...Starved of basic investment nutrients, the economy has been weak and the public is frustrated. A weak economy - which today is some $3 trillion smaller than it might have been with better policies - is the measure of our discontent. Weak growth is the root cause of people's frustration with trade, and the reason the recent election was all about spurning the ruling elite, who think that they can pull the policy strings and magically create growth and prosperity. Most people figure they could be working more productively, and they'd rather have a better job than more government handouts. Among other things, Hillary Clinton made the mistake of promising free college and a higher minimum wage to a public that instinctively understood that there is no free lunch.

Written by Scott Grannis (ScottGrannis.Blogspot.ca)

Economic Policy

...The Obama years have had one very positive result from the perspective of economists. They have been the equivalent of a laboratory experiment designed to answer the question "Can government spending stimulate the economy?" For decades economists have debated the value of the government spending multiplier (i.e., how many extra dollars of GDP does one dollar of additional government spending create?). Keynesians have generally argued that the multiplier was greater than one, while supply-siders have generally argued it was less than one. We now know for sure that it is less than one, and it could very possibly be negative. More government spending most probably means less economic growth.

Monetary Policy

The other really big thing that has affected the economy for years, and yet is generally misunderstood, is monetary policy, and more specifically Quantitative Easing. Most people think that QE was all about artificially lowering interest rates in order to stimulate the economy. How is it, though, that the Fed has purchased more than $3 trillion worth of notes and bonds since 2008, yet there has been no appreciable impact on growth or inflation?

The Fed is complicit in the public's misunderstanding, since it has falsely represented QE as "stimulus." In fact, it was not stimulus at all: it was accommodation. The 2008 financial collapse struck such fear into the heart of the markets and investors that risk aversion and strong demand for money and other safe assets has been the predominant driver of market sentiment ever since. Last year I recapped this argument, noting that "QE was not about pumping money into the economy, it was all about satisfying the economy's demand for liquidity. QE was erroneously billed as "stimulative," since printing money in excess of what's needed only stimulates inflation. Instead, QE was designed to accommodate intense demand for money, without which the economy might well have stumbled."

The proof is in the pudding: despite years of an unprecedented expansion of the monetary base, inflation remains relatively low. If the Fed had truly been "printing money" we would have seen much higher inflation by now. The Fed supplied the money the market needed, and interest rates fell because the economy could not manage to deliver anything resembling normal growth. Going forward, this means that we must watch very carefully whether, and by how much, the public is regaining confidence and becoming less risk averse.

As I've said quite a few times in recent years, the return of confidence is the Fed's worst nightmare. More confidence and less risk aversion would almost surely go hand in hand with reduced demand for money and safe assets in general. If the Fed doesn't take timely steps to offset a reduction in the demand for money (by reducing the supply of excess reserves and increasing the interest it pays on excess reserves), then inflation could come back with a vengeance.

We now know that:

1. government "stimulus" spending doesn't stimulate, especially when accompanied by rising tax and regulatory burdens, and
2. monetary "stimulus" didn't stimulate growth, since all it did was accommodate a risk averse public with an enormous appetite for safe assets.

This understanding will help us track whether President Trump is making things better and whether the Fed is going to keep the dollar strong and inflation low.

Trade Policy

Trade policy will be very important as well, since free trade is undeniably good, yet, thanks to Trump, free trade unfortunately has gotten a bad rap in recent years since it has been blamed for the loss of millions of jobs. Fortunately, David Malpass is a key figure in Trump's economic policy team, and I've known him for many years. He's a solid supply-sider, with plenty of public policy experience and a deep appreciation for markets. He fully understands the importance of free trade. Yesterday the WSJ excerpted some of his recent remarks on economic policy issues. On the subject of Nafta (North American Free Trade Agreement), David makes it clear that the problem with Nafta is not that it has made trade free, but that it has made trade less free:

 

I was there at the beginning of Nafta. The idea of Nafta was, it was supposed to be…a very clear, free-market orientation that would allow both sides of the border to do what they do best in the classical sense of more commerce.

But as it was negotiated, year after year, special interests descended upon it. And it got thicker and thicker and thicker. This was 1989, 1990 and into 1991. It's up to 1,200 pages and then [President George H.W.] Bush left, [President Bill] Clinton came in and added the environmental chapter and the labor chapter.

It became this monstrously large, managed trade process that doesn't work at all for small businesses in the U.S…. There are too many parts of it that are not working.

In other words, he wants to make "free trade" freer, not less free. This is very encouraging. If lower and flatter taxes and less regulation can boost the economy (and I'm sure they can), I'm confident that with David's help, Trump can renegotiate existing trade agreements in order to make them more free, and that in turn will help boost the economy. A stronger economy will then help absorb the millions of workers who lose their jobs to overseas competitors.

To sum up: the problems associated with free trade today stem from the fact that:

1. trade hasn't been as free as it should have been, and
2. the economy has been too weak to create new jobs to replace the ones lost to more efficient overseas markets.

If Trump ignores Malpass, preferring to slap punitive tariffs on China rather than negotiate better and freer trade agreements, then this won't help at all. We'll have to keep a close watch on this....

Conclusion

...If the public were to fully regain its confidence in the future...[there's] a lot of inflation potential to worry about, but it only becomes a concern if confidence rises and the Fed fails to take offsetting measures (e.g., raising short-term interest rates by enough to keep the demand for bank deposits from declining). Call it the Trump Paradox, in which good news could turn out to be bad news if the Fed flubs its job.

Stay tuned.