An economist recently shared a disturbing vision, projecting that the 2020s will look a lot like the 1970s. The stock market went nowhere during the 1970s, inflation was out of control, and a deep recession brought the unemployment rate to 9%.
Two terms became widely used during the decade. “Stagflation,” the combination of stagnant economic growth and high inflation, and the “misery index,” the sum of the unemployment rate and the inflation rate. The misery index peaked at 21.98 toward the end of Jimmy Carter’s presidency. The economy recovered in the 1980s, but only after severe monetary “shock therapy” from Federal Reserve Board Chair Paul Volcker.
I’m less fatalistic about the outlook for the 2020s, as I expect the disinflationary impact of technology, demographic trends and globalization to keep inflation from reaching prior peaks. However, the favorable near-term economic outlook may be creating a false sense of security about the long-term outlook. Although President Donald Trump’s economic policies will boost near-term growth, an overstimulated economy and lack of progress on structural issues may cause the next recession to be more severe.
Some aspects of the Republican tax overhaul strengthen the foundation for long-term economic growth. Reduction of the maximum corporate tax rate from 35% to 21% and elimination of the corporate alternative minimum tax (AMT) will move U.S. corporations from having one of the highest corporate tax burdens in the world to being in the middle of the pack. The tax law moves towards a territorial tax system, reducing incentives for corporate inversions and motivating companies to repatriate overseas profits back to the U.S. Although capital spending will receive a near-term boost because capital expenditures become fully deductible from profits in the year of the expense, it is likely that companies will pull forward spending that was already planned. Consequently, capital spending may spike in 2018 and 2019, but will probably fall back in 2020.
Personal tax code changes have far-reaching implications, despite being scheduled to expire in 2026. Consumer spending will also get a near-term boost, as the majority of taxpayers should benefit from reduced taxes. Longer-term, however, the impact on consumers will be more ambiguous as provisions expire and inflation adjustments become less generous.
Despite claims from Treasury Secretary Steve Mnuchin, incremental growth isn’t likely to fully offset the cost of tax cuts. As was the case when taxes were cut during the Reagan and George W. Bush presidencies, the impact of tax cuts will increase the federal budget deficit.
The deficit will also grow because of increased government spending. Congress increased defense and nondefense spending in the recent continuing resolution to fund the government, bypassing the sequestration process imposed by the Budget Control Act of 2011. Increases of $165 billion in military spending, $131 million of nondefense discretionary spending and $45 billion for disaster relief are projected by the Congressional Budget Office to increase the U.S. budget deficit from 3.3% to 5.5% of GDP in fiscal year 2019.
The federal budget deficit increasingly will need to be financed by investors other than the Federal Reserve. Rising interest rates and inflation are a likely consequence. All of this fiscal stimulus comes at a time when the economy is operating above full capacity. Consequently, faster growth in the coming quarters and a rising deficit may deepen the next recession.