CNBC got a hold of a note that Former Fed Governor and Bush Economic Advisor, Larry Lindsey sent out to clients. In it he slammed the Joint Tax Committee’s estimate of the Senate Tax Reform’s bill impact on the deficit. From CNBC:

He [Lindsey] called the JCT’s prediction of an “aggressive” Fed response to the tax legislation “absurd” and says it contradicts the Fed.

“If anything, the signals and market view have all been that the Fed will be less aggressive. Some members have even speculated about the advantage of raising the inflation target in order to allow a slower response,” Lindsey wrote. “Markets have consistently priced in far fewer interest rate hikes than what the FOMC projects.”

I haven’t seen Lindsey’s full note but based on these few quotes and the appendix offered by the JCT, I think Lindsey is probably right that the JTC model’s assumptions about the Fed response are off.

Vastly more importantly, however, he is right that different assumptions about the Fed’s response completely change what you think Tax Reform will accomplish.  It is nearly impossible to overstate how crucial the Fed’s response is in determining the consequences of the Senate’s tax reform proposal.

As I wrote earlier, the Fed can make or break this tax bill. Everything from the gloomy predictions of zero economic boost all the way to CEA chair’s Hassett extremely optimistic forecasts are possible if depending on how the Fed responds.

If the Fed acts to contradict the legislation, any direct boost to the economy will be zeroed out and any long term increases greatly reduced. On the other hand if the Fed accommodates the legislation, a significant direct boost to the economy will occur immediately, the long term increases will be maximized and indeed there is the strong possibility of a self-reinforcing feedback effect between the two known as the accelerator effect. If that happens then some predictions, so optimistic that were labeled crazy, could come true.

How would the accelerator effect work?

The Senate Tax Reform bill increases the deficit by at least $1 Trillion over the next ten years. That’s like $1 Trillion in extra spending put into the economy. (More precisely, this means the government is reducing its spending offset by $1 Trillion, but the logic, if not the precise timing and multipliers, is the same.) That extra spending would encourage businesses to expand—not for the supply-side reasons generally associated with a tax cut, but because there is more demand in the economy.

The Fed, however, is tasked with making sure the economy has the right amount of demand. They could respond by raising interest rates enough to suck $1 Trillion out of the economy. In this case there not only is no extra spending but businesses are facing higher interest rates. Higher interest rates reduce the incentive to invest.

Increasing investment is how the supply side of the Senate tax cuts are supposed to work. Corporations get to keep more of the profits from any investment so they are willing to invest in more projects and take greater risk. Any increase in interest rates works in the opposite direction. It increases the cost of investment and because of the way debt financing works, makes corporations more risk adverse.

Thus, if the Fed could almost completely shut down the growth effects of the Senate Tax Reform Bill.

On the other hand, if the Fed choose not to raise interest rates, then the $1 Trillion shot into the economy would increase demand. That increase in demand tends to encourage increases in investment, but businesses are cautious about making new investments they hadn’t already planned to make. The supply-side effects of the tax bill, however, lower the cost of those investment and increases the reward for taking risks. These supply-side effects induce businesses to respond much more rapidly to increased demand with increased investment. The rapid increase in investment from those businesses, however, forms even greater demand for other businesses. Those businesses then increase investment as well. This self-reinforcing cycle is like a bellows for the growth process.

The cycle of rapid increases in investment would also lead to increases in productivity. Increased productivity allows business to hire more workers even as the labor market tightens. Getting workers in a tight and tightening labor market means offering raises or, as implausible as it may seem, increasing the rate of raises. The businesses don’t do this out of the goodness of their heart’s but because there is a confluence of rising demand and rising long run return to investment that can only be taken advantage of with more employees. This is exactly what we saw in the 1990s when a boom in the tech sector resulted in sharply rising wages for low skilled workers, for the first time since the sixties.

Cliche’ Keynesianism would tell you that deficits should be increased in bad times and reduced in good times. At least that is its popular interpretation into a rule of thumb. However, what the very intellectual framework of Keynesianism is trying to tell you is that there is an interplay between expected investment and aggregate demand. This allows for self-reinforcing negative cycles, but it also allows for self-reinforcing positive cycles as long as the economy has the untapped capacity to increase output.

This economy does indeed have untapped capacity.  The employment population ratio is has failed to recover from the Great Recession. GDP has failed to return to its previous trend. Inflation has consistently fallen below the Federal Reserve’s target.  Real tangible investment is at its lowest rate in decades.

All signs point to an economy that has healed enough to (very) profitably employ its most skilled workers at its most technologically advanced firms. The economy has not, however, healed enough to draw low skilled discouraged workers back into the marketplace or to encourage business to invest in the tangible—as opposed to intellectual—capital that these workers need to be productive. These workers need tools. They need machine shops. They need warehouses. They need the latest and greatest industrial equipment.They need equipment that will allow them to compete in the modern economy. They do the manual and clerical work that is still necessary for our advanced economy to run at its maximum capacity.

We can get those workers back into the economy and get them the equipment they need if Congress passes Tax Reform and the Fed has the wisdom to accommodate it.