Make America Sane Again

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The Perils of Trump: Why Donald Trump is the Gravest Existential Threat to the U.S. Economy Since World War II

Donald Trump has run a presidential campaign branded on populism which rejects the global and domestic economic system developed by the two major political parties since World War II. Though politically appealing to a large segment of the population, Trump’s economic policies endanger the U.S. economy exponentially more than those of any presidential candidate of a major U.S. political party in history. The most severe (and hardly the only) economic dangers of a Trump presidency include the erosion of the dollar’s status as the world’s reserve currency, a recession longer than the one in the late 2000s, and the end of U.S. government debt’s status as the least risky asset in the world. If any of these three dangers are realized, there will be a sudden and indefinite collapse in the investment of stocks and real estate that Americans depend on for retirement and employment with firms of all sizes. For these reasons, Trump is the most irrational choice this year’s American voters have ever had in their lifetimes.

By Adam Smith

Editor’s Note: The views expressed by this author do not reflect the official views of the Penn State Economics Association or the views of the employers of any current or former member of the Penn State Economics Association. For purposes of ensuring readers do not infer otherwise, the author of this post is using a pseudonym.

The intellectual level of public discourse in the United States has been reduced to that of a third-grade elementary school student. This is not hyperbole; that is actually the reading level of Donald Trump’s diction during the past year-and-a-half. This would only be a mild nuisance if Trump was just bungling the United States Football League, suing a securities analyst for correctly predicting the failure of the Trump Taj Mahal, or “literally sold almost no steaks” in his hilariously awful business plan to sell Trump Steaks at The Sharper Image. Yet, Trump—a man with no government experience, breathtakingly scant public policy knowledge, and horrendous personal character—is somehow the Republican Party’s nominee for President and FiveThirtyEight’s Polls-Plus Model projects he has roughly a 35% probability of winning the general election on Tuesday.

Sadly, the comical failures listed above understate Trump’s failures as a business executive and fail to adequately articulate the dangers of his potential ascendance to the Presidency. Trump’s stated net worth of $2.9 billion means the real estate mogul underperformed four decades of returns on the real estate market (FTSE NAREIT All Equity REITS Index) by 57%, or left $13.2 billion on the table because of his bad decisions like the Trump Taj Mahal. Setting aside for now the specious logic underlying his economic policies, Trump has no experience in his business career that should inspire confidence in the public that he is qualified for the Presidency.

To the contrary, his boasting on tape of having committed acts that are legally defined as sexual assault, refusal to disavow support from Ku Klux Klan Grand Wizard David Duke, demagogic rhetoric and policy proposals attacking Muslims and Mexicans, and shameful personal indulgence of donations belonging to a private charity are just a few of the many actions which rightfully make investors and citizens fearful of political and economic instability if he wins the election. Trump’s actions validated the reported decisions of Republicans like Ohio Governor John Kasich, U.S. Senator John McCain of Arizona, former Florida Governor Jeb Bush, former U.S. Presidents George H.W. Bush and George W. Bush, former Secretary of Defense Colin Powell, former Secretary of State Condoleezza Rice, and former Massachusetts Governor Mitt Romney to take a stand against their own party’s presidential nominee. Far more important than Trump’s underwhelming business record, the fact that Trump does not deserve the unity of his own party makes it impossible to conclude he can unite Congress behind sound economic policies. These factors are responsible for the apprehension of global investors and consumers as the election looms, but Trump’s feeble attempts at policy prescription—inseparable from the demagoguery he has displayed in this election campaign—is arguably the biggest source of anxiety of all.

The World is Watching: Trump’s Abandonment of Globalization Would Threaten America’s Status as the Safe Haven of Financial Markets

The mythology that Trump is a business genius who would correct the (admittedly real) partisan dysfunction in Washington, D.C. inevitably leads to the dangerous abandonment of the foundations of global economic growth since World War II. It is also an abandonment of the Republican Party’s stance for decades in favor of free trade. The essence of Trumpism is the notion that foreign entities—namely corporations and governments, but also notably refugees and illegal immigrants—are conspiring to undermine American institutions. In his attempt to argue this point, Trump claims, “We’re losing a tremendous amount of money, according to many stats, $800 billion a year on trade…So we are spending a fortune on military to lose $800 billion. That doesn’t sound like it’s smart to me.” His prescription? A 45% tariff on Chinese imported goods, a 35% tariff on Mexican imported goods, and repeal of trade agreements like the North American Free Trade Agreement. It underlies a pathos appeal which resonates with Americans nostalgic for the more closed economy their parents and grandparents experienced before World War II. It also fundamentally misrepresents the United States’ role in the global economy and ignores the benefits it reaps from globalization.

