The first month of the Trump administration in the United States has involved dramatic policy changes. For the outside world, the initial focus has been the seismic shift in US foreign policy and on potential tariffs on trade. Both are profoundly upsetting the current world order.
There is a broad consensus among economists that trade wars being instigated by the US will be bad for all who are affected.
The UK National Institute for Economic and Social Research has estimated that if the initial tariffs proposed by President Trump on Mexico, Canada and China had gone ahead, and if they had been had reciprocated with similar tariffs on American exports, US GDP would be reduced by 0.4 per cent and US prices would end up almost 1.5 per cent higher. The effects on Canada and Mexico would be worse.
This gives a flavour of the likely fallout if Trump ramps up tariffs on the US’s trading partners.
Because tariffs will directly affect the world economy, this aspect of the US administration’s economic policy has received widespread attention. However, much less attention has been paid by the rest of the world to the implications of likely US fiscal policy.
Last year, US government borrowing amounted to more than 7 per cent of GDP, the most profligate fiscal policy in the developed world. The only countries in the OECD with borrowing approaching the US level are Hungary and Italy.
US borrowing rose over the last Trump administration from 5 per cent in 2016 to 7 per cent in 2019, with a large increase in the pandemic year of 2020.
While exceptional pandemic borrowing occurred in most other countries, under Joe Biden the subsequent “normalisation” in borrowing, unlike in Europe, stabilised at a very high level. This is one important reason why US growth has been faster than in the EU – more borrowed money has been pumped into their economy.
As a result of sustained high borrowing in recent years, the US national debt is now almost 125 per cent of national income. In the OECD, only governments in Greece, Italy and Japan are more indebted.
While Elon Musk is laying waste to the US civil service, the federal salary bill accounts for only a small part of US government expenditure. The really big items are health, social security and defence, totalling about 80 per cent of the federal budget
In Ireland, we saw that, after the 2008 economic crash and bank bailout when our own debt levels rose well above 100 per cent, the bond market vigilantes came calling.
So far, the rise in interest rates on US government debt has been limited, as the rest of the world remains happy to lend to the US. This reflects trust in the US central bank, the Federal Reserve (Fed), that it will use interest rates to maintain inflation at a low level in the long term.
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However, Trump has promised big tax cuts in future US budgets, which would only be partially offset by a rise in revenue from tariffs.
While Elon Musk is laying waste to the US civil service, the federal salary bill accounts for only a small part of US government expenditure. The really big items are health, social security and defence, totalling about 80 per cent of the federal budget.
Musk has not yet tried to cut these items. If he does, it would be hugely unpopular with many of those who elected Trump. So tax cuts are most unlikely to be paid for by spending cuts on the same scale. That will aggravate the budget deficit.
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Starting with a large deficit, if a further fiscal stimulus comes from unfunded tax cuts it will exacerbate the inflationary pressures that the new tariffs will bring. Under these circumstances, the Fed should raise interest rates to reduce inflation to its target level.
Trump is already very unhappy that the Fed has kept interest rates at a reasonably high level. If it needed to raise interest rates even higher to bring rising inflation under control, it would further fuel his irritation.
If Trump decides to live with the interest-rate consequences of his policies, he may avoid a big economic crisis linked to rising debt during his term in office. However, if he interferes with the Fed’s independence and ability to control inflation, as he has done with most other federal institutions, lenders to the US government will recognise that their loans would rapidly lose value through inflation.
The bond market would retaliate, as they did to Liz Truss, by requiring very high interest rates on new loans. That would inflict serious economic and political pain, and would precipitate a US economic crisis during Trump’s second term.
While Trump may believe that he can bargain from a position of strength with world leaders and US business chiefs alike, there is no bargaining with the bond market vigilantes.
