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Analysis
Mnuchin's costly financial tutorial

Mnuchin's costly financial tutorial

Difficulties for Fed from US tax cut

by Desmond Lachman in Washington

Mon 5 Feb 2018

Judging by Steven Mnuchin's first year in office, one has to wonder whether an entry-level economics course should not be a prerequisite for being Treasury secretary of the world's largest economy. Maybe then the US and world economies would be spared long-run damage from ill-advised US policy decisions.

Among the more egregious decisions to which Mnuchin has leant his wholehearted support was the tax law that passed the US Congress in December. According to estimates from the non-partisan Congressional budget office, this tax cut is expected to increase the deficit and add around $1.5tn to the country's public debt over the next decade.

Never mind that the US economy is operating at close to full employment and is growing at a healthy clip. Never mind that the economy is still receiving a boost from abnormally low interest rates and from both a 25% increase in equity prices and a 12% dollar depreciation since the start of the Trump administration.

Mnuchin should be familiar with the many countries that got into trouble through a lack of budget discipline and excessive debt build-up. He would have learnt that even the most diehard Keynesian economists would not be promoting budget stimulus at a time of cyclical economic strength. They too would subscribe to the erstwhile Republican idea that the budget deficit and public debt should be reduced in good times, to make room for stimulus if the economy moves into recession.

Mnuchin would do well to understand the extraordinarily difficult position in which he has put the Federal Reserve. The last thing the Fed needs is a sizeable fiscal stimulus at a time when the economy is close to full employment.

Overheating is bound to lead to higher inflation. That will force the Fed to move to higher interest rates, or risk incurring the wrath of bond vigilantes once the first signs of inflation emerge. In either event, Mnuchin's budget recklessness could very well have advanced the date at which today's global asset bubbles burst.

Mnuchin's pronouncement on the dollar at the World Economic Forum in Davos in January showed scant regard for the niceties of international economics. This would seem to be the explanation for his decision to talk down the dollar and to break from the decades-long mantra of Treasury secretaries about the US's interest in a strong currency.

Mnuchin does not seem to grasp that the US derives considerable benefit from the dollar being the world's major reserve currency. The dollar has earned that status by virtue of being strong. Talking down the dollar puts that status at risk.

A country's trade balance is not determined by its exchange rate. It is determined by the difference between a country's saving and investment levels. If a country saves less than it invests, as in the US, it will run a trade deficit irrespective of the level of its currency.

Mnuchin should be making every effort to increase the US savings rate. An unfunded tax cut, which he supported, will almost certainly weaken public savings and lead to a widening of the trade deficit.

In the year ahead, Mnuchin will probably get a costly economic tutorial from the consequences of his policies. The pity for the American public is that he did not get that tutorial while he was still in college.

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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