January 22, 2018
No Sugar High from Tax Cut Unless the
Fed and Banking System Provide the Sugar
There has been chatter about whether the Tax Cuts and
Jobs Act of 2017 (TCJA) will result in a temporary stimulus, or sugar high, to
U.S. economic activity because of the increase in corporate after-tax profits
and the increase in household disposable income that will flow from the
tax-rate cuts. How can putting this extra after-tax income in the hands of
businesses and households not
stimulate private sector spending? In order to answer this question, you have
to follow the money. And when I follow the money completely, I come to the conclusion that the tax cuts will not stimulate private sector spending unless the Fed and the banking system
finance the tax cut. In other words, TCJA will not produce an economic sugar high unless the Fed provides the
sugar.
If the federal government cuts our taxes, all else the
same, its budget deficit will increase. The tax cut in the short run, at least,
will result in lower federal government tax revenues. That’s what increasing
corporate after-tax profits and household disposable income is all about. But
unless the federal government simultaneously cuts its expenditures to match the
drop in its revenues, its budget deficit will increase. A wider budget deficit
means an increase in federal government borrowing. Now we are getting to the
nub of the issue – the implications of the funding
of the tax cut. I argue that unless the Fed and the banking system create the – here it comes – thin-air credit to finance the tax cut,
there will be no temporary stimulus from said tax cut.
Let’s assume that there is no additional thin-air credit (sum of bank credit, Fed reserves and
currency) created in reaction to the tax cut. In this case, the extra funds
needed to fund the wider deficit will have to be raised from the nonbank
nonfederal government sectors – households, businesses, nonfederal government
entities and the rest of the world. Because the U.S. Treasury cannot require
these sectors to fund the federal government’s widened deficit, market forces
must induce these sectors to voluntarily offer up these funds. The yield on
Treasury securities would be expected to rise sufficiently to induce these
sectors in the aggregate to reduce their current spending on goods and services
by the amount of the increased federal budget deficit and transfer this purchasing
power to the Treasury through the purchase of its additional securities
offerings.
Let’s net all of this out. Some households and businesses
that experience an increase in disposable income from TCJA might increase their
current spending on goods and services. But because the wider federal budget
deficit must be financed and we have stipulated no increase in thin-air credit,
some entities in the household, business, nonfederal government and foreign
sectors must cut their current spending on goods and services by the amount
that other entities increased their current spending on goods and services.
TCJA results in the federal government dissaving
more and the other sectors saving more. The net result of this is that TCJA
would not result in a net increase in
current spending on goods and services. Rather, the increased current spending
by some is offset the increased saving by others. TCJA, under these conditions,
would not produce an economic sugar
high.
Let’s look at some data. The blue bars in the chart below
are the annual observations of the net lending (+) or net borrowing (-) of the
U.S. federal government borrowing from 1965 through 2016. It should come as no
surprise that the blue bars are in negative territory during most of the
period. With the exceptions of 1999 and 2000, the federal government has run
budget deficits. The red bars in the chart represent the aggregated net lending
(+) or net borrowing (-) of households, nonfinancial businesses, state and
local governments and the rest of the world. With two exceptions, 1979 and
2006, these combined sectors have been net lenders. Notice that the blue bars
and red bars behave in a manner as though they are mirror images of each other.
That is, as the federal government’s net borrowing
increases in magnitude, i.e., the blue bars sink farther into negative territory, the combined
nonfinancial sectors’ (excluding the federal government) net lending increases in magnitude, i.e., the
red bars rise higher into positive
territory. The two series are negatively
correlated with absolute-value coefficient of 0.85. Recall that an
absolute-value coefficient of 1.00 represents perfect correlation. The data in the chart support my argument that
as the federal government dissaves
(borrows) more, other sectors save (lend) more.
If the Fed and the banking system, combined, fund the
wider federal government budget resulting from TCJA, then the tax cuts can stimulate private sector spending on
goods and services. The Fed and the banking system have the ability to create
credit figuratively out of thin air. If households and businesses increase
their current spending on goods and services because of their increased
after-tax income and the Fed and the
banking system create the credit out of thin air to fund the wider federal
budget deficit, then no other entity needs to cut its current spending. Under
these circumstances, TCJA could produce an economic sugar high because the Fed
and the banking system are providing the sugar.
What would motivate the Fed and the banking system to
create the thin-air credit to fund the wider federal government budget deficit
resulting from TCJA? All else the same, the wider federal budget deficit would
represent a net increase in the aggregate demand
for credit. When the demand for something increases, upward pressure on the
price of that something is exerted. In this case, there would be upward
pressure on the level of the structure of interest rates. If the Fed does not
let the overnight federal funds rate drift upward with other interest rates,
then banks will have an incentive to lend more (create more thin-air credit)
because the spread between their loan rates and their marginal cost of funds
will have widened. But the banking system will need more Fed-created reserves
if bank loans and deposits in the aggregate increase. In order for the Fed to
keep the federal funds rate from rising, it will have to create more cash
reserves out of thin air.
Will the Fed
and the banking system fund the wider federal government budget deficit? In the
words of President Trump, “We’ll have to see about that.” The Fed currently is in a rate-raising mode.
Consumer inflation is picking up. Consumer spending growth has been strong. Labor
markets are tighter than a snare drum. And thin-air credit growth picked up in
Q4:2017, ironically, due to an acceleration in monetary base growth. I say
“ironically” because monetary base growth, all else the same, would have been
expected to slow as the Fed began to pare its securities holding in late 2017. Obviously,
all else was not the same. The upshot is that the Fed in 2018 will be moving
the level of the federal funds rate in the same direction that the TCJA-induced
wider federal government budget deficit will be moving it. By sheer chance,
then, the Fed is likely to limit the amount of thin-air credit funding of the
wider budget deficit.
Paul L. Kasriel
Founder, Econtrarian LLC
Senior Economic and Investment Advisor
1-920-818-0236
“For most of human history, it made good adaptive sense to be fearful and emphasize the negative; any mistake could be fatal”, Joost Swarte
∆ + 6 = A Good Life
Send any comments to me at econtrarian@gmail.com.
