(Note: This piece first appeared as a post on my Patreon page.)

The textbook story of what happens if the government runs a budget deficit when the economy is near its potential is that interest rates rise. Higher interest rates then reduce demand in interest-sensitive sectors like residential construction, investment, and car purchases.

Higher rates also lead to a higher-valued dollar. This makes US goods and services less competitive internationally, which means a larger trade deficit. That also reduces demand. The result is that much or all of the demand created by the deficit is offset by the reduction in demand from this crowding out effect.

Of course, the textbooks often underemphasize the intervening step. The Federal Reserve Board could act to prevent this sort of crowding out by committing to keep interest rates low. The risk of doing this is that if the economy is really near its potential, then the excess demand will quickly lead to higher inflation.

It would have been desirable in my view if the Fed had taken this risk and kept interest rates at lower levels, to see how low we could get the unemployment rate. This is especially important since the additional employment would disproportionately benefit the most disadvantaged workers, blacks, Hispanics, people with less education, and people with a criminal record.

However, the Fed went the other way. It continued and likely accelerated its path of interest rate hikes. As a result, we have seen a sharp increase in long-term interest rates, with the 10-year Treasury bond rate rising from less than 2.2 percent a year ago to more than 3.0 percent in the most recent data.

This has had the expected results. Existing home sales peaked last November at a 5.72 million annual rate. The annual rate has since fallen by almost 400,000. (There is typically a one to two-month lag between when a contract is signed and the sale, which means the peak in contracts occurred likely occurred in September before rates began to rise.) Pending home sales show a similar pattern, with the levels reported for August down by more than 5.0 percent from last fall’s peaks. Residential construction reflects the slower pattern in sales, with housing starts down by more than 7.0 percent from the peaks last fall.

In addition to being a big factor in slowing sales, higher interest rates also reduce mortgage refinancing. In the most recent week’s data, refinancing was down more than 30 percent from year-ago levels. This matters for two reasons. First, refinancing itself employs a large number of people. While it is unfortunate that people have to pay all sorts of fees when they get a mortgage, these fees do create jobs.

The other reason the falloff in refinancing matters is that homeowners typically are able to free up money when they can refinance at a lower interest rate. They typically spend at least some of this money. If people are unable to refinance since mortgage rates are too high, we will not see this boost to their income and spending.

The impact of higher interest rates on non-residential investment has always been hugely exaggerated. As it stands investment is somewhat higher than its year-ago level. This means whatever negative impact higher interest rates may have had, other factors have been more than offsetting.

On the other hand, higher interest rates are having pretty much the textbook effect on the value of the dollar. The Fed’s broad index, which measures the value of the dollar against a basket of currencies of our trading partners, shows the dollar is up by around 5.0 percent from its year-ago level. This rise in the dollar, coupled with a modest pickup in growth, has had the predicted effect on the trade deficit.

In the first seven months of the year, the trade deficit in 2018 has been $337.9 billion. This is an increase of more than $22 billion from the deficit of $315.9 billion over the first seven months of 2017 (around 0.1 percent of GDP). The rise in the trade deficit is $4.3 billion more if we pull out petroleum products.

The preliminary data for August shows the gap is getting larger, with the deficit in goods more than $11 billion larger than the deficit for August of 2017.  This is important because it takes time for the economy to fully adjust to changes in currency values. To date, we have likely only seen a portion of the increase in the trade deficit attributable to the rise in the value of the dollar following the passage of the tax cut. If there is no reversal in the dollar’s rise, we are likely to see the deficit expand still further in the rest of 2018 and 2019.

Taking this all together, let’s say that the tax cut, coupled with the modest increases in government spending would have boosted demand by roughly one percent of GDP in the absence of any crowding out effect. The drop in residential construction is likely offsetting roughly one-fifth of this increase (0.2 to 0.25 percent of GDP). The rise in the trade deficit may offset one half or more of the increase in demand (many other factors do come into play here). And the lower consumption associated with higher mortgage interest payments may eventually knock off another 0.1 to 0.2 percentage points of GDP.

Taken together, we may see pretty much all of the increase in demand from the tax cut and spending increased offset by various channels of crowding out. We could say the net is zero, but it is important to remember that the tax cut went mostly to the rich. So they are spending somewhat more than would otherwise be the case. On the other hand, many moderate and middle-income people may be unable to afford a home because of higher mortgage interest rates. Alternatively, because they have to pay more in mortgage interest, they have less money to spend on other things. So we will have redistributed consumption from low and middle-income households to those at the top.

Of course, we do have to remember that this story depends importantly on the Fed’s decision to raise rates. If the Fed instead committed to leave rates low until there was clear evidence of accelerating inflation then we may have not seen anywhere near as much crowding out. That still would not mean that giving a tax cut targeted to the rich was a good idea, but the rest of the country need not suffer as directly from the policy.