As New York Times economic correspondent Neil Irwin writes, “trying to eliminate the trade deficit could mean giving up some of the key levers of power that allow the United States to get its way in international politics.” The dollar has been a global reserve currency since the Bretton Woods agreement in 1945, meaning that parties around the world use it for transactions in which the U.S. has no direct involvement. Its status as the centerpiece of global finance gives the U.S. government unparalleled power to enforce sanctions against Iran, Russia, North Korea, and terrorist groups by cutting off access to the dollar payments system to any bank in the world. Isolationists within Trump’s base of support might shrug at this benefit, but the U.S.’s power in the international political sphere is inseparable from the dollar’s status as a reserve currency. Moreover, amidst the 2008 financial crisis, U.S. government debt saw its interest rates fall when other countries’ rose because of Treasury securities’ unique status as the safe-haven asset. The United States is unique among national economies in its ability to borrow cheaply to provide fiscal stimulus when it experiences a recession and when the federal funds rate is at the zero lower bound.

All of this is relevant to Trump’s protectionist trade proposals because economist Robert Triffin warned that the provider of the global reserve currency must run perpetual trade deficits to keep the financial system stable. When nearly every country has a use for dollars, the upward pressure on demand for dollars makes exports more expensive and puts downward pressure on the price of imports in the U.S. In the 1940s, the U.S. was uniquely suited to be the global reserve currency due to the relative strength of its economy and standing as the global military superpower. It is because of the U.S. government’s continued spending on vast domestic infrastructure projects and military to secure hegemony that there is unmatched global demand for the dollar as a reserve currency. What other country could be safer for investing than the producer of the global reserve currency?

Furthermore, it is evident Trump’s claim that perpetual trade deficits are a sign foreign countries are taking advantage of the U.S. is flatly wrong. It is true that when China netted a $366 billion trade surplus with the U.S. in 2015 that the Gross Domestic Product (GDP) for the U.S. was reduced at first, but something had to happen with that extra sum of money. If Chinese investors keep the money at home, the Chinese yuan would appreciate and goods would become more expensive in the U.S., thus negating the gains of its exporters. Instead, China and other export-intensive countries prevent their currencies from rising too high by investing in U.S. stocks and bonds, investing in factories in the U.S., or having the government buy assets directly. Far from being an inherent drag on the economy, the nature of these persistent trade deficits experienced by the U.S. are arguably the mechanism which make it the safe haven financial market of the world.

This upward pressure on American assets provides high valuation of stocks and real estate, as well as low interest rates on fixed income assets relative to other countries, give American companies a unique advantage in financing. The effect is an advantage for those seeking to retire by generating a sufficient return on their investments. But if Trump signs the intensely protectionist legislation he is proposing and other countries respond with retaliatory tariffs of their own, the consequent slowdown in international trade could be enough to erode the status of the U.S. economy as a global safe haven and dramatically hit the wallets of Americans from every income bracket.

The King of Debt: How Trump’s Fiscal Policies Would Explode the National Debt and Borrowing Costs

While Trump deviates from the orthodoxy of the Republican Party on trade, he doubles down on it for the issue of taxation. Trump’s track record of insolvency in his business career and his actual proposals suggest a massive expansion of tax cuts and an increase in government debt far eclipsing that of his opponent. Yet, this in itself is not inherently alarming. Fiscal stimulus can be useful when monetary policymakers struggle with the zero lower bound (the effective federal funds rate is still historically low around 0.40%), as long as the stimulus is directed to activity which expands the economy. The problem with Trump’s version of fiscal stimulus is twofold: the nature of it is inefficiently allocated and the size of it undermines the creditworthiness of the federal government.

