Outlook for US Economic Policy and Growth

Dean Douglas Elmendorf
Remarks made in Hong Kong on June 28, 2017

Today, I would like to talk a bit about the outlook for US economic policy and growth. I want to begin by describing the political backdrop for policymaking. Then I’ll touch on four areas of policy—monetary policy, budget policy, regulatory policy, and trade policy—and conclude with my predictions for US economic growth.

In terms of political backdrop, three points deserve emphasis. First, the Trump administration is a chaotic mess and will remain so. President Trump is not knowledgeable about policymaking and has little self-discipline, so his personal views on most policy issues are very susceptible to the last thing he has heard and therefore will tend to bounce around. Most of the people the President has appointed to key positions are not knowledgeable about policymaking either, and because the President is appointing no one to many other senior positions, the large gaps in knowledge will not be filled. In addition, the ongoing investigation into the Trump team’s interactions with Russia and related actions will be a persistent distraction. All of this disarray will reduce the administration’s ability to change policy as much as it might like.

The second point about politics is that the Congress is led by Republicans with a traditional conservative agenda, and that agenda will dominate policymaking despite President Trump’s populist rhetoric. As just one example, the President campaigned on a platform of maintaining health insurance for nearly all Americans, but the House and Senate leadership have pushed legislation that would cause more than 20 million Americans to become uninsured, and the President is quite supportive. The conservative agenda will dominate in part because the President’s own views do not seem to be nearly as populist as his rhetoric, in part because the Congressional leadership is more knowledgeable and better organized than the administration, and in part because many Republican voters and most Republican donors support that traditional agenda.

The third point about politics is that changing policy is always difficult, even when one party controls both the presidency and the Congress. Moving most legislation through the Senate requires 60 votes, and the Republicans have only 52 votes even if all of their Members are on board. In addition, changing many federal regulations requires a long and complex process of rulemaking. Moreover, the courts can block actions by the executive branch, as we saw in a number of cases with the Obama administration and have seen already with the Trump administration, such as with the executive orders regarding immigration. Again, this implies smaller changes in policy than one might initially expect.

With that political backdrop, let me turn to the four aspects of US policy that I mentioned.

For monetary policy, President Trump will very probably appoint a new chair of the Federal Reserve Board next year. However, I expect that monetary policy will not initially look much different than it does today. For all of the complaints of Republicans in recent years about loose monetary policy, parties in power rarely want interest rates to rise. In addition, President Trump, who has borrowed huge amounts in his career and repeatedly had trouble paying off his loans, certainly finds low interest rates intuitively appealing. Therefore, I expect short-term interest rates to rise only slowly and modestly from their current levels.

However, if the US economy falls into recession, monetary policy under a new Federal Reserve chair would probably not respond as forcefully as it did several years ago under Ben Bernanke’s leadership or would today under Janet Yellen’s leadership. Republicans have generally become quite opposed to any form of expansionary monetary policy except for cutting interest rates. Given the low level of equilibrium rates in our country, other forms of expansionary policy would be appropriate during a future recession and would be pursued by a Chairman Bernanke or Chair Yellen—but probably not by a new Republican Chair.

Let me turn to budget policy. Relative to what would happen under current law, the Trump administration has proposed dramatic cuts to federal services and benefits and a sharp cut in federal taxes. Some of these proposals are quite vague, and anyway the administration will not get what it wants because of Congressional opposition. The outcome of the coming debates this year is highly uncertain, but my guess is that we will see a greater amount of tax reduction than spending reduction, putting federal debt on a steeper upward trajectory than we would experience under current law.

On the spending side, both the administration and Congressional Republicans declare that they want to cut federal benefits—for health care, retirement, disability, and other purposes—substantially relative to current law. Some of those changes would require 60 votes in support in the Senate, which would be very difficult for them to achieve. Other changes might take only 50 votes, but will be much less appealing to many Republicans up close than they seem from afar, because people would be hurt by those cuts and would complain. So, I think that fairly little will happen with the possible exception of the health legislation being debated right now.

The administration has also proposed substantial cuts in federal services, like infrastructure investment, education and training, health research, diplomatic efforts, and so on—with the notable exception of defense. However, Congressional Republicans are far less enthusiastic about those cuts in services because most specific cuts are much less popular with their constituents than is the abstract concept of cuts. Therefore, I expect that Congress will legislate lower limits on future spending for nondefense services to support the rhetoric of spending restraint, but will not cut nondefense spending much today—and then will not carry through with those lower limits when the future arrives. However, spending for the military will indeed be raised.

On the tax side, I think the chances of comprehensive reform are low but the chances of a sizable tax cut are high. Broad tax reform poses unpopular tradeoffs. Almost everyone endorses the idea of a broader tax base with lower tax rates, because that would be simpler and more efficient. But when one gets down to deciding exactly how the tax base should be broadened, almost everyone sticks up for the tax breaks that benefit them. That is the fundamental reason why tax reform occurs so rarely. There is no sign that the Republicans are converging on any specific proposal that might be enacted: House Republicans have developed a proposal that is not popular with many other Republicans, and the Senate Republicans and the Trump administration do not appear to have developed any specific proposals they support.

