Trump Is a Test of the Economy’s Breaking Point

(Bloomberg Opinion) -- The president usually doesn't do a lot to affect the U.S. economy. When people say that President Barack Obama or President George W. Bush created jobs, it shouldn't be taken literally -- what really created the jobs was a confluence of vast and complex economic forces that the president affects only marginally. To substantially change the course of the economy, a president has to enact bold, dramatic policies, such as a fiscal stimulus, tax cuts or a big infrastructure plan. Getting them through Congress is hard. Even big policies, like Trump's tax cut, often have only modest effects. And even when the effects are substantial, they're hard to measure. Nevertheless, we probably tend to give presidents too much credit for good times and blame for bad times.

But there may be some important situations in which presidents do deserve lots of credit or blame. As the 2008 financial crisis so painfully showed, financial-market disruptions that many initially wrote off as limited in scope can have big effects on the economy. And as economists have noted for many decades, the financial system itself is an inherently fragile thing. Banks are subject to runs. Asset markets are prone to bubbles and crashes. Webs of financial relationships are vulnerable to crises of confidence, when borrowers and lenders start to suspect that their counterparties are insolvent. Given this inherent instability, there's always the possibility that the president could inject pessimism or panic into the system at a moment of weakness, precipitating a crisis where none otherwise would have happened.

In recent weeks, President Donald Trump has taken several steps that might end up conjuring up just such a panic. First, he shut down the federal government in an attempt to force Congress to fund a border wall with Mexico. Government shutdowns have happened in the past without serious economic consequences, but Trump is promising that this one will last a long time.

Second, Trump has stepped up his criticism of the Federal Reserve, which has been raising short-term interest rates. Many presidents in the past have tried to jawbone the Fed into lowering rates, in order to provide a bump to an economy (and thus improve their re-election prospects). But instead of bullying Fed officials in a back room as past presidents have done, Trump has expressed his criticisms via social media and in press interviews, making the conflict between the presidency and the central bank more public and dramatic.

Finally, Trump's treasury secretary, Steve Mnuchin, recently announced that he had called a number of big bank leaders to ensure that “they have ample liquidity available,” and convened an emergency meeting of the nation's top financial regulators. If there really is a financial crisis brewing, then this was appropriate. But if there wasn't one, then moves like this -- which suggest the presence of financial turmoil -- could precipitate a crisis out of thin air. And announcing the phone calls and meetings publicly was almost certainly a mistake.

But will Trump's missteps cause damage to the wider economy? If the financial system is fundamentally sound, it seems unlikely. But if stresses and vulnerabilities have built up to dangerous levels, it seems like the turmoil and doubt created by the president's words and deeds could be enough to tip the system into a downturn.

And there are signs that stresses have been building up. Corporate debt is at record highs as a percent of gross domestic product:

Those who worry about corporate debt have focused on the leveraged loan market, and on bonds with ratings just above junk. BBB-rated bonds, which could quickly become junk in a crisis, have become a larger share of the corporate debt market:

Business uncertainty over an extended government shutdown or other Trump actions could conceivably spark a selloff in these markets. Panicky-sounding communiques from the Treasury could make banks and other financial institutions wonder if their counterparties are holding too much bad corporate debt. And open warfare between Trump and the Fed might raise concerns that the central would defy the president and raise interest rates in order to demonstrate its own immunity to Trump's bullying. That could reduce the value of corporate debt.

Already, there are signs of stress. Investors are pulling money out of both junk bonds and leveraged loans. The latter are being priced at a discount, while junk-bond yields have risen sharply as stocks have fallen:

Economists have noted that economic downturns tend to be preceded by periods of sharp uncertainty over policy. Although it's not clear which way the causation runs, it seems possible for erratic and bungled policy-making to tip vulnerable financial markets into panic and precipitate an economic downturn. If Trump's erratic moves manage to introduce chaos into an already shaky corporate debt market, then this president might really own the next recession.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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