It is not surprising that Trump unveiled a plan to significantly cut personal income tax rates due to the inherent positive reception of voters to receiving a tax cut. Bloomberg writer Richard Carroll shows there are some instances where tax cuts were a sensible solution to stimulating the economy, but also some where they failed to accomplish this end due to different economic conditions. The tax cuts proposed by John F. Kennedy and signed by Lyndon B. Johnson in 1964 successfully contributed to about 4.5% GDP growth for six years and shrank the debt-to-GDP ratio because marginal tax rates had been extraordinarily high—up to 91% for personal income (the top bracket). Ronald Reagan’s tax cuts made sense in 1981 because high inflation had arbitrarily pushed individuals into higher income brackets and firms had newfound incentives to invest with some additional fiscal stimulus in an environment of high interest rates. The main pitfall of Trump’s tax plan is the same as the one implemented by George W. Bush in 2001: tax cuts are not a magical panacea to every economic situation. In 2001, the job market was around full employment with an unemployment rate around 4.7%, the debt-to-GDP ratio remained moderately high at 56.4%, and the effective federal funds rate was relatively low at 3.97%. Consequently, GDP only saw an average increase of 2.7% between 2002 and 2006, following a stretch of five years where annual GDP growth exceeded 4% four times. Meanwhile, the debt-to-GDP ratio expanded by 28.8% during Bush’s presidency. Now, the unemployment rate is similarly low at 4.9%, debt-to-GDP is even higher around 75%, and the federal funds rate is even lower around 0.40%. The current economic conditions are even less suited to generate significant additional growth upon the injection of a large tax cut.

Furthermore, the allocation of Trump’s tax cuts is primarily to high-income consumers who spend a significantly smaller proportion of any reduction in their taxes than do lower and middle-income consumers. Moody’s Analytics calculated the marginal propensity to consume (percent of income consumed) of those in the top income quintile to be 0.49 and these individuals would receive 72% of Trump’s tax cuts. That means only 49 cents of every dollar in the vast majority of Trump’s tax cuts would add to consumption in the U.S. This is in contrast to the bottom-quintile, whose marginal propensity to consume is 0.86 and would receive 2% of Trump’s tax cuts. Cutting taxes for lower-income earners, or enacting other fiscal policies which boost their incomes, is simply more efficient at stimulating consumption in the economy as a whole.

This does not, in itself, refute the merits of cutting taxes primarily for high-income earners and capital gains income. If firms were constrained from expanding because of high borrowing costs, these individuals could use their savings to invest in them when they badly need capital. The problem with using that as a reason for implementing Trump’s plan now—in contrast to Reagan’s Presidency—is that the current market environment is such that stocks are very expensive: the S&P 500 has a historically high price-to-earnings ratio of 24.31, as of October 28. The P/E ratio was very low at 9.02 at the beginning of 1981, Reagan’s first year as President. Firms simply haven’t been having a problem raising capital because investors are in search for yield. Higher demand for financial assets would probably do little to increase future earnings. In essence, the marginal impact of Trump’s tax plan on economic growth would be underwhelming compared to past tax cuts.

Of course, many of Trump’s supporters are likely to favor his plan not because they think it will stimulate the economy, but simply because they want to have more after-tax income. They should be warned they could easily actually be worse off under Trump’s tax and spending plans, especially if these individuals are not in the top income quintile. Moody’s Analytics wrote that if Trump’s plan is adopted at face value, the “nation’s debt load rises from 75% of GDP currently to over 100% by the end of Mr. Trump’s first term and more than 130% a decade from now. Long-term interest rates are much higher as a result. Over the next decade in the scenario where Trump wins the election, 10-year Treasury yields are expected to average 6.6%, compared with near 4% in the current-law scenario. Businesses’ cost of capital and households’ borrowing costs are much higher, despite the lower marginal rates, which act as a corrosive on investment and ultimately on productivity and GDP growth.” With the job market around full employment (4.7% unemployment) and Trump’s refusal to alter the largest drivers of increased government spending—Social Security and Medicare, it is likely that there would be quick crowding out effects under his fiscal policies: “the increased government borrowing causes interest rates to increase, crowding out private sector activities such as business investment, housing, and consumer spending on vehicles and other durables.” Ready or not, the self-proclaimed king of debt will surely live up to his name.

The Trump Recession: A Perfect Storm

The best case scenario of Trump’s economic plan is that there is an economic recession that is not as severe as the one in the late 2000s, but more prolonged. The worst is a catastrophe that has never happened before and would throw the basic principles of finance out the window.

Along with the higher interest rates arising from his fiscal policies, Trump’s steep taxes on imports would hit the wallets of most Americans by increasing the prices of many goods ranging from groceries to clothing. It would replicate the effects of the Hawley-Smoot tariff law signed by Herbert Hoover during the Great Depression and similarly shrink global output at the worst possible time. Furthermore, Trump’s hardline plan to deport millions of illegal immigrants would also add to inflationary pressure by increasing the cost of labor for firms and decreasing output due to the lower labor supply. As a result, Moody’s forecasts the Federal Reserve to respond to this inflationary pressure with an increase in the federal funds rate in accordance with its congressional mandate to stabilize inflation.

