As the tax cut debate shifts into high gear, much attention is being focused on one set of questions: Will cutting taxes generate sufficiently rapid economic growth to have the tax cuts pay for themselves, as the administration’s tax cut proponents are claiming?
Or, will the tax cuts lead instead to a widening in the budget deficit and to an increase in the public debt by as much as $2.2 trillion over the next decade, as the Committee for a Responsible Budget is claiming?
{mosads}While these questions are certainly highly relevant, there would seem to be an equally relevant question to be asked: Will an unfunded tax cut not seriously constrain the administration’s ability to cope with the next U.S. economic recession, especially should that recession prove to be severe?
More specifically, might a tax cut now not unduly limit the administration’s room for future fiscal policy maneuvering should it be needed down the road?
Raising questions about the room for future fiscal policy maneuverability would not seem to be misplaced considering the unhealthy path on which the nation’s public debt is headed.
According to the Congressional Budget Office, even before the proposed tax cut, the U.S. public debt is projected to rise from its present level of 76 percent of GDP to nearly 90 percent of GDP by 2025. Adding further to the public debt mountain by a tax cut would not seem to be consistent with making contingency economic plans for a rainy day in the future.
It would also not seem to be premature to ask whether the administration should not already be making contingency plans for dealing with the next U.S. economic recession. Nor would it seem to be overly alarmist to be considering the possibility that the next economic recession could be as severe as that which occurred in 2008-2009.
After all, the current economic recovery is already some nine years old, while many years of ultra-easy monetary policy might have set up the conditions for a perfect economic storm in the not-too-distant future.
Among the reasons to be concerned that the next economic downturn could be severe is the fact that today, global debt levels in relation to GDP are significantly higher than they were on the eve of the 2008-2009 economic recession.
Compounding matters are the facts that global asset market prices are at very high levels and that many risky loans have been made at interest rates that do not adequately compensate the lenders for the risk of default on those loans.
As to stretched global asset market prices, it is not simply, as Alan Greenspan recently reminded us, that the global government bond market is in bubble territory.
Rather, it is that global equity valuations have reached levels only experienced three times in the past 100 years, and there are now housing bubbles in a number of key economies, like Australia, Canada, China and the United Kingdom.
The main reason why global asset prices have reached levels that might pose a real threat to the U.S. and global economic recoveries is that in the post-2008 world, too much of the burden for supporting economic growth was placed on monetary policy, both in the United States and abroad.
With U.S. fiscal policy on hold following the initial Obama budget stimulus, monetary policy became the only game in town.
The Federal Reserve felt obliged to resort to ultra-unorthodox monetary policy, including the setting of zero policy interest rates and three rounds of quantitative easing, in order to meet its dual mandate of stabilizing prices and maximizing employment.
One indication of how unorthodox the Fed’s policies have been is the fact that the size of its balance sheet increased from around $800 billion in 2008 to its present level of $4.25 trillion.
One has to hope that in finalizing its tax cut proposal, the Trump administration will be mindful of the desirability that it leaves itself with ample room for fiscal policy maneuverability to deal with the next economic recession.
If it does not do so, it will be exposing us once again to a world in which too much of the burden for supporting the economy will be placed on the Federal Reserve. That would be highly regrettable as it would likely mean that the U.S. would be setting itself up for yet another 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.