Monetary policy reaches its limits: time to get fiscal?

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The old arguments against big fiscal deficits are changing. A major shift among some academic economists and the financial markets is taking place. It suggests that the traditional reasons for restricting budget deficits no longer hold. Could fiscal spending be about to surge?

Ultra low interest rates have led many to conclude that monetary policy can no longer be relied upon to underpin the world economy. Governments should boost spending and cut taxes without worrying about the deficit until after inflation picks up.

If governments follow this advice, growth should accelerate, boosting stock markets. If inflation were to stay low, all well and good. If not, then interest rates can be raised.

Among economists, the most extreme proponents of fiscal policy are advocates of “Modern Monetary Theory” (MMT), several of whom are now serving as economic advisers to Democrat politicians in the United States. MMT argues that a country that issues its own currency cannot run out of money and therefore does not need to worry about the path of government debt. Instead of quantitative easing (QE) being used to buy government debt, it should be used to finance government spending. If inflation did eventually rise, higher taxes could be used to rein in spending and cool price pressures. Given that massive doses of QE by the world’s leading central banks have failed to generate much inflation since the global financial crisis, there is an implicit hope that inflation might stay low.

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As an indicator of the change in the intellectual climate, central bankers, such as the outgoing President of the European Central Bank, Mario Draghi, have advocated fiscal expansion in Europe; the former head of the U.S. Federal Reserve, Ben Bernanke, has done so in the U.S. Even the International Monetary Fund, the world’s fiscal steward, has advocated fiscal expansion, albeit only for a select group of countries like Germany and South Korea.

This change in emphasis in the debate is very significant. It has energized those Americans on the left who feel well justified in asking: if the U.S. was able to finance a hugely costly war in Iraq or large tax cuts under Trump without worrying about funding, then why worry about it for financing a Green New Deal? It may lead Germany to finance their own Green New Deal by borrowing rather than cutting spending elsewhere. In the UK, the Labour Party has resisted embracing MMT as they wish to appear financially responsible. Were they to gain power, this may well change.

So far, the moves have been modest. JP Morgan estimates that seven years of fiscal squeeze at the global level has given way to a small boost in 2019 with an even smaller boost in 2020. If the mood music around fiscal policy continues we may see much bigger numbers in the future.

Global fiscal thrust

%-pt. impact on real GDP growth (average, annualised)

 

2011-13 2014-15 2016-17 2018

Global

-0.5

-0.3

0.1

-0.2

Developed

-0.9

-0.4

0.0

0.2

US

-1.3

-0.7

0.1

0.6

Euro area

-1.2

-0.2

0.0

-0.2

Japan

0.0

-0.6

0.1

-0.2

Emerging

0.4

0.0

0.4

-1.0

EM Asia

0.5

-0.1

0.6

-1.2

China

0.8

-0.3

0.9

-1.8

Latam

0.4

0.4

0.0

-0.3

EMEA EM

-0.1

-0.5

-0.2

-0.5

Note. Fiscal thrust defined as the charge in the structural deficit as a % of potential GDP as projected in the IMF’s April 2019 World Economic Outlook report. For the major economies, the figures have been adjusted judgementally by J.P. Morgan economists. Source JPMorgan and IMF. 10-Sep-19

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