The expectation that Trump will have better luck on this front has produced a textbook asset-price response. Stock prices have climbed, led by financials and industrials; interest rates on US government bonds have risen, both on a standalone basis and relative to those in other advanced economies; and the dollar has surged to levels not seen since 2003.
Here is where the rest of the world comes in. Other major economies – namely, in Europe and Asia – may have a much harder time than the US rebalancing their policy mix (which continues to be characterized by excessively loose monetary policy, inadequate structural reforms, and, in some cases, excessively tight fiscal policy). But if they do not, the Fed’s continued interest-rate hikes would stimulate investors to trade their German and Japanese bonds, in particular – which are now bringing low and even negative returns – for higher-yielding US varieties. The resultant wave of capital flows into the US would push up the value of the dollar even further.
Though the US economy is doing much better than most of the other advanced economies, it is not yet on sound enough footing to withstand a prolonged period of a substantially stronger dollar, which would undermine its international competitiveness – and thus its broader economic prospects. Augmenting the risk is the prospect that such a development could spur the Trump administration to follow through on protectionist rhetoric, potentially undermining market and business confidence and, if things went far enough, even triggering a response from major trade partners.
If Trumponomics is to deliver on its promise, key countries – in particular, Germany (the largest and most influential European economy) and China and Japan (the world’s second- and third-largest economies, respectively) – must promote their own pro-growth policy adjustments. They should implement quickly growth-enhancing structural reforms to support monetary stimulus. Germany, in particular, would also need to pursue a looser fiscal policy, while adopting a more conciliatory attitude toward outright debt reduction for beleaguered Greece.