A disquieting gulf has opened up between the front pages and business sections of major newspapers. The real estate above the fold on page one is all Trump, all the time. Stories describe a disorganized White House, testy relationships with foreign leaders, discord with Capitol Hill and demonstrations in college towns across the U.S. Meanwhile, business news sources, more decorous but still somewhat breathless, list record highs for major equity indexes, subdued asset-price volatility and economic data that consistently beat expectations.
Most economists apparently skip straight to the business section. In the latest Wall Street Journal survey of over 70 of the guild (as shown in the chart), forecasts for U.S. real GDP over this year, as well as the next two years, cluster tightly around 2.25%. How tightly? As the table shows, about nine-in-ten economists expect real GDP growth to fall between 1% and 3% over the next three years. In the event, the historical record spans a much wider range, as plotted by the shaded area in the chart and summarized at the bottom of the table. Only 30% of the post-World War II observations were in that narrow window.
That economists almost uniformly write down forecasts with no drama seems at odds with the political theater running nonstop in Washington. Perhaps it reflects their admission of defeat, that it is better to feign ignorance when so much about the political outlook is uncertain. However, investors who presumably are voting with their dollars rather than just their pride share this trait. Market pricing conveys no obvious sense of heightened uncertainty, nor extra compensation required to insure against uncertainty. As shown in the chart, implied volatility on the S&P 500 equity-price index has further extended its decline; protection against adverse tail risk on that same index (CBOE SKEW Index) is not especially expensive and implied volatility on interest rate futures (Merrill Lynch Option Volatility Estimate, or MOVE, Index) is also low.
This leads to the uncomfortable possibility that financial markets are pricing assets with an overblown assurance on the economic outlook. To understand the range of what could go wrong (or right) requires following the consequences of electing a populist president to command a coalition of disparate interests. The coalition is called the Republican Party and the president is in charge as long as enough establishment figures in that coalition collaborate. Such coalitions are not uncommon in U.S. history, but tend to be covered by the big tent that the two national parties pitch to accommodate a diverse assortment of occupants. After all, John Kennedy and Strom Thurmond were Democratic senators in the 1950s and Barry Goldwater and Nelson Rockefeller were dominant Republican figures in the 1960s. More unique in U.S. history, President Donald Trump, as head of the Republican Party and the government, represents a populist strain that is less integrated into the party apparatus than typical.
This characterization raises two distinct questions. First, what were the forces fueling the rise of populism? This information, which is key to understanding its durability, will necessarily be informed by foreign experience. Second, how can the leader of a minority faction control the levers of power? We will work through the simple analytics of a coalition to consider potential outcomes, with a particular emphasis on trade and monetary policies. As a result of the latter, we end on a troubling note, as most of the arrows of influence point toward more inflation from a compromised U.S. Federal Reserve (Fed).
THE RISE OF POPULISM
Rudiger Dornbusch and Sebastian Edwards wrote several papers in the late 1980s on the economics of populism in Latin America and many of their arguments ring true in current circumstances.1 They argued that the following three elements were common in their national experience:
- Public dissatisfaction with initial conditions, including slow output growth and increased income inequality;
- Official rejection of constraints associated with the ‘conventional wisdom’ about deficits, inflation, and the exchange rate;
- The public and private sector ‘battle for rents,’ both at home and abroad, with direct interventions in private contracts.
In some sense, the sequence goes from straightened circumstances to an abandonment of rules and finally to directly divvying up output among interest groups. As for a gloomier present, a key feature of the U.S. economy for the past two decades has been the slowing of the growth of potential output. The Congressional Budget Office estimates that the growth of aggregate supply slowed about 2.5 percentage points since 2000, as our aging population grew more slowly and added less extra output per additional hour worked. This rotated the expected paths of household income and business earnings down, lowering lifetime income as real wages no longer increased with rising productivity. Households saved more and firms invested less, with the market outcome of lower real returns further limiting opportunities.
The sense of a more slowing expanding economic pie was further darkened by shifts in income shares. The chart that follows examines the distribution of gross value-added on the nonfinancial corporate sector (taken from the expanded accounts of the Fed’s Financial Accounts of the United States, which allows a matching of these income statements with balance-sheet snapshots). As is evident in the top line, gross labor compensation fell 8 percentage points from 2000 to 2013, the low point. As the long-time series that follows shows, this drop in labor share followed a half-century of sideways movements. Smaller payments to workers were associated with a higher operating surplus, net interest, rent and taxes (which have been on a secular downtrend). That is, the return to the owners of these firms rose a couple of percentage points this century.
These two regularities combine to generate the Dornbusch-Edwards observations. The declining labor share of income reinforces the adverse effects of the slowing of potential output, raising the possibility that the existing order is no longer generating net benefits to the broader public. The logical result, when the adverse consequences are sufficiently severe and persistent, is to question the rules of engagement of the existing order. If so, the higher profit share creates the temptation for officials to intervene directly in private-sector activity—in effect, clawing back some of those ‘rents.’ As the century unfolded, the net shift in sentiment was toward someone who promised change as a deal maker outside the conventional wisdom.
