September 25, 2017

To Make Their Tax Cut Realistic, The GOP Needs the Fed to Risk Higher Inflation

Try overshooting for once! ~ Ryan Avent, senior editor, The Economist

The GOP really wants to cut the corporate tax rate — like bad. The problem is, under Senate rules they can’t do anything that would raise the deficit without 60 votes and there are only 52 Republican senators. So, as Damian Paletta and Mike DeBonis recently reported in the Washington Post, the Republicans are ready to embrace a certain morally mathematically casual attitude.

…there is a growing willingness within the GOP to embrace controversial, optimistic estimates of how much economic growth their tax plan would create. Those upbeat estimates, often rejected by nonpartisan economists, would supplant the traditional forecasts offered by official scorekeepers at the Congressional Budget Office and Joint Committee on Taxation, helping lawmakers argue that the plan would not increase the national debt.

Not everyone approves. As one Wharton professor said in the same Washington Post article:

“Thinking that you are going to get at $1 trillion of additional revenue from a dynamic score, it’s just impossible in a model that seriously treats the additional debt,” said Kent Smetters, a University of Pennsylvania economics and public policy professor who was a key tax adviser under former President George W. Bush. “It’s only possible in the models that are being used by various think tanks that don’t take into account the debt effects.”

Consider that for a moment. As you may remember from 2008, there was a – shall we say – robust debate among economists over how much, if at all, you can directly stimulate the economy through spending increases and tax cuts. Yet, almost everyone agrees that you can stimulate the economy indirectly through tax cuts, through what are called supply-side effects. Most modelers, however, say that unless taxes are already sky-high, these supply-side effects are likely to be small and take a long time to play out. This is not good, if you’re trying to argue that $1 trillion in corporate tax cuts will all be made up for by the booming economy they create.

There may be a way out though, if you are willing to incorporate those direct, otherwise known as demand-side, effects. Indeed, there is an argument that the two could feed on each other. The government stimulates demand and the lower rates induce corporations to respond with even greater supply. The flaw in this otherwise felicitous bit of fiscal alchemy is the debt.

Demand-side stimulus requires borrowing money. Borrowing money raises interest rates. Higher interest rates have a de-stimulating effect on the economy, in part because they make it costlier for corporation to raise money for supply-side expansions. There was a time when Republicans argued that the supply-side effect of borrowing money was so large that it canceled out the demand-side effect of any government stimulus.

I am not here, though, to expose petty inconsistencies.  There is a way out: The Federal Reserve can run the economy hot, that is, to risk a little bit of extra inflation.

Interest rates rise only if the Federal Reserve allows them. In a modern global economy, billions of dollars of debt are issued and retired every day by governments, corporations, and households throughout the world. The Fed ensures that key interest rates in the United States stay steady through this storm via a complex set of financial interventions conducted every day.

In the face of otherwise wild swings in the financial market, the Fed changes its key interest rate targets very slowly and after intense analysis and deliberation. The Fed staff analyzes every sector of the economy and its Board of Governors and regional bank presidents deliberate over a wide range of economic issues, but above all else they are all focused on inflation.

Rising inflation suggests that the Fed’s interventions are causing the economy to borrow and spend at a higher rate than it would otherwise. Falling inflation, on the other hand, suggests that on average the interventions are reducing the amount of borrowing and spending. Steady inflation implies that the interventions are canceling each other out.

When the 2008 global financial crisis first hit, markets were in such a panic that the Fed’s normal interventions were unable to keep key interest rates steady no matter how hard it tried. Indeed, for most of the financial world that is the very definition of a  “crisis.” In response, the Fed designed and implemented an unprecedented array of interventions. Most economists credit that with staving off the worst the crisis had to offer and slowly pulling us out of recession. Yet, even with its new toolkit the Fed has consistently fallen below its target of a stable 2 percent inflation per year.

This brings us back to the GOP dreams for a massive yet massively stimulating tax cut. As we said, the problem remains the debt. Without offsetting spending cuts, the tax cuts Republicans have in mind would require the government to borrow an enormous amount of money. The Fed, fearing a rise in inflation, would raise interest rates. Higher interest rates would de-stimulate the economy and ruin the GOP’s plan.

Given that it has consistently failed to reach its target of 2 percent inflation, you might think the Fed would resist raising interest rates in the face of a large tax cut and the associated increase in borrowing that such a tax cut brings.

The Fed of late, however, has been exasperatingly skittish. The Fed’s governors and regional bank presidents in particular are absolutely convinced that, any day, inflation could start shooting upwards and so they should raise interest rates preemptively to avoid going over their 2 percent inflation target. The fact that they, because of this skittishness, have failed to reach their target over a decade seems to wash off their backs.

While ultimately the Fed bears responsibility for hitting its target, this skittishness isn’t entirely the Fed’s fault. The Senate approves the Fed’s governors and Congress as a whole conducts oversight. Yet only a handful of members of either house show any interest in the Fed’s day-to-day operations. That handful blames Richard Nixon’s adoption of liberal Keynesian economics and his appointment of Arthur Burns as Fed chairman for allowing inflation to get out of control in the 1970s. Despite a complete revamping of the Fed’s approach to inflation and its adoption of an explicit inflation target, those members are hypersensitive to the slightest indication that the Fed is not taking high inflation seriously enough.

The rest of the GOP has played along with this, likely because they were more concerned with enacting the rest of their agenda. Now, however, to get the economic growth numbers they need, to pay for the tax cuts they want, the PGOP needs the Fed to stop being paranoid about overshooting the 2 percent inflation target. Three percent inflation would not be the end of the world and would soon be corrected by today’s inflation-focused Fed.

I realize that at this stage in the game the GOP leadership is more focused on getting the Congressional Budget Office to score its tax cuts as highly stimulus. Yet, on some level surely  it wants the tax cuts to actually be stimulating. That requires a Fed that is willing to at least tentatively accommodate the extra borrowing those tax cuts will produce and wait for inflation to show up before interest rates.