Nikkei Veritas – Market Eye column, 25th February 2008
The weakness of the US economy has produced calls for a tax cut. Since politicians love bribing voters with their own money, particularly in a presidential election year, the idea has been taken up enthusiastically and Congress has agreed a stimulus package of $170 bn.
The short-term attractions are clear. Not only will voters pay lower taxes, but the move will reduce the likely severity of the coming downturn in the economy. But it increases two longer term risks. One is that the next recovery will come too soon, before inflation has fallen enough. Inflationary expectations would then rise and a more prolonged period of poor output will be needed to bring them back. The other risk lies in the poor long-term outlook for the budget due to the increased cost of social security as the population ages. In response to the second of these issues, there has been an accompanying propaganda exercise designed to cloak the tax cuts in as much respectability as possible, by emphasising the need for the cuts to be timely, targeted and temporary.
However the tax cuts will only start to impact the economy towards the end of the year. It will therefore only be timely if the US slow down is otherwise on track to last well into 2009. Despite widespread optimism that the weakness of the US economy will be brief, such a pessimistic view seems justified to me.
Those expecting the US economy to recover quickly see its main weakness as coming from the current decline in house building. But the fall in house prices is likely to have a much wider impact. Over the past 20 years household savings have fallen to near zero from 10% of disposable income, and the rise in house prices has probably been an important factor in this decline. Two things seem likely; the first is that the current level of savings is well below its equilibrium and the second is that a return to that level will happen slowly and steadily. This will cause personal consumption to grow only feebly for some time and thus, without some offset, the economy would face a long period of weakness.
There is therefore a reasonable case for a tax cut, provided that other ways in which demand could rise to offset the prospective economic weakness will take time to arrive and if the Fed is willing to raise interest rates quickly if an early recovery is indicated. If consumption is weak, the only private sector candidates to offset the impact on the economy are investment and exports and the two are closely linked. Exports are much more capital intensive than the output needed to satisfy domestic demand, which has a high service content. If US exports could rise to meet the gap opened up by weak consumption, then the help should be reinforced by higher investment.
The future level of US exports should be helped by the pronounced weakness of the dollar over the past two years. In the short-term, however, exports depend more on demand than relative prices and the weakness of the US economy, together with the impact of financial instability, is likely to reduce the demand for US exports in the rest of the world. There is therefore a good case for a temporary US tax cut, provided that the widespread scepticism about its practicality is unjustified and the cut would not prove to be a long- term one.
While the case for a US tax cut seems reasonable to me, it is based on the assumption that the US economy faces a prolonged period of weakness. If it bounces back quickly, the risks of rising inflation, which are already present, will be magnified. The US needs a period in which it grows relatively slowly. Without this inflation will not fall back and if, as is then likely, inflationary expectations rise, then the Federal Reserve will need to push interest rates up sharply and induce another and probably more severe or prolonged period of sub-par growth.