The Promise and Peril of the Trump Economy

Such a shift in momentum can be powerful, asserts the veteran executive. “We needed some kind of a spark,” says Cote. “And the spark was the change that occurred because of the election.”

Indeed, it’s not just Fortune 500 CEOs who have viewed the U.S. economy as primed for a breakout since Donald J. Trump’s surprise victory on Nov. 8. Small-business optimism has spiked. In its December survey, the National Federation of Independent Business registered an astounding 38 percentage-point jump from November in the portion of business owners who expect better conditions going forward—from 12% to 50%.

The most obvious scorecard of confidence in Trumponomics, of course, is the stock market. And the huge Trump Rally in equities clearly indicates that investors are betting that the new President’s policies will recharge corporate earnings. Since Election Day, the S&P 500 has risen more than 8%, adding some $1.4 trillion in value, and the manufacturing-heavy Dow Jones industrial average breached the historic 20,000-point threshold and kept climbing. After Trump said in early February that he was going to “announce something phenomenal on taxes in the next two to three weeks,” the indexes leaped again to close at new highs.

The market rally assumes that the Trump administration can make good on its early promises to raise America’s annual growth rate by gigantic proportions—from the dreary 2% of recent years to a robust 3% to 4%. That may just be doable, say a number of veteran economists, if Trump can deliver lower regulations and taxes without derailing the economy in some other way. “It’s not in the bag, but it borders on the likely,” says Allan Meltzer, a legendary monetary-policy specialist and onetime Reagan adviser.

That’s what could go right. But there is much that could go very, very wrong.

Even many of Trump’s ardent supporters in the business community fear that core elements of his platform could steer the economy in a far darker direction. The biggest risk is trade. Trump is advocating protectionist policies that could reverse the decades-old march toward open borders that has enriched both the U.S. and its partners, potentially igniting a global trade war. As he vowed he would on the campaign trail, Trump has already killed the Trans-Pacific Partnership—the trade agreement negotiated by the Obama administration that would have lowered barriers to U.S. exports with Japan, Australia, and nine other nations.

Conservative economists who support the tax and regulatory portion of his agenda are ex­tremely wary about his instincts on trade. Trump has threatened Mexico and China with tariffs ranging from 20% to 45%—a strategy theoretically intended to lower our trade deficits with the two largest exporters to the U.S. that could backfire bigly. “The big risk to his success is a trade war,” says Douglas Holtz-Eakin, the president of the American Action Forum and a former director of the Congressional Budget Office under George W. Bush.

But Trump’s protectionist proclivities are hardly the only concern. His harsh anti-­immigration stance is another downer for growth—with the potential to drive away or deport millions of workers who are the bedrock of the farming and construction industries, as well as to surrender the U.S.’s dominant position in the global talent wars by restricting visas for engineers and programmers who help power America’s R&D.

“I talk to him every day,” says Trump’s friend Tom Barrack. “He thinks it’s a revolution, and all the tumult is normal.”

Therein lies the promise and peril of the Trump economy: Put simply, America has never witnessed such a contradictory mix of free-market and antigrowth policies in the White House. Or a President who operates in such an unorthodox and unpredictable way.

Bolstering the case for pessimism is Trump’s hair-trigger temperament and penchant for launching scorched-earth attacks on a daily basis—including on world leaders from whom the self-declared master dealmaker will need cooperation to deliver the export-boosting concessions that are the centerpiece of his “America First” economic plan. In addition to antagonizing China and Mexico, the President has lambasted Chancellor Angela Merkel for “ruining Germany.” He even berated Prime Minister Malcolm Turnbull of Australia, a close U.S. ally, in a heated phone conversation.

Yet those incidents were but minor controversies in the chaos of the Trump administration’s first few weeks. The Twitter-happy President lashed out at the “so-called judge” who suspended Trump’s controversial immigration ban on people entering the U.S. from seven ­Muslim-majority nations, as well as the federal appeals court judges who upheld the ruling. Trump also found time to go after department-store chain Nordstrom after the retailer dropped his daughter Ivanka’s clothing line because of falling sales, tweeting that she had “been treated so unfairly.”

