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.
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