects that would yield positive commercial, let alone social returns.  Transport;  green energy;  broadband for all;  social housing;  even R&D into friction-reducing, Brexit-facilitating border administration technology!

A fiscal stimulus might be more compelling now if the proposal to raise the inflation target had gained proper traction.  Senior Fed officials have talked openly about it in the US, though not here, where the division of labour is such that it would be more of a faux pas for BoE officials to contemplate the idea openly.  Arguments against this idea are that it might set the central bank up for failure or extend the period of low interest rates to a point that would be politically intolerable.  A fiscal stimulus at the start of such a venture would surely help guarantee success, and limit the extent and duration of very low rates.


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