So much meshuggaas emanating from the Oval Office has raised very real questions about execution risk on all issues, including the economy. The hastily imposed Muslim ban in particular infuriated congressional Democrats, limiting chances for compromise even in areas like fixing roads and bridges, an initiative with bipartisan support. ­Although Republicans control both houses of Congress, it’s unclear how much of the Trump agenda will actually become law. For ­example, ­financing his reductions in corporate levies depends heavily on the passage of an extremely complex “border adjustment tax,” or BAT, that the Senate Republican leadership has yet to endorse.

“After the election, we were looking for areas of common ground, such as an infrastructure program,” says Rep. John Delaney, a Maryland Democrat. “But now with the way the administration is behaving, the way they throw things out, people in Congress have gotten a lot more pessimistic. You need reliable parties at the table to negotiate a big, complicated tax and infrastructure plan. You have to ask, Are they going to be serious?”

Trump’s sudden shifts in policy—and the difficulty in ever ascertaining whether he is bluffing or serious about his more dire threats—are causing widespread uncertainty. And if business hates anything, it’s uncertainty. “I think things are moving in the right direction, but I’m seeing lots of nervousness,” says Tom Barrack, chairman of real estate investment manager Colony Capital and one of Trump’s closest friends. “I’m seeing totally polarized views on what’s going to happen, from one camp believing things are going to be great, and an opposing camp predicting disaster.”

Some of Trump’s proposals are already undermining his principal goals. His tariff threats against Mexico, for instance, have helped push the peso down 10% against the dollar since Nov. 8. That’s made U.S. exports of everything from auto parts to appliances a lot more expensive across our southern border, slowing the exports that Trump vows to grow.

Both Trump’s conflicted policy and his erratic execution have caused some on Wall Street to have second thoughts. For example, Ray Dalio, founder of the world’s biggest hedge fund, Bridgewater Associates, praised Trump’s policies in an essay on LinkedIn shortly after the election. In late January, he hedged his position in a note to clients and warned that he had become “more concerned that the damaging effects of President Donald Trump’s populist policies may overwhelm the benefits of his pro-business agenda.” In early February, Goldman Sachs sent a note to clients warning that “risks are less positively tilted than they appeared shortly after the election.”

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Danger is also lurking in the buoyant stock market. The big gains since the election have made pricey shares even more expensive, driving the trailing price/earnings ratio of the S&P 500 to 25 in mid-February—well above the historical average of 16. That leave equities extremely vulnerable to deep declines if investors begin to sense that Trump can’t deliver the GDP gains that he’s promising.

It’s important to remember that it is still early days for the Trump administration. There’s plenty of time for the new President and his advisers to refine their approach to governing and, in economic matters, to deliver his promised reforms. Speculating on the odds of that happening, however, is a fool’s game. For now, we can focus only on what he has said he wants to do.

To better understand the specifics—and the unknowns—of Trump’s policies and how they’re likely to drive or slow the economy, Fortune interviewed dozens of economists, policy experts, former government officials, and business leaders.
What does Trump think of the turmoil he has caused so far? “I talk to him every day,” says Barrack. “He thinks it’s a revolution, and all the tumult is normal. He’s not bothered at all by all the divisions in Congress and the electorate.”

The near future of the American economy will depend on which side of the scale predominates under Trump: free-business initiatives or protectionist policies. Corporate tax cuts and regulatory relief will weigh heavily on the plus side. But an upheaval in trade would swamp all the potential gains from slashing regulations and taxes.

Trump’s team appears divided on trade. Commerce Secretary nominee Wilbur Ross and White House National Trade Council chief Peter Navarro are in the protectionist camp, while Treasury ­Secretary Steve Mnuchin and top economic adviser Gary Cohn, the longtime No. 2 to Lloyd Blankfein at Goldman Sachs, seem wary of disrupting free-trade agreements. Keep in mind that Trump’s pledge to protect workers from cheap, job-killing imports from China and Mexico was a key factor in helping propel him to the White House.