There are a number of ironies here, not the least that the adverse distributional trend appears to have bottomed out in 2013 as the growth of potential real GDP and the labor share of income both rebounded. By then, however, the voter base had changed. A more consequential and unfortunate irony comes from another Dornbusch-Edwards observation—that populist policies ultimately unfold to reduce the welfare of initial supporters. It is a point that we will return to during the discussion of risks.
HOW DOES A MINORITY GOVERNMENT GOVERN?
Poor macroeconomic performance can breed populism, but such enthusiasm does not typically lead to the creation of a majority party. Here it is important to follow the dynamics of coalition formation, and the international experience provides numerous examples of change. In that regard, the Database of Political Institutions provides the political orientation of governments across 181 countries from 1975 to 2015. In 14% of the time, there are spanning outcomes in which leadership switches from left to right or right to left, without stopping at the center, that are equally split as to direction. Quite frequently in many countries multiple groups jockey for position, forming potentially changeable coalitions.
How does change take place, then, if the party of the elected leader does not command majority support? Political scientists (importantly including Jan-Werner Müller) argue that the success of a faction—in current circumstances, a populist party—requires some of the establishment to ‘collaborate.’2 In the current context, the questions are:
1. How long are Capitol Hill Republicans willing to tolerate an unconventional president?
2. How much is an unconventional president willing to accommodate party leaders?
Presumably, establishment Republicans cooperate with the president because the new administration provides a window of opportunity for long-sought changes in national policies, even though it requires staying silent after presidential pronouncements that sometimes sound anathema to their world view. Unfortunately, the story is complicated by the fact that Republicans on Capitol Hill are divided. As a result, the ruling party can be viewed as a collection of at least four factions, with some interests that are shared and some that are in opposition. The overlap provides the incentive to cooperate. The disunion is the potential source of future friction.
At the risk of some arbitrariness, we can align each of those groups with a dominant proponent. All of them share the desire for core public policies: tax reform, deregulation, strengthening the military, investing in infrastructure and changing the court. After that, differences accumulate. (1) While it is hard to say for sure, if there is a ‘Trump doctrine,’ its author would be Steve Bannon, President Trump’s chief strategist. Central to his story is a distrust of the rest of the world, reflected in a desire to manage trade and end foreign entanglements. (2) That instinct runs counter to the careers of Senate Majority Leader Mitch McConnell and some of his colleagues. To them, the appropriate participation in the established international order has served the nation well. Moreover, they and the corporate leaders with whom they interact tend to be change averse. (3) Less change averse, as they are more committed to ideas, Speaker Paul Ryan and his House colleagues want to maintain a market focus that includes open trade. For them, revamping the tax code to increase economic efficiency is a generational opportunity. (4) Senator Rand Paul and his Libertarian colleagues are even more committed to a few core principles—freedom of contracts facilitated by a small government—that make them least change averse. For this reason, they have been willing to force ultimatums associated with the Congressional calendar (think of the debt ceiling).
If the White House limits itself to pronouncements about the objectionable items on its agenda and not overarching action, the coalition holds—legislation is passed and signed into law and the electoral prospects of the Republican Party in 2018 and 2020 are well maintained. That legislation probably includes comprehensive corporate and personal-income tax reform, sun-setting (with replacement) of the Affordable Care Act, infrastructure investment and a military build-up. Electoral success would include adding to the majority in the Senate and control of statehouses in advance of the 2020 census that will be used to redraw House district lines. As shown in the table, Democrats have to defend Senate seats in the ratio of three-toone, about the same task as Republicans have with sitting governors. The possibility of success or failure on such a massive scale is the glue holding the coalition together.
Nevertheless, not enough time has passed or accomplishments achieved for the glue to have set. If too much that is objectionable to the coalition partners is said or done in the White House, comity collapses and the election campaigns of 2018 and 2020 are brought forward, marginalizing the president. As opposed to a parliamentary system, President Trump retains occupancy of the White House, but as a diminished figure. So too, diminished would be Republican prospects in upcoming state and local elections.
The result is the familiar issue of job-market clearing with quits and lay-offs, although there is an important wrinkle. The apprentice stays in the job (does not quit) as long as the chance of meaningful policy change outweighs the indignities of the association, subject to job alternatives given looming elections. The boss seeks out evidence of at least limited loyalty (implying no layoffs), also looking to the calendar. This show may run longer if the president is more of a ‘faux populist’ who is concerned with appearing to appease his base but willing to compromise to the established order. Or, the Majority Leader and the Speaker may be so concerned with legislative accomplishments so as to let slights slide.
