Trump's 1st budget could worsen distortions as economy cools and assets soar: Don Pittis

It's a strange economic mystery. Despite interest rates bouncing along at their lowest levels in history, consumer price inflation remains persistently weak. Yet at the same time, asset inflation, including the price of houses and stocks, continues to shoot into the stratosphere.

The Bank of Canada yesterday announced it would once again hold interest rates at 0.5 per cent to help boost the economy, as the U.S. stagnated in the first three months of the year. 

• Weak U.S. economy prompts Bank of Canada to hold rate steady

And while the stated intention of the budget proposed this week by U.S. President Donald Trump is to break the economy out of the doldrums, there are some dangerous signs that it will merely drive assets even higher while missing its targets on economic growth.

'Room to grow'

A lot of economic analysis out there suggests that interest rate cuts have simply stopped working, although Bank of Canada governor Stephen Poloz is not on that side of the argument.

In the past, he has come down firmly on the side that low rates "give the economy extra room to grow."

The conventional economic view is that low rates stimulate new investment, using up the economy's excess capacity. In other words, more workers are fully employed, pushing up wages. More companies invest, causing shortages of ingredients essential to the production process.

As well-heeled workers and expanding businesses compete for a limited supply of goods, consumer prices start to rise, pushing inflation higher. That is why inflation, while annoying in some ways, is a reassuring sign the economy is firing on all cylinders.

But despite about a decade of low, low interest rates, that economic theory has not yet been matched by reality.

Persistently low inflation

​Instead, Canada's consumer price inflation has remained low, recently coming down to 1.6 per cent and staying there.

"The bank's three measures of core inflation remain below two per cent and wage growth is still subdued, consistent with ongoing excess capacity in the economy," said yesterday's Bank of Canada statement.

Wages and consumer prices may be stagnating, but those low interest rates are having an effect. 

In Canada, the most obvious sign has been the soaring value of real estate. While wages and the basket of goods measured by the consumer price index have remained subdued, asset prices, including houses and stocks, have shot up at rates many times inflation.

One explanation is that instead of stimulating new job creation and rising wages, all the money that poured into the economy in Canada, the U.S., Europe, Japan and China through liberal lending policies and quantitative easing has gone into the pockets of people who want to tuck it away somewhere safe.

In economics, there are several ways of describing the same thing, but excessive credit at low interest rates means there's scads of money floating around in the global financial system, and since everyone knows it may not last, they are anxious to turn that money into something with real value.

Snatch and run

We have seen this in Canada, where the value of money, if measured in houses, has been plunging — $300,000 won't buy you a home in Toronto anymore. That means sitting in cash has been a losing proposition.

That brings us around to Trump's new budget, which promises to drive up the economic growth rate to three per cent while slashing expenditures and balancing the budget. 

"We're no longer going to measure compassion by the number of programs or the number of people on those programs, but by the number of people we help get off of those programs," said budget chief Mick Mulvaney, left to defend the budget in Trump's absence.

In theory, the cuts may have a positive policy effect. Austerity enforces discipline: people living on food stamps may be pressured into the labour force, expanding economic capacity. And cutting environmental oversight will, in theory, make new businesses easier to start and cheaper to run.

But if the budget's main impact is to give shareholders and wealthy taxpayers an increased slice of the pie, it may not do any more to stimulate economic growth than the low interest rates of the Obama era.

Cutting money to the poor will mean less spending, since they're the ones who spend what they have. The rich, on the other hand, save and invest, further bidding up the price of assets, making them richer.

By definition, increasing the value of financial assets only helps the people and corporations that can afford to hold those financial assets.

As we have seen over the past 10 years, making the rich richer has not created an economic boom.

Maybe this time it will be different.

Follow Don on Twitter @don_pittis

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