Nicolas Rapp

As quickly as things appear to be moving now, it’s important to remember as well that negotiating big trade deals is a lengthy process. If Trump can significantly boost growth in the next two or three quarters, America will be in a far better mood. With payrolls and wages waxing, the pressure to build trade barriers will abate, and Trump could declare victory by trumpeting relatively minor concessions. That’s probably the best-case scenario for achieving a healthy balance of policies. “If Trump can achieve consistent 3% to 4% expansion in GDP, nothing else matters,” says Gary Hufbauer, an economist at the Peterson Institute for International Economics and a stern critic of Trump’s views on trade.

Trump has a realistic shot at reaching that ambitious goal, though it will require implementing his unambiguously pro-business policies and mostly scuttling the rest. The President inherited a so-so economy that grew at just 1.6% in 2016 and has expanded at an average of 2.3% annually since the nadir of the Great Recession in mid-2009. Although the unemployment rate is now just 4.9% and the economy has created 11 million jobs in the past seven years, roughly an equal number of working-age Americans have ceased looking.

Many economists argue that a small pool of employable labor and an aging population, capped by low levels of immigration, have helped create a “new normal” that confines America to a plodding GDP growth rate of 2% or so. Trump isn’t buying it. In the view of his economic team, the roadblock is a dearth of capital investment. They argue that Obama hobbled business with a host of expensive regulations in banking, energy, and manufacturing that forced CEOs into a defensive posture, in which they shunned risk taking and hoarded cash.

Whatever the reason, it’s undeniable that capex in the U.S. has languished and that a healthy dose of new investment is absolutely essential to lifting America’s growth trajectory. The crucial measure of capex, private nonresidential fixed investment, stalled in the third quarter of 2014. Since then, spending on new plants, labs, and research facilities has increased less than 0.5% a year, adjusted for inflation, creating a substantial drag on GDP.

Trump wants to jolt the U.S. economy back into action. He predicts a virtuous cycle in which his tax plan allows companies to raise their profits from new investments, driving them to boost spending. Then new machinery and tech breakthroughs will raise worker productivity and, hence, wages and employment. At the same time, lifting burdensome regulations should also recharge capex across the economy.

So let’s go deeper into Trump’s plan to jump-start things. His three big pro-growth initiatives are corporate tax reform, regulatory reduction, and infrastructure renewal. We’ll start with taxes.

Trump aims to greatly enhance the competitiveness of the U.S. economy by radically lowering the corporate rate. America’s 35% federal corporate tax rate is the highest of any major developed nation, at least statutorily. In practice, U.S. corporations take advantage of so many write-offs that the effective tax rate is much closer to par with that of other advanced economies. Still, tax reform has a great potential to juice GDP. The Organisation for Economic Co-operation and Development (OECD) has identified heavy corporate levies as the most antigrowth of all tax categories.

Two plans are now in competition. The first is the relatively general platform that Trump issued during the campaign and hasn’t updated. The second is the more comprehensive House Republican proposal. The two are remarkably similar, with one huge exception: The House plan includes a complex, controversial measure called the border adjustment tax, or BAT, which has the potential to raise a massive $1 trillion in tax revenue. More on that in a moment.

On personal taxes, both plans go big on simplification, reducing the number of brackets from seven to three and lowering the top rate from 39.6% to 33%. And on the business side, the House and Trump plans would both greatly reduce the corporate tax rate. Trump proposes a top federal rate of 15%, one of the lowest levies in the developed world. The House champions a maximum of 20%.

Both plans also propose another historic tax break for businesses, one aimed at raising investment. They would allow companies to write off 100% of all capital investments in the first year instead of expensing them gradually over three to 20 years or more, as required under current law. “It’s crucial because when companies depreciate a $1 million investment over 10 years, they’re really getting a tax break of maybe $750,000 because of inflation,” says Kyle Pomerleau, an economist at the Tax Foundation, a nominally “nonpartisan” think tank with a free-market tilt. “If they write it off in year one, they get the entire $1 million as a deduction.” That difference substantially raises the future returns on new plants and equipment.

