The figure below, by David Mericle from the Goldman Sachs Research team, is brimming with important insights about the current macroeconomy and our misbegotten fiscal policy stance in recent years.
The point of the figure is to demonstrate the economics behind the recent claim by Federal Reserve officials that “head winds have become tail winds,” meaning forces that were once slowing U.S. growth are now supporting growth. Those forces are fiscal policy, financial conditions and the growth of our trading partners. Fiscal policy can be contractionary or expansionary; financial conditions dictate the strength of credit flows and investment; stronger global growth can boost our exports and vice versa.
I added the unemployment rate table to the right to emphasize the main point I take from this figure: Our fiscal policy is backward. It’s “austere” — subtracting from growth — in weak times, as 2011-13, when the jobless rate was between 7 and 9 percent. Now, when the unemployment rate is about 4 percent and going lower, according to my forecast, fiscal policy is stimulative, predicted to add about a ½ percentage point to growth in 2018-19.
In other words, instead of the traditional countercyclical role of fiscal policy — the private economy goes south, government spending ramps up to temporarily make up the difference — current fiscal policy is pro-cyclical, further juicing growth even as we close in on full employment. As I’ve written elsewhere, this is highly unusual. Outside of wars, I don’t recall that we’ve ever generated such large budget deficits when the economy was as strong as it is today.
What’s wrong with that? On the one hand, if I’m right about where the unemployment rate is headed, I’ll very much welcome such low unemployment and the extra bargaining clout it will deliver to workers who are only recently sharing in the benefits of the nine-year economic expansion. But the problem with this approach to fiscal policy is at least twofold.
First, some of the stimulus in play now, specifically the tax cuts, likely generate low bang for the buck in terms of helping people who still need help in this economy. Corporate rate cuts, pass-through loopholes and goodies for wealthy heirs do not directly help working-class families in left-behind parts of the country.
Second, and this concern is particularly serious, such backward, pro-cyclical fiscal policy really hurts in recessions, when we’ll need countercyclical deficit spending to offset the contraction in private sector demand. But if we’re using up perceived “fiscal space” now, they’ll be that much less fiscal help available when we really need it (“perceived” is important in this context; see here).
Another interesting point in the figure is the large, negative contribution from financial conditions in 2015. Jay Shambaugh, director of the Brookings Hamilton Project, points out that exchange rate and Fed dynamics were in play here. “Assumptions that the Federal Reserve would raise rates much faster than the rest of the world helped spur a substantial appreciation of the dollar (15 to 20 percent in 18 months) which contributed to slower U.S. and global growth in 2015 and 2016.”
Strong equity markets and credit flows flipped the financial component from big head wind to big tail wind last year and this year, and the Fed appears to be in a fairly accommodative mode, which is why I forecast an even lower unemployment rate this year. That is, I expect them to tap, not slam, the growth brakes, though this warrants close watching. Even as head winds shift to tail winds, both wage and price inflation have been relatively tame, suggesting there’s more room to run in this economy.
In that regard, this stimulative part of our ongoing fiscal experiment might pan out okay, especially given the bargaining clout points noted above. But the bigger, much more fundamental problem is that we’ve got fiscal policy working backward these days, and that leaves me extremely concerned about forthcoming austerity in the next recession, a policy stance that has the potential to mete out a great deal of unnecessary economy pain.