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IPE special report May 2018

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Economic Policies: Pendulum swings towards use of fiscal stimulus

Daniel Ben-Ami finds consensus in the western world is shifting towards greater use of fiscal policy to stimulate economic growth 

There is at least one respect in which President-elect Donald Trump is thoroughly mainstream. His support for a fiscal stimulus – greater public spending and tax cuts – is shared by an increasing number of leaders across the western world.

It is not that they have turned against an activist monetary policy. Most would argue that central bankers have done a good job in staving off a global economic depression in the wake of the 2008-09 financial crisis. But in many cases they would contend that central banks are, to use the favoured expression, “running out of ammo”. Interest rates are so low and quantitative easing so extensive that their efficacy is diminishing. Léon Cornelissen, the chief economist at Robeco in Rotterdam, says, “We are in a climate of overreliance on monetary policy.” Alternative means are needed to bolster still sluggish economic growth.

Even central bankers themselves understand these limitations. “Central bankers recognise there is only so much a central bank can do,” says Bob Baur, chief global economist, Principal Global Investors in Des Moines, Iowa. “The best they can do is buy time.”

Jason Furman, the chairman of President Barack Obama’s Council of Economic Advisers, described the shifting consensus among policymakers and economists at a conference in October. He concluded that: “More and more policymakers appreciate that fiscal policy is a critical complement to monetary policy and that we have used it too little, especially given its effectiveness and given the greater fiscal space we had relative to eight years ago.”

Of course, there were always some who favoured activist fiscal policies and there are still some who remain sceptical. But the pendulum of opinion has swung decisively in favour of the former.

This shifting consensus is reflected in many ways. The array of international think tanks such as the International Monetary Fund and OECD have published papers in favour of it. Many central bankers have advocated it too. For example, Janet Yellen, the chair of the US Federal Reserve, gave a speech on ‘Macroeconomic Research After the Crisis’ in October which essentially made the case for fiscal stimulus. Mario Draghi, the president of the European Central Bank, made a speech along these lines as far back as 2014 at the annual central bank conference in Jackson Hole, Wyoming. “It would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy,” he said.

leon cornelissen

Political leaders too have moved towards taking a more positive attitude towards fiscal stimulus. For example, the leaders of the world’s largest 20 countries endorsed a communiqué to that effect at the G20 summit in Hangzhou in September. Japan has been perhaps the most amenable to stimulus packages in recent years. Shinzo Abe, the prime minister, launched one in August after having launched another with the advent of ‘Abenomics’ back in 2012. 

In the UK, the prime minister, Theresa May, suggested the government would take a looser fiscal stance in one of her first speeches in her new role. The announcement came a few months after the Brexit referendum and marked a break from the austerity policies previously pursued by her Conservative party colleagues. “They were really the champions of austerity,” says Robeco’s Cornelissen.

But it was perhaps inevitable that the US, as by far the largest developed economy, would attract the most attention. Although the details are not yet clear it looks certain that the incoming Trump administration will pursue some kind of fiscal stimulus. It will combine an infrastructure building programme along with tax cuts for corporations and perhaps individuals too. There may also be some associated regulatory shifts to make bank lending easier – with the dismantling of the Dodd-Frank Act – while greater military spending could also stimulate economic activity.

The possibility of a Trump administration stimulus has received the tacit endorsement of the Fed. In a speech in late November, well after Trump’s election victory, its vice-chairman, Stanley Fischer, endorsed the idea in principle. “Certain fiscal policies, particularly those that increase productivity, can increase the potential of the economy and help confront some of our longer-term economic challenges,” he said.

This is despite the fact, as Bob Baur of Principal, points out, that it is unusual to have a fiscal stimulus at this stage of the economic cycle. More often they are implemented in the depths of recession rather than after several years of recovery. But given the weakness of the upturn “maybe later is better than never”.