The crucial difference between the two plans is the BAT—a revolutionary new border tax that resembles the VAT, or value-added tax, levied by virtually all of America’s trading partners. The BAT, however, is a different animal.

How does it work? Whereas the VAT is essentially a sales tax that’s eventually tacked onto the price of a product or service, the BAT is more complicated. It would raise and lower corporate income taxes, increasing levies on importers and providing big credits to exporters. Today importers pay a 35% rate on their profits. Under the BAT, they would pay the new rate—let’s call it 20%—on the entire revenue they collect selling, for example, Japanese cell phones or French perfume in the U.S. That would more than double the taxes paid on a $30,000 car with a 20% profit margin—from $2,100 to $6,000.

By contrast, U.S. exporters would get an added deduction for the full revenue collected on the products they sell abroad. So they would go from paying 35% on their profits in Germany or Japan to receiving a big rebate. Supporters of the BAT claim that it will cause an already-strong dollar to further strengthen, lowering the cost of imports, so that foreign nations would sell the same volume of goods in the U.S. as they do now, and that the big rebates would exactly offset the drag on exports from the higher dollar, leaving foreign sales unchanged as well.

See more: Will Donald Trump Blow Warren Buffett’s Clean-Energy Bet Off Course?

The House bill pairs the BAT with what’s called a “territorial” tax regime. Today U.S. companies pay the 35% rate on all income, earned anywhere in the world. Most other major nations impose their national tax only on profits booked at home. The Irish subsidiary of a French drugmaker pays tax only in Ireland on the products it sells in Ireland. The House plan would change the U.S. from an outlier by adopting the global standard of a territorial tax.

The combination of a BAT and territorial tax has important virtues. U.S. companies would no longer have an incentive to switch their headquarters to low-tax nations through notorious “inversions.” And because import revenues are fully taxable, it would no longer make sense for importers to manipulate pricing to inflate the “costs” of goods sent to the U.S., a common practice for reducing profits, and thus lowering U.S. tax payments. Nor would U.S. companies have any reason to park hoards of cash in foreign subsidiaries, where $2.5 trillion in unrepatriated profits sit today.

The BAT is a levy the likes of which the U.S. has never seen—and there is understandable resistance to introducing such an intricate new system. Trump himself has been waffling on the idea, stating in late January that the BAT was “too complicated,” then seeming to endorse it two weeks later. Big retailers such as Walmart, Target, and Rite Aid are adamantly opposed to the BAT, arguing that we don’t really know if the dollar would appreciate enough to offset the tax levies on clothing and furniture from China. Nor has the Senate Finance Committee or Majority Leader Mitch McConnell endorsed the BAT.

If the BAT isn’t enacted, it’s likely that either one of the two pillars of Trump’s tax overhaul will have to go, or that both the immediate expensing of capex and a corporate tax rate cut will be scaled back to lower the cost of reform. On paper, the BAT is crucial to making the numbers work.

Although both Trump and House Speaker Paul Ryan claim that replacing the ACA is their top priority, the Republicans and the administration haven’t agreed on a plan, nor on a deadline for when a replacement bill will be introduced. It’s simply not clear if Trump will keep his pledge not to disrupt coverage for the 20 million people who gained coverage via Obamacare. “Whether he will stabilize Obamacare for now or blow it up by getting rid of the individual mandate or cutting payments to insurers that cover losses is still ­unknown,” says Larry Levitt, a senior official at the Kaiser Family Foundation.

Right now, the stability scenario looks more likely. The administration is actually moving to strengthen the ACA. It’s imposing new regulations that maintain a stronger balance between healthy and sick folks in the insurance pools. The goal is limiting enrollment periods to cure an Obamacare syndrome: a flood of patients who game the system by signing up only when they’re seriously ill and dropping coverage as soon as they recover.

