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US recipe for market turbulence

US recipe for market turbulence

Congress should temper Trump's budget proposals

by Desmond Lachman

Fri 18 Nov 2016

In considering the US president-elect's plans for fiscal stimulus, Donald Trump's economic team would be well advised to consider the teaching of The Bible’s Book of Ecclesiastes, 'There is a time for everything and a season for every activity under the heavens.'

In economic policy, the time for fiscal stimulus is when an economy is faltering and when unemployment is high. It is not when the economy is recovering and when it is at close to full employment. It is also not at a time when the last thing that a fragile global economy needs is a sharp rise in US interest rates or a significant dollar appreciation.

While the new administration is yet to take office, there are already strong indications of a highly expansionary budget policy. Proposed fiscal measures include a sharp reduction in the corporate tax rate to 15% and a decline in the top household income tax rate from its present 39.6% to 33%. Ideas being floated include a $550bn increase in public infrastructure spending and large increases in the defence budget.

There might be merit in Trump's proposal to slash corporate and household income tax. The same applies to proposals to ramp up infrastructure and defence spending. However, there is no merit in slashing tax rates and increasing public spending at the same time. Such an approach is bound to impart a large fiscal stimulus to the US economy when it is close to full employment. It risks opening a substantial budget deficit and increasing the US government's already large debt burden.

With wage pressures beginning to increase, this appears reckless. A meaningful fiscal stimulus is bound to result in either higher inflation or a series of Federal Reserve interest rate increases to stave off such an outcome. That in turn is likely to lead to a further significant appreciation of the dollar, particularly since major central banks like the Bank of Japan and the European Central Bank are still in an expansionary policy mode.

The new administration should not underestimate the dangers of higher US interest rates for the global economy. The world is drowning in debt and credit risk is grossly mispriced on financial markets. Rising US interest rates risk triggering a repricing of global credit risk and a bursting of the global sovereign debt bubble. Because of global economic integration, this would in turn have important adverse ramifications for the US economy and its financial markets.

Further dollar appreciation resulting from higher US interest rates would counter Trump's much propounded wish to improve the competitive position of US industry and bring jobs back home. A Republican Congress, adhering to its principles of budget responsibility and prudent debt management, will hopefully substantially temper Trump’s budget proposals. If Congress fails to do so, the year ahead will brim with turbulence in US and global financial markets.

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.

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