A Test Of Macroeconomics: What Is Going To Happen To The Economy?

by: John M. Mason

Summary

- Many analysts are comparing the election of Donald Trump with the election of Ronald Reagan and the fact that President-elect Trump is proposing economic policies not unlike those of Reagan.

- There are major differences, however, as Reagan was elected while a recession was taking place and while inflation was getting so bad that Volcker and the Fed had to act.

- Trump faces an economic recovery that is seven and one half years old, is the slowest on record, where inflation is little or no problema.

 
The picture since the election day when Donald Trump was elected as President of the United States: the stock market has soared to new historical highs, longer-term bond yields have risen dramatically, and the value of the US dollar has strengthened against most other currencies.
 
The headline on the front page of the New York Times tells the story: "Investors Make Bullish Bet on Trump, and an Era of Tax Cuts and Spending."
 
In other words, Donald Trump, president-elect, is going to come into Washington, D. C. and cut taxes all over the place and increase government spending, especially on infrastructure, and goose up economic growth and inflation in order to put disaffected Americans back to work and make them feel a part of the United States again.
 
If this is the case, and a President Trump actually gets his wish to reduce taxes and substantially increase government spending, we are going to be in a position to observe a vast macroeconomic experiment that will test the limits of our knowledge of how the economy actually works.
 
Some analysts are seeing Donald Trump as the new Ronald Reagan, who came into power in 1981 and lowered marginal tax rates substantially and increase government expenditures, especially spending on the military, and brought on a new age of economic prosperity.
 
The hopes for the Trump expansion have one major difference with the Reagan situation.
 
Reagan got elected toward the end of a recession, the recession going from January 1980 until it reached a trough in July 1980. Reagan, optimistically, saw a brighter future, one that included pulling out of the recession and moving into a period of sustained expansion.

The problem Reagan faced was that inflation was also taking off and Paul Volcker had been brought in as the Chairman of the Board of Governors of the Federal Reserve System toward the end of the Carter presidency in order to break the back of the inflation, which is what he did.
 
But, there was another recession in the first year of Reagan's tenure at U. S. President, the recession beginning in July 1981 and running until November 1982, a period of 16 months.
 
Then, however, the expansion took off and lasted for seven years and eight months before the next recession came along in July 1990. This is the third longest period of economic recovery since the Second World War.
 
Trump faces a wholly different situation.
 
Trump will come into office, if the expansion continues until then…and it will…with the current expansion extending seven years and six months.
 
And, Mr. Trump will not be facing raging inflation like the inflation taking place at the beginning of the 1980s.
 
But this situation, to me, sets the stage for the macroeconomic experiment.
 
Not only is the economic expansion going to be seven and one half years old, this expansion has been the weakest expansion on record.
 
Over these seven and one half years, the economy has only expanded at a 2.1 percent compound annual rate. And, the expansion has been accompanied by a declining rate of growth of labor productivity and a historically low level of capacity utilization in the industrial sector.
 
Furthermore, this expansion has taken place with high levels of federal budget deficits and, in terms of monetary policy, three rounds of quantitative easing that has taken the balance sheet of the Federal Reserve to such huge levels, unimaginable before the Great Recession occurred.
 
Given these expansionary policies, the question has been raised concerned the effectiveness of attempts to manage the economy by means of policies to stimulate aggregate demand.
 
It seems as the supply-side of the economy is dominating the expansion of the economy and that demand-side policies can do very little to change the trajectory of the economy.

I have written about this dilemma, both here and here.
 
If this is the case, then policies to stimulate the demand-side of the economy can do very little to boost economic growth. Tax cuts aimed at stimulating demand in the short-run and spending programs, like infrastructure renewal, can do very little if the supply-side of the economy is setting the pace.
 
But, the supply-siders will say that Mr. Trump's ideas provide incentives to stimulate the supply-side, boost labor productivity and capacity utilization. If this is true, then I am all in favor of them.
 
The problem is that these kinds of supply-side efforts take time to work themselves through the economy. Gaining more rapid growth in the short-run will not be achieved in this way.
 
Going further, there is the problem with the age of the current economic recovery.
 
The longest economic recovery since the end of the Second World War is ten years.
 
Recoveries get weary. Uncertainty starts to dominate the economy. And, problems grow up…both in the United States and the world…that have evolved within the recovery.
 
So, it seems to me that we are on the cusp of an interesting experiment having to do with our understanding of how the macro-economy works…whether or not it is predominantly driven by demand-side factors or by supply-side factors.
 
One thing is sure, however, the economic situation we face today is not that similar with the one faced by the incoming Reagan administration.

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