See more: Why the Stock Market Is Stacked Against Donald Trump

Outside of the ACA, Trump is beginning a regulatory rollback unmatched in generations. The field is vast and varied, and estimates of the annual costs of federal red tape range widely, from the Office of Management and Budget’s estimate of $250 billion to the Competitive Enterprise Institute’s $1.8 trillion. Whatever the true figure, the number and burden of new rules rose sharply during the Obama years. From 2009 to 2016, Obama implemented about 300 regulations costing more than $100 million annually, compared with 120 during the George W. Bush years.

Trump has pledged to eliminate 75% of existing federal rules. In reality, that won’t come close to happening. It can take years of public hearings and lawsuits to eliminate regulations already on the books. Still, he’s already wielding his pen as a giant eraser.

On Jan. 30, Trump issued an executive order requiring that in the future, any executive branch agency or department must eliminate two rules for every new one it issues. In addition, the regulations added and repealed can’t add to the agency’s total cost of regulation, a rule that will be enforced by the OMB. He has also imposed a moratorium on the 2,596 proposed-but-not-implemented regulations.

Infrastructure renewal should be a prime area of cooperation between Trump and the Democrats. But the two sides have highly divergent approaches, especially on funding. During the campaign, Trump called for $550 billion in federal spending. The new administration hasn’t proposed a specific plan. But Trump is on the record advocating that most of the spending be channeled into partnerships between government and private companies. In a position paper written for the campaign, Ross and Navarro proposed granting tax breaks equal to 87% for up to $187 billion in equity that companies invest in infrastructure projects. The idea is that those public-private partnerships would leverage that equity into $1 trillion in new infrastructure spending and that payroll taxes on newly created jobs and contractors’ profits would cover the full costs.

In practice, the Ross-Navarro plan won’t nearly do the job. Many of America’s roads and bridges don’t have tolls or any source of revenue, and projects that do are mostly owned by the government. The partnerships could finance pipelines or private water systems. But they won’t work for most of our crumbling highways, commuter rail networks, and the aging electrical grid, all of which are in desperate need of funding. “For the vast majority of projects, direct public funding is needed,” says Marcia Hale, president of Building America’s Future, a group that champions a bold offensive on infrastructure.

“With the way the administration is behaving,” says one democrat, “you have to ask, are they going to be serious?”

Trump’s public-private concept contrasts ­sharply with a new proposal from New York’s Chuck Schumer, the Senate minority leader. Schumer wants to spend $1 trillion in federal funds—aided by a tiny dollop of private money—on projects stretching from bridges to schools and veterans’ hospitals. His counterpart, McConnell, trashes the Schumer plan as far too expensive.

A possible compromise is a bill sponsored by Rep. Delaney, which gets around the spending issue by tapping the proceeds from repatriation of foreign profits. Both the House Republican and Trump tax plans mandate that companies bring back all of their approximately $2.5 trillion in profits parked abroad. It’s not a choice; they have to do it.

Three Key Economic Policy Questions

1. Will Trump go to BAT?
   One Republican tax-reform plan calls for a complicated new levy called the border adjustment tax. It could raise $1 trillion to offset corporate tax cuts. But U.S. retailers hate it.
2. What’s the right way to finance an infrastructure building boom?
   Trump has advocated public-private partnerships, which aren’t practical for many projects. The Democrats are pushing a $1 trillion federal public-works campaign. A possible compromise: Use the tax windfall from repatriating stranded overseas profits of U.S. companies to fund the much-needed investment.
3. Is Trump serious about starting a trade war?
   The President has threatened to impose tariffs on countries like Mexico and China if they don’t lower barriers to U.S. exports. But odds are that a full-on breakout of protectionism would cause the value of the dollar to spike, shrink-exports, and hobble growth.

Nothing in Trump’s rhetoric or his actions has polarized the nation more than his stance on immigration. And his views on the subject threaten both the high and low ends of the U.S. workforce. A pair of draft executive orders leaked to the press contain two provisions that could greatly restrict immigration. The first directs the Department of Homeland Security to issue a rule stating that any immigrant deemed likely to receive public assistance, such as Medicaid or children’s health insurance, cannot be admitted to the U.S. That rule would grant the officials wide latitude to possibly shrink today’s inflow of legal immigrants, already at a low level of around 1 million a year. That would be bad for growth. Research has shown that immigrants are disproportionately likely to start new businesses. A study last year by the National Foundation for American Policy found that 51% of startups in the U.S. worth over $1 billion were founded by entrepreneurs born abroad.