Therefore, I think the most likely outcome is a prolonged debate about comprehensive tax reform that ends in a straightforward tax cut early next year. That tax cut will probably include an incentive for American firms to bring back to the United States some of their accumulated overseas earnings, and it might include a modestly lower corporate tax rate. I expect that it also will include some reductions in individual tax rates, especially because it is politically difficult to cut taxes on business and not on individuals.

The third type of policy I highlighted is regulatory policy. Here, the instincts of the administration and Congressional Republicans are closely aligned. Nonetheless, changes in law regarding regulatory policy would require 60 votes in the Senate, which the Republicans would have great difficulty in getting because Democrats would be almost completely opposed. Therefore, the changes we will see will occur primarily through executive action in writing and implementing regulations.

On energy and environmental regulations, the Obama administration used executive actions up to—and in the eyes of some observers, beyond—what was permissible under law. The Trump administration is working to roll back many of those actions. The effects will be somewhat limited by the cumbersome nature of the regulatory process (which affects rolling back regulations as well as imposing them), by the existence of state laws and regulations, and by the actions that businesses have already taken to comply with the regulations from the Obama administration. Still, I expect that there will be more extraction of fossil fuels, more pollution, and more carbon emissions than would have been the case under previous policies.

On financial regulation, there is a reasonable consensus among the various US regulators—including the Federal Reserve as well as executive-branch agencies—about rolling back some aspects of the implementation of the Dodd-Frank legislation of 2010. However, I think those changes will be fairly limited, because the regulators generally think that significant changes from the pre-crisis regulatory regime were warranted and generally do not think that the tighter regulation of recent years has been a significant hindrance to economic growth. I also do not expect any substantial legislation to pass in this area, although Congressional Republicans will certainly talk about it.

The fourth type of policy I want to comment on is trade policy. President Trump has argued vigorously that imports are damaging to the US economy and that international trade agreements have systematically hurt US interests. And, in contrast with some things he has said since he started running for president, he has been offering the same views about trade for the past few decades, so we can presume that he really means them. Concern about the effects of international trade are not new in the United States: President Reagan restricted auto imports from Japan, NAFTA passed the Senate by a slim margin, and the Clinton administration worried endlessly about steel imports. Those developments reflected significant ongoing concern about trade by many voters and elected officials, including both Republicans and Democrats. Indeed, although I support policies to encourage international trade myself, I think that one of the principal mistakes of US policy during the past few decades has been a failure to protect Americans who have been hurt by growth in US imports. So, opposition to greater international trade is not new in US politics or policy. However, it is new for us to have a president who is so negative about trade, and that matters.

I do not think we will have a broad trade war, but I do think there will be protectionist changes in policy. I expect some renegotiation of aspects of NAFTA, I do not expect TPP to be approved in the United States in the next few years, and I expect there will be more aggressive use of tariffs and other tools to block imports in certain circumstances.

That is my quick outlook for US economic policy. What do those policies and underlying economic conditions imply about US economic growth? I think the new policies will, on balance, provide a small boost to growth in the next few years but will be a small drag on growth in the medium term.

The small boost will come primarily from an increase in demand for goods and services stemming from the tax cut I expect. However, the boost will be small for two reasons: First, because I expect the tax cut to be sizable but not overwhelming—maybe $100 or $200 billion per year, which is just one-half to one percent of GDP. And second, because the unemployment rate is already at or below most estimates of the sustainable rate, the Federal Reserve will aim to offset the expansionary impact of the tax cut. They will not be able to offset the impact completely, though, which is why I expect a small boost to growth in the next few years.

The small drag on growth in the medium term will come from a combination of factors. Restrictions on international trade will be a small negative factor; restrictions on immigration will be a small negative factor; and cutbacks in government investment in infrastructure, research, and education and training will be a small negative factor. On the other side, deregulation will be a small positive factor (on GDP, although not necessarily on well-being). I do not expect tax reform to have much effect on economic growth beyond the short-term boost to demand, because I doubt that we will see the sort of broad tax changes that would significantly improve incentives and because the wider budget deficit stemming from the tax cut also needs to be considered. On balance, then, the new policies will be a small drag on growth in the medium term.

With little net impact of new policies, where does that leave my expectation for growth in US GDP over the next several years? At about two percent per year, on average. Our labor force will growth about one-half percent per year, and labor productivity will probably increase about one and a half percent per year, for a total of two percent.

This growth rate is well below the growth rate we experienced in the 1970s through 1990s because of the different demographic circumstances. Our baby boom generation is retiring, and their exodus from the labor force is offsetting a significant part of the inflow of younger people. In addition, women’s labor force participation has roughly plateaued, in contrast with its dramatic earlier rise. Those two factors together imply that our labor force growth over the next decade will be about one percentage point per year slower than in the 1970s through 1990s, which reduces our sustainable output growth from around three percent to around two percent. Predicting productivity growth is very difficult, and I think the best forecast is essentially the average experience of the past few decades, which is an increase of about one-and-a-half percent per year.

I will close by noting that the US economy may well fall into recession at some point in the next several years. I think the immediate risk is small, but recessions are recurring features of market economies. Moreover, with interest rates low and with the likely change in Federal Reserve leadership that I discussed, the Federal Reserve may not be as effective in fighting the next downturn as I would like. In addition, with countercyclical fiscal policy in some disrepute—quite unjustifiably, in my view, but so it is—tax and spending policy may not be as effective in fighting the next downturn either. And on that worrying note, I will stop. Thank you.