For decades, it has been considered common sense that governments should borrow more in bad times and less in good ones. President Trump is ignoring this principle.
The Congressional Budget Office forecasts that US government borrowing will rise from under $800bn this year to over $1 trillion in 2020 – almost 5 per cent of GDP – and will rise even further thereafter. That would mean that government debt would exceed annual GDP in the 2030s.
This increased borrowing isn’t a response to a weak economy; the official unemployment rate is under 4 per cent for the first time since 1969. Instead, it is a deliberate policy move: the OECD calculates that fiscal policy will ease by 2.5 per cent of GDP this year and a further 1 per cent of GDP next year.
This has had a curious effect on bond markets. On the one hand it has raised real yields: the five-year inflation-proofed yield recently hit a nine-year high. But it has had less impact upon nominal yields. In other words, it hasn’t much changed inflation expectations. Bond markets expect inflation to average less than 2 per cent over the next five years, which is why they don’t expect much of a rise in interest rates: futures markets are pricing in a fed funds rate of only 2.7 per cent by 2020.
This is puzzling. Orthodox economics tells us that government borrowing adds to aggregate demand. When the economy is operating around full capacity, this should raise inflation, which should mean higher interest rates. Even if investors are relaxed about the extra supply of bonds, they should be worried about this.
So why aren’t they? It’s because bond markets are in effect betting on a continuation of what we’ve seen in recent years – a flat Phillips curve, or inflation not responding much to low unemployment. There are three big reasons why they might be right:
- Globalisation. An open economy can respond to capacity shortages simply by buying from abroad. Capacity constraints are replaced with a balance of payments constraint. But the US – thanks to its 'exorbitant privilege' (strong overseas demand for US dollars) can run big overseas deficits, at least for a while.
- Weak workers. Workers lack the bargaining power to push for higher pay. This is why labour’s share of GDP has fallen in recent years. One reason for this is that the workforce is more atomised. But another reason is that there is hidden unemployment – people outside the measured labour force who want to work. A wider measure of unemployment, which counts some of these, puts the jobless rate at 7.5 per cent.
- An innovations gap. Stronger demand might not raise inflation because it increases capacity. The prospect of high future demand can encourage companies to invest in innovation and training, in replacing labour with machines, or simply in ways of tweaking productive methods to raise productivity. Igal Hendel and Yossi Spiegel, two Israeli economists, have shown that even in very traditional manufacturing, productivity rises with demand with the result that capacity is “ill-defined”.
If all this is right, then Trump’s fiscal expansion is actually benign even if it does directly contradict the conventional belief that policy should be counter-cyclical. Whether it is right is, however, dubious: there must surely come some point at which strong demand does push up inflation even if we don’t know what it is.
In this sense, Mr Trump is conducting an interesting experiment. And it’s one that will end badly – although whether for conventional economics or for bond markets remains to be seen.