Today, H-1B applicants are chosen by a lottery, and the annual number is capped at around 85,000. It isn’t clear that Trump’s new policies would cut that number, but the draft states that U.S. policy should “prioritize the protection of American workers.” A new House bill with bipartisan support would raise the minimum salary companies need to pay H-1B workers from $60,000 to $100,000, a measure designed to prevent highly skilled immigrants from taking jobs from U.S. workers. The Trump team is pointing in the same, anti-H-1B direction.

For decades, the U.S. has benefited mightily from the spread of free trade. For example, our exports in goods to Mexico have risen 259% adjusted for inflation since NAFTA was enacted in 1994, to $231 billion in 2016. Over the same period, Mexico’s exports to the U.S. jumped 345%, creating a $63 billion trade deficit—which by the way, mainly consists of our imports of Mexican crude oil and petroleum products.

Does that trade gap, or the bigger one with China, hurt the U.S.? From an economic point of view, just the opposite. “It makes no sense for us to make things at home if it costs less to import them,” says Harvard economist Robert Lawrence. “We raise living standards by sending the Chinese airplanes that we exchange for their clothing.”

Mainstream economists mostly agree that although imports can cause acute pain by displacing workers, especially in manufacturing, the economy benefits overall because the cheaper products leave our consumers with more money to spend on other things. Free trade steers capital into sophisticated, high-paying, high-value-added fields where America enjoys a competitive advantage. For example, by creating a single market in North America, NAFTA has encouraged superefficient supply chains where manufacturers produce parts and assemble cars in Canada, Mexico, and the U.S. depending on where costs are lowest—a system that has enhanced the competitiveness of Ford and GM (GM) on world markets.

One possible sticking point in the negotiations: The Trump team doesn’t seem willing to offer more access to U.S. markets, where we protect airlines, forestry, sugar, and a number of other industries and award public projects mostly to the home team. “The idea is that we’ve been ‘stripped naked’ on trade agreements, and we have nothing to give,” says Hufbauer.

That one-way attitude is unlikely to extract significant concessions, according to such experts as Hufbauer and Lawrence. So the question is whether Trump will really unleash the big stick, namely tariffs. If that happens, America’s economy will likely grow not faster but slower.

An outbreak of full-on protectionism could potentially shrink both imports and exports. That’s because when the U.S. slaps, say, a 35% or 45% tariff on Chinese goods, the world will become a far more uncertain place. The Chinese will look for somewhere safe to park their yuan, and the safest currency is the U.S. dollar. Ironically, the flight to safety could drive the dollar far higher, hiking the costs and prices of our exports and hobbling growth.

According to the most recent CBO projections, by 2027, interest on the debt alone will triple, to $768 billion, accounting for one dollar in every eight the U.S. spends. And that’s using the rosy assumption that the 10-year Treasury rate reaches only 3.6% in 10 years. In a few years, soaring deficits and debt could prompt foreigners who now own $8 trillion in U.S. government bonds to dump them, forcing up interest rates and choking a Trump recovery.

That’s a dangerous attitude given the scope of the problem, and one that can’t last long. An immediate issue is how Trump plans to finance his proposed tax cuts. If the U.S. enacts the BAT and deploys the repatriation windfall to pay for infrastructure, the additional rise in future deficits, over and above current projections, could be modest. But if Trump borrows an additional $500 billion in 2019 to finance his stimulus, the deficit will quickly zoom to over $1 trillion, or a gigantic 5% of GDP.

If President Trump suddenly stops picking fights with retailers and federal judges and starts working on a debt-reduction plan instead, that might be the most promising sign of all.

A version of this article appears in the March 1, 2017 issue of Fortune.