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Analysis
US fiscal policy may burst asset bubble

US fiscal policy may burst asset bubble

Painful repricing of credit will damage emerging markets

by Desmond Lachman in Washington

Mon 2 Jul 2018

Last year, President Donald Trump opted for a highly expansionary budget policy stance at a time when the US economy was at or beyond full employment. In 2018, ignoring economic troubles abroad, the administration is reinforcing its commitment to 'America first' policies, raising the risk of retaliation from trade partners.

The principles of sound budget management dictate that while budget deficits might be helpful during times of economic weakness, they should not be tolerated in times of strength. If not, the government's debt would be on an ever increasing path. In addition, as the budget deficit widens during times of strength, the government would not have the room for fiscal policy stimulus in times of weakness.

Seemingly oblivious to these principles, the Trump administration opted in 2017 for an unfunded tax cut that will increase the public debt by an estimated $1.5tn over the next decade. The administration also assented to a $300bn congressional increase in public spending.

Years of easy monetary policy by the world's major central banks have led to overvaluation in global equity and housing markets. At the same time, ample global liquidity has caused credit risk to be seriously mispriced around the world.

Pursuing expansionary fiscal policy risks causing long-term interest rates to rise sharply. As the Federal Reserve shrinks its bloated balance sheet, an increase in the US budget deficit is bound to push long-term rates markedly higher.

That threatens to burst asset price bubbles and could lead to a painful repricing of credit around the world. It risks suddenly halting capital flows to emerging markets. That could be especially damaging for countries like Argentina, Brazil, Indonesia, South Africa and Turkey.

Escalation in Trump's protectionist posturing on trade policy further exacerbates already tense global conditions. This goes well beyond taking punitive trade actions against China, where such measures might well be justified. Rather, it includes the imposition of steel and aluminium import tariffs on US allies in the Americas and Europe. It also includes the adoption of a much tougher stance in negotiations around the North American Free Trade Agreement, an antipathy towards trade agreements in general, and the threat of much higher tariffs on imports of German cars.

The reason given for increasing import tariffs is that the administration wishes to eliminate the country's trade deficit. But this contradicts its expansionary budget policy.

If there is one point on which almost all economists can agree, it is that a country's trade balance is arithmetically the difference between its savings and its investment rates. By following policies that increase the budget deficit and reduce the country's savings rate, Washington is increasing the probability that the US will return to the twin deficit problem of the 1980s. That, in turn, raises the chances that the administration will intensify its protectionist stance on trade policy when the country's trade deficit widens.

The timing of Washington's beggar-thy-neighbour policies is especially unfortunate for Europe. At a time when developments in Italy threaten the return of the European sovereign debt crisis, the last thing the region needs is a trade war with the US that might further undermine investor confidence.

If Trump's budget and trade policies trigger a global economic recession, the US will hopefully be compelled to co-operate with trade partners to promote a quick recovery. However, such optimism seems misplaced in the light of the administration's major macroeconomic mistakes and high-handed treatment of US allies.

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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