28 Aug 2018 20:48 IST

The Trump economy has many safeguards

The US Federal Reserve building   -  REUTERS

The US Fed’s long-term gambit is paying off in a high-growth rate economy

In the 32 years that I have studied, worked, and lived in the US, I have never seen anything like this. The US economy is on steroids, and there’s no stopping it.

On August 27, all stock indices — the S&P 500, the Nasdaq Composite and the Dow Jones Industrial average — reached record highs.

Since US President Donald Trump took office in January 2017, the GDP has grown from an annual rate of 1.7 per cent to 4.1 per cent. A 4.1 per cent GDP growth rate may seem low for countries like China and India, where 7 per cent plus rates are expected and normal. But for an economy the size of the United States to grow at 4.1 per cent is remarkable.

To put this in context, the US’ GDP was $19.4 trillion in 2017. Assuming it will grow at an average rate of 3 per cent for all of 2018, it will have increased by $582 billion this year alone. In other words, the change in GDP this year is larger than the entire economies of 190 countries in the world, including Sweden, Belgium, Austria, Norway, the United Arab Emirates and Israel.

Unemployment and the economy

Meanwhile, unemployment has dropped to 3.9 per cent, falling a full percentage point since Trump took office. As a practical matter, if the unemployment rate is lower than 4 per cent, the country is considered to be at full employment. The least count for unemployment is 0.1 per cent, so for each 0.1 per cent uptick or fall in unemployment, the economy is considered to get meaningfully worse or better.

In 28 US states, the unemployment rate is so low that there are many more jobs than there are people. In Iowa, the rate is just 2.1 per cent. The only qualification for many unskilled jobs in Iowa is that you should be able to breathe. In populous states like Virginia and Massachusetts, the rates are under 3.5 per cent, a remarkable state of affairs because millions of people work there.

Low unemployment rates are a tremendous boost to government fortunes in two ways. To understand this, let’s examine the situation when unemployment rates are high. Then, people who are out of work can’t pay taxes to support the government, so the government loses revenue. Worse, these people draw more benefits from the government in subsidised housing, food assistance and cash unemployment payments. If this situation persists, the economy really suffers.

This may be hard to believe but the United States was in a terrible economic position in 2009, just nine years ago, the year President Obama took office after the Great Recession. The unemployment rate peaked to 10 per cent in October 2009. The stock market was down and it looked like the US would never recover.

Monetary and fiscal policy

Governments have two tools at their disposal to manage the economy, whether it is doing well or doing badly. The first is fiscal policy with which the government decides how much to tax, borrow, and spend. This is a tricky tool because, when the economy is doing poorly, you can’t increase taxes on citizens. They’re already hurting, so increasing taxes is a terrible thing to do.

This forces the government to borrow and spend, another bad thing to do because long term debt levels go up for the nation as a whole. This is especially a bad option for 98 per cent of the world’s economies (with the exception of the US, Japan and some rich countries in the EU) because governments have to go out and borrow in dollars, from foreign banks or international organisations like the World Bank or the IMF. In contrast, the US and Japan can borrow in their own currencies (dollars and Yen), a direct result of the economic stature of these countries.

The second tool is monetary policy, the amount of money that the government can print and circulate. This in many ways is an even more dangerous tool because if governments circulate too much money, its value can fall. Inflation is a cancer for which the cure is extremely painful because people’s assets begin to rapidly lose value. Venezuela’s inflation rate is expected to hit 1 million per cent in 2018. In contrast, the US inflation rate stands at at 2.9 per cent.

Monetary policy is a lot easier for the US, because the dollar serves as the world’s reserve currency, and so, the US Federal Reserve can literally print money and begin circulating it. Of course, the Fed has the responsibility not to flood the world market with too many dollars because that would cause the value of asset prices to fall globally.

In November 2008, during the last few months of the Bush presidency, the government borrowed nearly $1 trillion to inject into the economy in a programme called the ‘Troubled Asset Relief Program’, or TARP. This was a fiscal policy measure, but things continued to go into a tailspin.

TARPs and Quantitative Easing

Then, the US Federal Reserve quietly entered the stage and announced that it was willing to print money to buy up US treasury bonds and mortgage-backed securities. This was a monetary policy solution and the idea was the same as TARP’s — to motivate banks to give loans to consumers and businesses, and keep short-term interest rates low so that economic growth would return. The first Quantitative Easing (QE) was rather small in size — injecting about $600 billion of new cash.

But the US economy yawned. It wanted more. And the Fed obliged. Four months later, the Fed said it would print an additional $750 billion, and 18 months later, in November 2010, when the unemployment rate was 9.8 per cent, it printed $600 billion more. And all the while, it kept the Fed’s funds rate at zero, meaning that it was giving away money to banks without charging any interest.

The scale of this intervention was unprecedented, and it flooded banks and financial institutions with cash like never before in human history. Because treasuries and mortgage securities are held by organisations the world over, this amounted to flooding the world with cash. At its peak, the Fed was buying $85-billion-a-month of assets, leading to a total asset accumulation of $5 trillion.

A balanced sheet

Now, in the last three years, as the US economy recovers and grows, the Fed has slowly begun to mop up the cash. As securities mature, the Fed is demanding its cash back. As it does so, the Fed’s books are getting balanced.

How does this work? When it gave out cash, this was a credit transaction appearing on the right hand side of the Fed’s ledger. The Fed received treasury bonds and securities as a result of the transaction — and this would appear as a debit on the left hand side of the Fed’s ledger. For the balance sheet to be, well, balanced, credits must equal debits.

The Fed action was brilliant in that all of the assets it acquired, such as a bond, had an expiry date. When a bond matures, the Fed has an obligation to return the bond to the original holder (this would be a credit entry in the Fed ledger) and demand cash in return, with interest — a debit entry. Because the values of the two entries are identical, the Fed’s balance sheet is again unchanged. All that has happened is that the content of the Fed’s sheet has changed from bonds and securities to cash.

The impact on the economy is, however, quite significant. The bond holder has to corral cash from somewhere to pay the Fed and receive the bond or security instead. This amounts to vacuuming real money from the economy to return to the Fed — an action exactly opposite to the flooding of cash by the Fed eight years ago.

Demand and supply

The tightening means that the world, used to an excess of $5 trillion of cash during the last eight years, is slowly seeing it all returned to the Fed. Money in the economy becomes scarce and increased demand for the dwindling money results in rising interest rates. When dollars become scarce, their value rises. This is why the US dollar is at record highs.

This safeguard that the Trump economy has is not discussed much in the media. If the economy cools a little (whatever goes up has to come down), the Trump economy has many tools at its disposal, starting with fiscal policy tricks. And the big gorilla in the room can be unleashed too; the Fed can start lowering interest rates to keep the economy strong. Or it can even get into another round of Quantitative Easing.

But, looking out into the horizon, none of these safeguards seem necessary at present. The Conference Board (a global, independent business membership and research association working in the public interest) forecasts that US growth will be above 3.2 per cent during the rest of 2018.

Fascinating times indeed.