Bill Dudley may be on his way out as president of the Federal Reserve Bank of New York, but he has a few parting shots before he goes.
As this article reports, Dudley gave a speech last week in which he said that tax cuts in the new Trump tax law might give a short-term boost to growth, but that the boost would be small and the longer-term impact could be a drag on growth. Dudley based this conclusion on the huge deficits likely to result from the tax cut and the drag on growth produced by those deficits.
Conventional thinking is that tax cuts will stimulate the economy. The view is that the additional growth resulting from the stimulus will generate added tax revenue, which will make up for the lost revenue from the tax cuts themselves. This result is the so-called “Laffer curve” effect.
The problem is that empirical support for the theoretical Laffer curve is weak. The Laffer curve is especially likely to fail under present conditions in which we are already in the ninth year of an expansion and the U.S. debt-to-GDP ratio already exceeds 105%.
In those conditions, added deficits resulting from a tax cut are more likely to slow growth or even produce a recession than they are to support growth. In short, the tax cut may produce a sugar high in 2018, but is likely to be a major drag on growth in 2019 and beyond.
The tax cut will also push the U.S. debt-to-GDP ratio closer to 110%, at which point a crisis in confidence in the U.S. dollar could result. Dudley’s Fed is adding to the problems by raising rates at exactly the wrong time. But Dudley is probably spot on in terms of his critique of the tax bill.
As 2018 stretches into 2019, these effects will become more prominent, growth will slow, stocks will retreat and U.S. citizens will be left with an even higher pile of unpayable debt.