If Trump is elected and gets most of his policies adopted even in a modified form, Moody’s model forecasts all of these factors would cause a recession beginning in 2018 that would last longer than the 2000s Great Recession. The model predicts it would result in 3.5 million Americans losing their jobs, unemployment rising to 7%, and a sizable fall in home prices and stocks. Movements in futures contracts during the presidential campaign also provide a strong signal that investors would price in the effects of Trump’s policies as soon as Wednesday. During the first general election debate, Trump’s odds of winning fell by 5.2% and S&P 500 futures rose by 0.8%. Given that there were no other significant news events during this two-hour window and that price movements are typically minimal then, it is reasonable to assume a direct connection between these two shifts. It corresponds to a 15.38% difference in the value of the S&P 500 between a certain Trump victory and a certain Trump loss.

Though the expected effect of Trump’s presidency on the population’s wealth is large, this is largely due to the uncertainty of what events his election would bring. It is possible that Trump would govern as a more conventional politician than his rhetoric suggests, so volatility in both financial markets and the real economy could be mitigated. On the other hand, it is also possible (and in my opinion, more likely—considering that Trump’s only consistent trait is his erratic behavior) that the market has not priced in the full extent of Trump’s irrationality and its economic consequences.

Take, for instance, Trump’s suggestion that “[b]ringing back the gold standard would be very hard to do, but, boy, would it be wonderful. We'd have a standard on which to base our money.” The events of the Great Depression demonstrate that the gold standard was actually a disastrous policy. According to Wall Street Journal economics commentator Greg Ip, “In 1929, a recession in the United States caused prices, output and imports to plunge and the trade surplus to surge. This drew in gold from its trading partners, forcing them to raise interest rates. When European central banks tried to ease monetary policy, speculators guessed they would devalue, and pulled their gold out, causing the money supply to contract.” If Trump had appointed individuals who espoused these ideas to the Federal Reserve Board of Governors prior to the 2008 financial crisis, the Fed would have been unwilling to expand the money supply by lowering the federal funds rate and undertaking quantitative easing—the central bank’s purchase of long-term Treasuries and other fixed-income assets which kept interest rates low in the aftermath of the crisis. The recession would have literally followed the script of the Great Depression.

But the worst scenario of all becomes horrifyingly plausible to imagine when one considers Trump’s comments that he would not pay back the government’s creditors in full in the event that there is a recession in his presidency: “You go back and say, hey guess what, the economy just crashed. I’m going to give you back half.”

A few recent events suggest this idea (and Trump’s track record of undertaking similar actions as a business executive) could lead to catastrophic volatility in financial markets eclipsing the 2008 crisis in severity. For instance, Congress already flirted with a default on Treasuries in 2011 (and again in 2013) when $6 trillion of value from global stocks was eliminated by the time the two parties agreed to raise the debt ceiling. Moreover, the $19.8 trillion of outstanding government debt is more than 38 times the $517 billion Lehman Brothers owed when it filed for bankruptcy, and the stock market lost almost half its value in the five months after that happened. A big reason why Lehman’s collapse was so devastating was because its counterparties discovered the collateral they thought was backing their loans in the repo market couldn’t be returned. This problem would be even worse if Trump does not pay back creditors in full because at least $2.8 trillion of Treasuries served as collateral for repo and reverse repo loans as of 2013 (likely more Treasuries serve as collateral since that time), according to Fed data. If Treasuries were no longer eligible as collateral, the losses for lenders and borrowers could be unprecedented. This has never happened before, so it is impossible to quantify the damage precisely. However, the idea of $19.8 trillion in risk-free assets suddenly taking a haircut means markets would have to price in an unprecedented high risk discount to nearly all assets ranging from stocks to houses. It would be a recipe for millions of Americans to foreclose on their homes and firms to collapse. Modern portfolio theory would be moot.

Trump did walk back his comments, but he demonstrated a hazy (at best) understanding of public finance in the process. He still has not retracted his support for Congressional Republicans’ failed attempt to defund Planned Parenthood and force another government shutdown in 2015, suggesting he remains willing to use the risk-free status of Treasuries as a political football. Trump should instead heed the advice of Warren Buffett who said of using the debt limit as a weapon, “It should be like nuclear bombs, basically too horrible use.” Of course, Trump has apparently not fathomed that actual nuclear bombs are too horrible to use either. Don’t hold your breath, America.

 

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