Why Monetary Policy Will Cancel Out Fiscal Policy

Good cheer has arrived at precisely the perfect moment.  You can really see it.  Record stock prices, stout economic growth, and a GOP tax reform bill to boot.  Has there ever been a more flawless week leading up to Christmas?

We can’t think of one off hand.  And if we could, we wouldn’t let it detract from the present merriment.  Like bellowing out the verses of Joy to the World at a Christmas Eve candlelight service, it sure feels magnificent – don’t it?

The cocktail of record stock prices, robust GDP growth, and reforms to the tax code has the sweet warmth of a glass of spiked eggnog.  Not long ago, if you recall, a Dow Jones Industrial Average above 25,000 was impossible.  Yet somehow, in the blink of an eye, it has moved to just a peppermint stick shy of this momentous milestone – and we’re all rich because of it.

So, too, the United States economy is now growing with the spry energy of Santa’s elves.  According to Commerce Department, U.S. GDP increased in the third quarter at a rate of 3.2 percent.  What’s more, according to the New York Fed’s Nowcast report, and their Data Flow through December 15, U.S. GDP is expanding in the fourth quarter at an annualized rate of 3.98 percent.

Indeed, annualized GDP growth above 3 percent is both remarkable and extraordinary.  Remember, the last time U.S. GDP grew by 3 percent or more for an entire calendar year was 2005.  Several years before the iPhone was invented.

A Cornerstone Promise of the GOP Tax Reform Bill

But despite closing out the year strong, 2017 won’t be the year when annual U.S. GDP growth finally eclipses 3 percent.  By our rough calculations, annual GDP growth for 2017, using the Q4 estimate, comes out to 2.92 percent.  What to make of it…

Certainly, strong GDP growth is a cornerstone promise of the GOP tax reform bill.  Specifically, the promise is that resultant economic growth will pay for the tax cuts.  Yet based on the work of one group of number crunchers, the expectation that the U.S. economy will produce 3 percent economic growth in 2018 is wishful thinking.  The Tax Foundation, an outfit out of Washington, offered the following assessment:

“According to the Tax Foundation’s Taxes and Growth Model, the plan would significantly lower marginal tax rates and the cost of capital, which would lead to a 1.7 percent increase in GDP over the long term, 1.5 percent higher wages, and an additional 339,000 full-time equivalent jobs.  In 2018, our model predicts that GDP would be 2.45 percent, compared to baseline growth of 2.01 percent.”

To be clear, we don’t know what assumptions went into the Tax Foundation’s Taxes and Growth Model.  Does it factor in the latent effects of quantitative tightening?  Does it assume a total of 3 Fed rate hikes in 2018?  What about the flattening yield curve?

In short, will tightening credit markets offset any boost that tax cuts are expected to deliver to the economy?  In other words, will monetary policy cancel out fiscal policy?

Most likely it will.  Here’s why…

Why Monetary Policy Will Cancel Out Fiscal Policy

Plain and simple, the entire financial system and economy has become fully dependent on cheap and ever expanding credit.  Consumers, the federal government, and corporations have gone hog wild gorging on a decade of artificially suppressed, cheap credit.

Presently, American’s owe $3.8 trillion in outstanding consumer credit – some of which, no doubt, was used to purchase light up reindeer antlers.  Of this, more than $1.2 trillion of consumer spending has been borrowed into the economy over the last decade.  This is consumer spending that has been borrowed from the future into the present.

Similarly, over the last decade the federal government has borrowed and spent over $11 trillion, bringing the federal debt from $9 trillion to over $20 trillion.  That’s more than a doubling of the debt in just 10 years.

But that’s not all.  Corporations have been on a massive borrowing and spending binge too.  Total outstanding nonfinancial corporate debt has jumped from about $3.2 trillion in 2007 to over $6 trillion today.  Again, that’s a doubling of debt over the last decade.

What makes the growth of consumer, government, and corporate borrowing over this period so dangerous – in addition to its pure enormity – is that it was encouraged by the Fed’s artificially low interest rates.  The scale and magnitude of this cheap credit expansion is nothing short of a manic credit bubble.

The point is, as mentioned last week, we appear to be entering a period where the price of credit – specifically, interest rates – rise and, thus, credit contracts.  Naturally, this is occurring at the worst possible time; after everything and everyone has become wholly dependent on cheap, expanding credit.

As the Fed raises interest rates, borrowing costs become more expensive.  With respect to government debt, it will take a larger and larger share of the government’s budget to finance the debt.  This will reduce the funds that the government can spend elsewhere.  Similarly, with respect to consumers and corporations, increasing borrowing costs will subtract from spending and investment.

And this is precisely why monetary policy will cancel out fiscal policy.  And this is precisely why the cornerstone promise of the GOP tax reform bill will come up empty.  And this is precisely why we are all doomed.

And on that cheery note, we’ll conclude our ruminations.

Merry Christmas!

MN Gordon
for Economic Prism

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