A growing number of investors have become increasingly concerned as of late that central bankers are fast running out of monetary ammunition. Those investors are beginning to question whether central banks still have the capacity to support the economy and achieve their price stability mandates. We do not happen to share this pessimistic assessment; we do not believe that the monetary cupboard is bare (please read Central Bank Watch by Steve Friedman). However, this post is about the instrument that many of those investors do still believe in: fiscal policy.
Almost as soon as interest rates appeared to hit the lower bound in 2008/09 and central banks started supporting the economy through large scale asset purchase programmes, fiscal stimulus came back into fashion. Academic research published soon after the crash appeared to show that fiscal policy was far more powerful in these circumstances – a conclusion that seemingly chimed with the ‘Keynesian common sense’ that cutting taxes or increasing government spending is a more effective way to stimulate aggregate demand than ‘pumping up asset prices’. The feeble recovery in activity since the crash has only further reinforced this view that fiscal policy has been too tight for our own good and that a fiscal shot in the arm is precisely what the global economy needs right now. However, the case for fiscal policy is more complex and less compelling than it first appears.
Monetary policy – have we reached the end of the line?
For a start, you need to assume that monetary policy is on auto-pilot or is ineffective if you want to argue that fiscal stimulus would be highly effective. The stance of monetary policy should already be calibrated to deliver the best possible path for output and inflation given the current macro outlook including the stance of fiscal policy. A loosening in the fiscal stance should therefore lead to central banks dialling back on monetary stimulus in response. Some investors may argue (incorrectly, in our view) that tighter monetary policy would have little impact on the real economy if it involves the central bank buying less bonds or cutting rates less into negative territory but we doubt that many would make the same argument for a rate hike.
Under the wrong circumstances fiscal stimulus could backfire….
We also need to worry about the impact of the fiscal stimulus on the people who will pay for it in the short run investors) and the long run (taxpayers). If the macro outlook is sufficiently poor and the burden of debt is sufficiently high, then creditors may start to question whether public debt is sustainable and may start to demand greater compensation for the risk of losses either through restructuring or inflation (where the country concerned still has control over the printing press), leading to a contractionary tightening in financial conditions and deterioration in the public finances. Even in the absence of that fiscal crisis, households may choose to save more in anticipation of the taxes they will have to pay in the future when the government announces a fiscal stimulus today, and that could temper the boost to demand.
What form should fiscal stimulus take?
We also need to think hard about the design of any fiscal stimulus. Demand management is not the primary objective of fiscal policy. Finance ministers should instead focus on efficiency and equity – essentially, improving the supply side of the economy to increase the sustainable level of national income and trying to deliver a fairer distribution of that income across the population. A particular package of fiscal measures should be evaluated accordingly. Investment in public infrastructure projects with a high social rate of return or welfare payments to those with a high propensity to consume out of disposable income might score highly on these criteria even if the central bank crowds out the initial stimulus to aggregate demand.
Japan – are fiscal stimulus measures next up?
The fascination with fiscal policy is currently fixated on Japan. As evidence mounts that the Japanese economy has failed to achieve escape velocity from the deflationary malaise of two lost decades investors are looking for ways in which Abenomics could be re-booted to deliver the necessary stimulus to demand and inflation. The Bank of Japan’s experiment with negative interest rates in January and its decision to sit on its hands in April has encouraged many to conclude that the next iteration in the policy response will be fiscal not monetary.
The first item on the agenda is the two percentage point increase in the consumption tax that is slated for April 2017. Prime Minister Abe has signalled that barring some unforeseen event the tax hike will proceed as planned.
However, the hike has already been postponed once and it seems likely that the government will do so again, most likely as part of a broader fiscal package. The government has already unveiled reconstruction measures worth almost ¥800 billion in response to the natural disaster in the Kumamoto Prefecture. Additional fiscal measures look set to follow in a supplementary budget where the focus will likely be on supporting the so-called second phase of Abenomics, which is intended to address the structural rigidities holding back the Japanese economy, including its demographic problem. Expenditures designed to increase labour force participation rates among women with young children and the elderly are one obvious element of that package.
One cannot divorce a discussion about the case for further fiscal stimulus in Japan from the fiscal backdrop. According to the latest set of International Monetary Fund projections, the primary balance was in deficit to the tune of almost five per cent of GDP in 2015 and is expected to remain so until 2021. Moreover, adjusting those numbers for the impact of the economic cycle – the drag on tax receipts and the boost to spending when the economy is weak – makes little difference: the public finances are structurally in deficit. Then there is the small matter of a ratio of general government gross debt to GDP of the order of 250%. In short, fiscal policy is already loose by standard metrics and there is already a formidable stock of debt to be paid for at some point. Adding to those deficits and that debt load is not to be sneezed at. Creditors may begin to wonder whether Japanese finance ministers will perpetually postpone implementing the painful fiscal measures that are required if Japan is to achieve the aspiration of a primary surplus in 2020.
One question that investors have to ponder is how the Bank of Japan might respond to such a hypothetical stimulus package. In theory if we are witnessing a shift in the fiscal – monetary mix in Japan and if we believe that this fiscal package will prove effective at stimulating demand then the knee-jerk market reaction may be for the yen to appreciate, as investors scale back their expectations of the additional monetary stimulus that the Bank of Japan will provide in the future. On the other hand it is theoretically possible (though far from certain) that the Bank of Japan may step up its asset purchase programme in response, neutralising the impact of the increased issuance that comes with fresh fiscal stimulus on the net supply of government bonds to private investors. In effect, we would get more fiscal easing and more monetary easing.
The difference between a ‘helicopter drop’ and fiscal stimulus – just semantics?
There is nothing particularly controversial about the latter outcome: the United States and the United Kingdom both engaged in a combination of discretionary fiscal stimulus and quantitative easing during the acute phase of the crisis. However, the difference here is that investors may expect that the bonds that the Bank of Japan buys will remain on the balance sheet for the foreseeable future, at which point the distinction between this policy and a pure helicopter drop starts to become academic (please read Central Bank Watch by Richard Barwell and Steve Friedman). Of course, if the bonds are going to remain on the central bank’s balance sheet for the indefinite future then the original stimulus package has effectively been permanently money financed, and will therefore not have to be paid for through higher taxes. If households appreciate that fact then the standard Ricardian offset where the private sector saves more when the government spends more may not materialise, making the current stimulus package more effective. Indeed, Japan may have reached this point some time ago and the helicopter drops have already begun in all but name. [divider] [/divider]
This article was written on 24 May 2016, in London.