In the early part of our course we explored some of the structural problems challenging policymakers. Specifically, we identified evidence of stagnation in productivity growth and thus a slowing in the growth of living standards. Not unrelated, we have seen clear signs that the “normal” real interest rate, r-star, has fallen in recent decades.
In our sessions dealing with business cycles, the implications of a low r-star for demand management will become clearer. For any given inflation target, a lower “normal” real interest rate must mean that a central bank’s “normal” nominal interest rate must also be lower. In the US’s case, for instance, our session 10 exercise in Fed Watching (using dot plots) will suggest that the FOMC is indicating 3% as the new normal for the fed funds rate rather than 4% as was assumed pre-GFC.
This downgrading of normal policy rates is important since it suggests that central banks will have less headroom than in the past should we be afflicted by another recession which necessitates aggressive interest rate cuts. The effective lower bound, not significantly different from zero, is much closer than it was over a decade ago.
So with signs that monetary policy is more constrained – at least in its conventional interest rate setting form – it comes as no surprise that fiscal policy will probably bear more of the burden of demand management in future business cycles. Governments, as well as central banks, will need to be more proactive.
But fiscal policy also has its problems.
- Automatic stabilisers are not that large and discretionary shifts in tax & spend programs can take time – too much time – to plan, agree and implement in modern democracies. In addition, even when fully implemented, fiscal policy may fail to gain to gain traction.
- Multipliers, even if they are positive in the short run, often fade to nothing within a short space of time.
- As we discussed in session 8, crowding out is not always a problem – especially in large recessions – but the potential for failure in the transmission mechanism cannot be denied.
In session 9 we explore in more detail the challenges that arise when fiscal policy is more actively used to cushion a weak economy. In particular, after becoming more familiar with budget accounting measures, we are going to address the question of long-run fiscal sustainability.
Unless matched by productive assets, high debt can hamper growth, diverting resource from more productive uses and so undermining the long-run tax base. High debt also means high debt payments (our INT of T = TX – TR – INT fame from early accounting sessions). But high debt payments mean higher budget deficits which mean more debt in future. If you’re thinking “this sounds like a doom loop” – well, you’re right!
If the economy is stagnating, and thus not producing much growth in tax revenues, then interest payments will feed a vicious cycle leading to ever increasing debt. But ever increasing debt will get investors twitchy who will then sell that country’s debt – forcing interest rates even higher! Like so many financial cycles, we get into a nasty, self-fulfilling prophecy of doom. Fiscally weakened governments, recessionary economic conditions and failing banks – a toxic brew indeed.
Following the GFC, when both central banks and governments pulled out all the stops to prevent a socio-economic collapse, many countries have been left with a huge public debt legacy. As the introductory video makes clear, governments are striving to contain this debt overhang by running underlying budget surpluses as well addressing some of the structural barriers to higher growth (and thus a stronger base for tax revenue).
The bottom line is that fiscal largesse – perhaps launched with noble, anti-depression motivations – can exacerbate problems rather than solve them.
The analysis contained in the video accompanied the IMF’s April 2013 Fiscal Monitor. The narrative focused on 10 major countries that accounted for the bulk of global public debt. The list included the US, Japan and several Europeans. So how are they getting on now?
For an update let’s look at the IMF’s latest projections for government debt (as a % of GDP) for 2020 and compare that forecast with the outturn for 2013, when the IMF’s analysis was compiled. One country appears to be back on the straight and narrow. Ireland seems set to reduce its debt ratio to around 60% from 120%. Portugal is also making modest progress although its debt ratio is projected to remain significantly above 100% in 2020. However, all the rest have either seen their debt ratios stabilise at high levels or, in some cases, are even set to increase.
The US is a case in point. The legislative changes in the 2017 Tax Act plus additional measures in early 2018 will set America on a much more fiscally expansive path.
The Congressional Budget Office’s April 2018 assessment makes for sober reading…
“federal debt is projected to be on a steadily rising trajectory throughout the coming decade. Debt held by the public, which has doubled in the past 10 years as a percentage of gross domestic product (GDP), approaches 100 percent of GDP by 2028 in CBO’s projections. That amount is far greater than the debt in any year since just after World War II. Moreover, if lawmakers changed current law to maintain certain current policies — preventing a significant increase in individual income taxes in 2026 and drops in funding for defense and nondefense discretionary programs in 2020, for example — the result would be even larger increases in debt.”
“Over the 2021–2028 period, projected deficits average 4.9 percent of GDP; the only time since World War II when the average deficit has been so large over so many years was after the 2007–2009 recession.”
Part of our session will explore what the projections mean for US fiscal sustainability (if time permits, the outlooks for Brazil and Russia will also come under scrutiny). Other than eating humble pie, reversing the tax cuts and spending programs, there are no easy fixes for the problems we uncover.
- Selling the family silver? …buys some time but asset stripping is, itself, unsustainable
- Resource bounty? …unlikely that shale is enough and then there’s that dreaded resource curse
- Inflate the debt away?… quite possibly, it’s been done before!
- Financial repression?… capping interest rates is a throwback to WW2 and its aftermath, again not a new idea but much harder to implement in today’s market environment
- Rebound in productivity growth? …ok, now you’re talking. Good luck with that, but at least it underlines the key point that fiscal sustainability is more about supply-side policy than occasional budget squeezes. Moreover, supply-side policy needs to pay close attention to the financial sector; poor bank capitalisation, inadequate liquidity, weak regulation will only intensify fiscal sustainability problems. As the GFC debacle proved, private banking problems quickly morph into massive public debt headaches. If you have great policies with great institutions nurturing great ideas then great results follow. Fiscal space can be created by additional public spending in carefully chosen infrastructure and other projects. Crowding in can happen and it is certainly worth trying. But , if it were that easy, you wouldn’t have a fiscal sustainability problem!
Of course, the US enjoys an “exorbitant privilege” in that it has a captive audience as regards creditors. America’s perceived safe haven status, also reflected in the primacy of the US$ in international finance, means that it can preside over widening deficits and mounting debt burdens without necessarily suffering a crisis of credibility. For sure, it is doubtful that the dollar and US Treasury bonds are about to collapse any time soon. But, as history and playground antics teach us, you can only stretch the elastic so far before it snaps back in your face!
28 Mar 2019