The Donald Trump tax cut, mainly for the rich, is sending ripples through the economy, creating billions of dollars in hidden costs that will come out of the pockets of millions of consumers and businesses over the next decade.
The problem in a nutshell is the level of federal debt relative to gross domestic product (GDP). It’s projected to rise significantly over the next decade, according to a new Congressional Budget Office (CBO) analysis.
The rising deficit will put upward pressure on interest rates that will boost the cost of everything from mortgages, auto loans and student loans to credit-card purchases and other types of consumer and business loans
“The relationship between debt and interest rates plays a key role in the Congressional Budget Office’s economic and budget projections (especially long-term projections),” according to the new study.
“The sensitivity of interest rates with respect to changes in the level of debt is vitally important.”
Based on the analysis, the CBO found that the average long-run effect of debt on interest rates ranges from about 2 to 3 basis points for each increase of 1 percentage point in debt as a percentage of GDP.
As the deficit rises relative to the GDP a phenomenon known as “crowding out” will occur caused by higher government borrowing in private markets to cover the shortfall in revenues and spending.
The situation could worsen if government fiscal policy contains few or no incentives to invest in additional private capital or supply additional labor. In other words, a slow-growth economy could increase the pressure on interest rates.
Under current law, the debt-to-GDP ratio is projected to increase from 77.8 percent at the end of fiscal year 2018 to 92.7 percent by the end of 2029.
“The ratio of debt to GDP causes investors to lose confidence in the real value of the principal and interest payments on Treasury securities. That loss in confidence leads to higher interest rates as investors demand greater compensation for possible future losses,” the analysis states.
Under a worst case scenario, the government might have to increase the money supply to finance its expenditures.
“Such increases could boost inflation, which would reduce the real value of principal and interest payments to existing bondholders.
“Once investors begin to worry that this might happen, they will demand a greater inflation risk premium to compensate for the increased risk, and interest rates might rise much more dramatically in response to an increase in the debt-to-GDP ratio.”
During the 2016 election, Trump promised to balance the federal budget and lower the national debt. But he’s done just the opposite in office thanks to the Trump tax cut.
In a conversation with his then chief economic advisor Gary Cohen, Trump offered his solution to the problem, according to Bob Woodward’s book, “Fear: Trump in the White House.”
“Just run the presses — print money,” Trump said.
“You don’t get to do it that way,” Cohn reportedly relied. “We have huge deficits and they matter. The government doesn’t keep a balance sheet like that.”
Cohen, a veteran Wall Streeter, was “astounded at Trump’s lack of basic understanding,” about the economy, according to the book. But Cohen is no longer in government.
“With the debt-to-GDP ratio projected to rise to unprecedented levels, it is increasingly likely that at some point investors will become concerned about the risk of default.
“Once investors begin to believe that such a possibility is more likely, they will demand a default risk premium, and interest rates might rise much more in response to an increase in the debt-to-GDP ratio than the estimates presented here suggest,” the analysis said.
Trump, of course, notoriously defaulted on bonds used to underwrite construction of his New Jersey casinos, which ultimately collapsed into bankruptcy.
In May, 2017, shortly after taking office, Trump talked about his willingness to “negotiate that debt down.”
He suggesting the government could buy it back at a discount, negotiate somehow with the holders of the debt so that they will agree to take less than the full amount they are owed.
But that’s tantamount to a default.
It would put the United States on the same level as Puerto Rico, Argentina and Greece. Because the U.S. Dollar is a world reserve currency, such a scenario would touch off a worldwide financial crisis deeper than the Great Recession of 2008-2009.
“A large and rising federal debt would almost certainly heighten the risk of a fiscal crisis,” the analysis notes.
“Those concerns could perpetuate a cycle: Higher interest rates would increase concerns over repayment, which would continue to raise interest rates even further. Even in the absence of a full-blown crisis, such risks would lead to higher rates and borrowing costs for the U.S. government and the private sector.”
Rising interest rates are already affecting the economy, especially in interest-rate sensitive industries like home construction.
The Federal Reserve last month raised its benchmark interest rate a quarter-point, setting the target for its benchmark funds rate to 2.25 percent to 2.5 percent. It was the fourth increase in the past year.
President Trump railed against the hike on Twitter. He called it “incredible” that “the Fed is even considering yet another interest rate hike.” The Fed is calling for two more hikes in 2019, although it has pulled back on a planned third hike.
In a major address on the economy during the 2016 presidential campaign, Trump boasts his plans for tax cuts, better trade deals and more manufacturing jobs would generate 4 percent economic growth per year.
At the time, economists scoffed at the claim and their skepticism has been borne out. Despite the massive Trump tax cut, 2018 economic growth is expected to fall short at about 3 percent on the year.
For 2019, GDP is now seen rising by only 2.3 percent, about the historic norm, according to the Federal Reserve.
Long term, the Fed estimates GDP growth of 1.8 percent to 1.9 percent, in line with estimates by the non-partisan Congressional Budget Office. The CBO projects real GDP is projected to grow by about 1.7 percent each year from 2023 to 2028.
The Trump tax cut fueled deficit is becoming a big drag on the economy.
It soared 17 percent in fiscal year 2018, hitting $782 billion, according to the CBO. That amounts to 3.9 percent of gross domestic product (GDP), up from 2.4 percent the year before. It’s expected to hit $1 trillion in 2019.
Beside failing to throw a life-line to the struggling middle class, the Trump tax cut will punish households even more by raising the cost of money.
It can only get worse from here. Check out the video below.