Why might the center not hold? The wrinkle is the collective action problem that the complete coalition must stay intact to benefit all members, an especially important consideration given the thin margin of Republican control in the Senate. This gives power to those waiting to fight over some core principle, whatever that might be.
THE RANGE OF OUTCOMES
Even if they can hold together in a marriage of convenience, execution risk looms. Well-intentioned and cooperative leaders do not always get deals done. Important in their planning will have to be:
- Sequencing of legislative proposals, as considerable Congressional bandwidth will be devoted to the Supreme Court nomination and the Affordable Care Act, rendering other opportunities for change limited;
- Strategic use of budget reconciliation, as that is the only mechanism to get past a filibuster in the Senate but can only be used sparingly, creating a choke point on the calendar; and
- Sunsetting, because sometimes promising to make hard decisions later allows some easier wins and improves budget arithmetic.
- Even if this all works, President Trump will explain these policies in an unconventional way, adding to the execution risk.
Over time, the U.S. government will be judged by how committed its leaders are to change and how constructive are those changes. This introduces the four possibilities in the table. Deep skeptics of the president find their home in the upper left box. They believe that the White House neither hopes to, nor has a plan for, change and that a Twitter storm obscures that the system moves sideways. Sideways is better than worse, if, as in the lower left box, that entails confrontation for confrontation’s sake with domestic political opponents and foreign leaders without achievable goals. Even goal-oriented governments fail, as would be the case if the legislative calendar gets clogged to the point of D.C. dysfunction. The remaining hopeful outcome is that White House confrontation is directed toward a common purpose with effective Hill leadership. This implies legislation ticking off the items in the earlier Venn diagram—tax reform, deregulation, strengthening the military, investing in infrastructure and changing the court. Combined with executive action and agency restructuring, the government would be fundamentally reshaped. Even here, though, the process would be a strain on the public discourse because this represents the efficient execution of one particular partisan vision.
Specificity might help, and so the table below lists the range of possibilities for international trade relationships. Along the main diagonal, we travel from all talk and bluster with no action to a meaningful restructuring. The latter probably includes a tax reform that has the net effect of encouraging exports, discouraging imports, and removing the corporate incentive to shift profits overseas through transfer pricing. Also on the list is NAFTA 2.0 that updates the two-decade-old North American Free Trade Agreement with some of the content negotiated for the Transatlantic Trade and Investment and the Trans-Pacific Partnerships.
The minor diagonal matters for financial markets. The White House may settle for specific interventions (especially if it is abandoned by its partners on Capitol Hill) by seeking a victory a week in coaxing large firms to alter their production plans. This battle for rents will be asymmetric in incidence—one job gained in the Midwest matter more than multiple jobs lost abroad—but mostly mediated to the macroeconomy through equity markets. That is, the share price of this week’s target will be volatile; not so if across-the-board tariffs or sanctions are imposed. Those relative price shocks will most likely prompt changes in the foreignexchange value of the dollar that influence both trade flows and balance sheets.
CONCLUDING THOUGHTS ABOUT RISKS
The president may be able to hold his electoral base together simply by the vehemence of the criticism directed toward him by sources they hold in disrepute. But Dornbusch and Edwards identified another fundamental threat to the enterprise: Populist governments tend to worsen the lot of their initial supporters. In the extreme case of the Latin American governments they consider, inflation balloons, debt is repudiated, and a financial crisis follows. The more likely series of unfortunate events in the U.S. revolves around international trade.
President Trump has the seemingly incompatible ambitions of engineering export-led growth and pursuing a fiscal policy agenda tending to appreciate the exchange rate. That is, in current circumstances with the unemployment rate near its natural rate, a boost to spending will kick Fed tightening into gear more quickly, pushing the currency up and impairing the competiveness of the president’s voter base. If the administration could expand potential output, the Fed need not step into action, but that is a big ‘if.’ A more efficient tax policy should boost productivity, but that presumably tilts up the path of potential output over time rather than its level immediately. The Fed would still be inclined to move to preempt pressures on inflation.
By way of example, in the Mundell-Fleming model of a small and open economy, as below, a policy boost to aggregate demand leads the central bank to raise the domestic real interest rate.3 All else equal, opening up an interest-rate differential with the rest of the world puts pressure on the exchange rate to appreciate, impairing international competiveness and pulling aggregate demand back to potential output. National income winds up where it started, except with a more appreciated currency crowding out the initial stimulus.
This formalism suggests two policy responses. For one, injecting uncertainty into the conversation about trade and foreign policies might raise risk premiums on dollar assets, offsetting some of the policy-interest-rate wedge. For another, the White House could lean on the Fed to be less responsive to excess demand. Given that there are already three open seats on the seven-member U.S. Federal Reserve Board, and that two more come into play next year (importantly including that of Chair Yellen), President Trump can engineer that result relatively quickly. A less responsive Fed, of course, does not repeal capacity limits, and the net result will be higher inflation.