Yay For The Bond Vigilantes

The New Year has started off as well as one could suspect. In addition to the Co-President arguing that the United States should invade the United Kingdom on Twitter, and we Canadians lost our Prime Minister with the timing due to the crisis caused by the threat of massive tariffs from a country that we allegedly have a free trade agreement with. (Trudeau’s hold on power was slipping, so the tariff threat was not the cause, rather the trigger for an event that would probably have happened anyway.)

The tariff situation is what I want to comment on in this article. As I expected would happen, Trump is pushing for a massive economic bill that combines a hefty income tax cut, with matching “pay fors” coming from a limited amount of spending cuts as well as a farcical amount of projected tariff revenue. (I am sorry that this article is pretty much a repeat of an article from last month, but the implications of this policy fight will overwhelm detailed analysis of historical date.)

There is no guarantee that the bill will pass — the Republic margin in the House is extremely narrow, and the political management of the Trump team is most charitably described as shambolic. That said, it seems extremely unlikely that the Republic Party will turn its back on tax cuts this early in Trump’s term.

The difficulty with relying on tariffs to “pay for” the tax cuts is that they are effectively locked in as a policy option thereafter. The hope that they might just be a club for negotiations are dashed if they are a key component of Voodoo Economics 2.0. The problem with taxing the hell out of something is that the volume of that something tends to decline. A trade war could nuke economic activity, causing an across-the-board drop in revenue.

Second Order Effects

The stimulative effects of tax cuts for the rich are likely to have a low multiplier, while the spending cuts targeted at programmes that benefit poor people will have a high multiplier. As such, the dollar amount of the increase in the deficit is unlikely to match the economic effect of the policy. Nevertheless, a tariff increase has the explicit objective of making some goods more expensive. Since the tariffs are across-the-board and aimed at major trade partners, these price hikes will not be a micro “relative price” story, they would hit the price level across a lot of categories. On top of that, domestic producers could easily decide to use the price level increase to raise prices to pad their profit margins. And if there is an attempt to expel minorities (although this is already being resisted by Republican business people who finally figured out the implications of the policy), there would be a tightening of the labour market.

In other words, Transitory Inflation 2.0 may be on the horizon.

Fed Policy

If the Fed has any sense of self-preservation, they will lag any policy changes. This reduces the political pressure on them, as well as reflecting the possibility that any radical moves may be a political fiasco that is quickly reversed. The bond market would be left to price in Rate Armageddon, and the Fed could just ratify market pricing. “The bond market vigilantes made us do it!” is an excuse that would easily sway a majority of the Republican Party.

Will the Fiscal Hawks Prevail?

The scenario outlined above could easily not happen — it would not take many fiscal hawks to derail a maximalist economic package. That said, it is easy to see a watered down version of the package passing, which would have the same directional effects with smaller headline figures.

The Pop MMT Challenge

The current situation shows the Achilles Heel of pop Modern Monetary Theory (MMT) for anyone other than a low-tax, small government MMT proponent. The most potent political challenge to the programme is to scream loudly about unsustainable fiscal deficits, targeting a fracture of the Republican Party by appealing to fiscal conservatives.

Saying that the government can sustain the tax cuts, but they are a bad policy since they just benefit rich people has two weakness that are obvious to anyone who has reflected on the post-1980 political trajectory.

1. Describing the policy in that way makes it more likely to keep the Republican coalition together to enact the tax/spending cuts.

2. When the fiscal deficits blow out in response, it is guaranteed that it would be labelled a “fiscal crisis” and the fiscal hawks would rally around cutting benefits for the poor.

To add insult to injury, deliberately causing an inflationary accident makes an anti-austerity argument harder to sustain. It was much easier to argue against the austerity policies in the 2010s when there was a mild deflationary undertow gripping the developed economies.

Concluding Remarks

Street research has a normalcy bias and an aversion to taking overt partisan stances. As such, the consensus is not going to be yelling too loudly about Transitory Inflation 2.0 — at least not until it is too late. There are good reasons to expect policies to end up more moderate than what Trump is currently tweeting. Nevertheless, there is no sign that Trump is in any mood to moderate his demands, nor is the Republican Party in any mood to resist them.