Trump needs to find balance between infrastructure and tax priorities: Westpac's Bill Evans
On August 22, I wrote a note in which I concluded:
- Record low interest rates have not been effective in stimulating investment to close the savings/investment imbalance. A change in policy from governments on infrastructure and structural reform is urgently required.
- Central banks are exacerbating the imbalance with (quantitative easing (QE) policies. With these policies now generating negative yields and pressuring the banking system while sending confusing signals on risk free rates there is an urgent need for these policies to be reviewed and abandoned.}
- When these QE policies are finally abandoned, as they surely must be, there will be a huge re-pricing of risk free assets with rates heading in the direction of nominal GDP growth, although the pace of this adjustment will still depend on the other progress which governments have made in closing the savings/ investment imbalance.
At that time the US 10 year bond rate was 1.54% while the Australian 10 year bond rate was 1.9%. Today these rates stand at 2.35% and 2.75% respectively.
I nominated nominal GDP growth in the US at around 4% (2% real growth and 2% inflation).
The US bond rate has risen about a third of the way towards what I would call that “equilibrium” despite no clear progress on lifting investment although, of course, markets are pre-emptive.
In the period 1992-2002 when we had more of an alignment between savings and investment, and bond rates were broadly in line with nominal GDP growth, we saw that investment in the US was growing at around 8% compared to the average growth rate in recent years of around zero.
The recent rise in bond rates can be considered in two periods – before and after the Presidential election.
The US bond rate started to rise from around late September from 1.55% to reach 1.85% on the eve of the US presidential election.
A key catalyst for that move was a change in tone from both the Bank of Japan (BOJ) and the European Central Bank (ECB). In the case of Japan policy was adjusted to target a level of the 10 year Japanese Government Bond (0%) rather than continuing to expand the balance sheet.
In the case of the ECB, prospects of further increasing the €80 billion of monthly asset purchases took a downturn and while there is no signal from the Board that tapering is imminent the debate around the effectiveness of QE and negative interest rates has been vigorous both in the market and amongst the officials.
Finally, I expect that markets believed that whoever was elected to the presidency we would see a measure of fiscal stimulus.
Since the election of Mr Trump, the US 10 year Treasury bond rate has risen from 1.85% to 2.35% - the total increase in bond rates, from the lows (80 basis points), represents about a third of the move towards my “equilibrium” target of 4% (250 basis points). As we expect with markets, this adjustment has occurred purely through a change in expectations. I would not expect this to progress much further until we see concrete evidence around progress on infrastructure and reform.
So what else in my “wish list” apart from a significant change in ECB and BOJ approaches has occurred?
The second part of the “wish list” was “change in policy from governments on infrastructure and structural reform”.
Do Mr Trump’s policies provide some comfort in that direction?
Recall that the first policy he referred to in his acceptance speech was to “rebuild” America. Given my emphasis on the need for aggressive infrastructure investment to lightening rod the US economy out of secular stagnation, I was impressed.
Until I looked into the details of his infrastructure policy. The current policy is to invest US$1 trillion (around 5% of GDP) in public infrastructure, over 10 years, with 85% to be financed from the private sector. Unless his team is aware of a massive list of public assets that could be privatised with the funds being used to finance the road/bridge/inner city spend, this policy is likely to fail due to a lack of support from the private sector.
My view is that he needs to redirect a large amount of the tax package towards direct infrastructure investment. The current tax package, which includes reducing the corporate tax rate from 35% to 15%, is estimated to cost (according to the Committee for a Responsible Federal Budget) around US$5-6 trillion over 10 years. The corporate component is around 75% of the total package cost with the remainder representing the cost of lowering personal tax rates. But the Tax Policy Centre estimates that 47% of the benefits of the personal cuts will go to the top 1% of income earners.
The starting point for the total government debt position also threatens the tax package. When Reagan adopted his “supply side” economic policies, government debt stood at 24% of GDP compared to 78% today. The tax package could lift debt to around 110% of GDP over the next 10 years.
So my view on policy as it stands is that a much larger and realistic infrastructure package needs to be embraced at the expense of a significantly more modest tax package.
What about reform?
Reform is required to convince businesses that growth is in prospect and therefore investment should be lifted.
US firms pay US taxes on income generated anywhere in the world while allowing the firms to defer tax on these earnings by keeping the money offshore. Trump has considered offering companies a window tax “holiday” to repatriate some of the $2 trillion held outside the US. Such reform would 'spark' new investment if firms anticipated stronger growth in the US. An angle might be to 'link' the tax savings to the proposed private funding of infrastructure.
Currently there is some market belief in his claim to “clean up regulation”, with the unwinding of Dodd-Frank (a complex banking regulation) being the most comprehensive. Policies to unwind excessive regulation and some early successes in that regard will be just as crucial as a much more aggressive infrastructure policy to lift confidence in growth prospects.
The moderated approach to QE and negative interest rates by the ECB and BOJ started the move away from unrealistically low rates.
The emphasis in the Trump rhetoric on infrastructure and reform has been a very welcome development. However, at this stage, Trump’s policies do not signal a clear commitment to infrastructure and there does not appear to be a list of “achievable” reform initiatives.
Markets and firms will need to see clear evidence of Trump’s ability to implement ambitious policies before I could declare that we are on a steady path towards equilibrium and 4% bond rates.
Bill Evans is chief economist at Westpac.