The shift towards fiscal stimulus coincides with a widely perceived need for greater investment in America’s crumbling infrastructure. Joe Davis, the chief global economist at Vanguard, says there is no doubt that the US requires more infrastructure spending. “There is clearly a structural need for infrastructure spending on the public side in the United

States,” he says. “It’s just the nature of the deterioration.”

general government net lending borrowing

But despite the widely perceived need for fiscal stimulus and infrastructural investment, the Trump administration’s tentative proposals have not gained universal approval. It is, of course, possible to support stimulus as an idea in principle while objecting to the design of any particular set of proposals. Both Keynesians and fiscal conservatives have their particular objections to Trump’s plans.

For example, Trump’s infrastructure proposals are centred on providing tax incentives for private companies to invest in approved projects. But many Keynesians argue that a better solution would be more direct spending by governments.

Keynesians also tend to argue that the stimulative effect of tax cuts for the wealthy will be limited. That is because the marginal propensity of the wealthy to consume is relatively limited. That is, richer people tend to save a higher proportion of their earnings, whereas poorer people spend a greater share of any additional income.

In contrast, fiscal conservatives tend to be wary of any government-backed stimulus. They generally dislike large public infrastructure programmes and are more supportive of curbs on welfare payments.

A more widespread concern is that an excessive stimulus could cause inflation to take off. But, in Baur’s view, the chances of such an outcome are exaggerated because there is less labour market slack and there are fewer capacity constraints than many assume.

Finally, there are those who argue that a shift to protectionism and curbs on immigration could nullify the positive effects on any stimulus. Davis describes these as a “wild card”. In his view the actions of the new president in these areas is likely to be less extreme than his campaign rhetoric suggested. “I don’t think we are going to see a massive reduction in trade openness in the US despite the threats,” he says. “What is said on the campaign trail and what is implemented by the administration are historically two different things.”

Although the situation in the US is not straightforward, the situation in Europe is more complex. For a start the euro-zone is broadly divided between north and south. The northern countries tend to be fiscally stronger and the southern ones more indebted. At the same time, and not entirely by coincidence, the northern countries, most notably Germany, are reluctant to reward what they often see as fiscal irresponsibility in southern Europe.

Peter Westaway, the chief European economist at Vanguard, says German economists tend not “to think of fiscal policy as the policy tool of choice in these circumstances”. They more often see excessive stimulus as the cause of economic problems in the first place. He says it is unlikely Germany will support any strong fiscal measures until at least after the federal elections later this year.

Meanwhile, the situation in the UK is complicated by Brexit. The economy defied predictions from the Treasury and others of an immediate shock in the event of a Leave vote in the referendum. As it turned out, GDP grew by 0.5% in the third quarter. But the Office for Budget Responsibility, an official advisory body to the government, still upholds the widespread view that Brexit will do significant harm over the longer term. From that perspective, a fiscal stimulus might be necessary simply to nullify such an effect. 

“After the Brexit shock, it seems inappropriate to continue with the previous austerity,” says Peter Westaway. That does not mean that a balanced budget will necessary be ditched as a long-term target but the priorities in the shorter term are different.

In the government’s recent Autumn Statement – one of two key economic proclamations made each year – it announced the formation of a £23bn (€27bn) National Productivity Investment Fund to be spent on innovation and infrastructure over the next five years. It will include initiatives to improve transport, telecommunications and housing.

Inevitably there were criticisms of the measures from a variety of perspectives. Some lamented the lack of more substantial tax cuts while others pointed out it was not much of a stimulus at all. Capital Economics, an economic consultancy, argued that: “Although the Chancellor’s package of measures gave a bit of money away (£8bn per annum by 2019-20), there is still set to be a fiscal tightening (proxied by the change in the cyclically-adjusted budget balance as a percentage of GDP) equivalent to just under 1% of GDP per year over the next three years.”

What looks set to be true of the UK could easily apply more broadly. Despite the widespread consensus, the reality of fiscal stimulus across much of the developed world could be significantly less than expected.

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