Time for expansionary fiscal policy?

Anthony Dass: To avoid fiscal stimulus from raising interest rate and crowding out private investment, this is where monetary policy comes into place. It needs to create ample liquidity and keep interest rates low to support private sector.

THE strength of the global economy is tunnelled by a series of issues and is placing the global economy in a “precarious” situation.

Trade conflicts which remain open ended and can cut across many countries are undercutting investment and weakening manufacturing. Prospects for a no-deal Brexit, high debt levels, geopolitical tensions and sharper slowdown than expected in the United States, China and eurozone raise uncertainty and drills into global growth.

Following the 2008 global crisis, it damaged global growth that lost sizeable amount of potential output dragged by issues like the bailout costs for banks, lower tax revenues as a result of slower economic activity, concern about the sustainability of public finances, fear of higher sovereign debt risk premia, and fiscal cutbacks to stabilise sovereign debt risk premia.

Besides, the 2008 crisis impacted capital stock due to reduced credit supply despite lower interest rate following stricter financial regulation and higher risk aversion from the financial institutions. Labour productivity fell from rising aging population which lower hiring profitability and will quasi-permanently stay below trend. Thus, it is going to be a challenge to improve total productivity even if the loss of capital stock is fully reversed.

With today’s concern of a potential global economic slowdown, central banks around the world have started easing their monetary policies by reducing short-term interest rates and some lowered their reserved required ratio like China for instance.

Can lowering interest rates support growth? More so, global interest rates are already low from the easy monetary policy employed post-2008 crisis.

Many countries failed to revert to the levels prior to the 2008 crisis, thus limiting their flexibilities to use the monetary policy.

Even if interest rates have done all they can, there is the “unconventional” monetary policy i.e. quantitative easing. It works better in practice than in theory as it will lower longer-term bond yields and encourage expenditure. But its effectiveness depends on the context and fuzzes the border between monetary policy and fiscal policy.

Risk of cheap monetary policy likely to be less effective in current circumstances. It is not due to some intrinsic weakness, but due to the context in which it is operating. Lowering interest rates may not be powerful. Consumers and businesses are used to low rates of the past decade to expand their borrowing and many are now facing leverage limits.

Continued restrictions on access to financing will discourage capital investment, research and development and other productivity enhancing expenditures.

Thus, active macroprudential policy is needed to avoid leading to financial instability.

Countries with fiscal space can use the fiscal policy to support growth. There is a need to look at “expansionary fiscal policy”, where government spending increases but risk leaving the fiscal deficit higher than earlier projected. Higher budget deficits is bad as budget surpluses are needed to go into more debt to cover expenses and drags markets down.

This may not be true if the government decides to operate on a higher deficit, and with stronger governance and transparency, added with measures to ensure the fiscal stimulus is temporary and targeted as well as being able to service debt. Hence, the fiscal space should not be determined by just the level of public debt.

Public debt-to-GDP ratio can improve over time and create additional fiscal space. It is a static concept and can vary with market and economic conditions, sometimes quite quickly and substantially. They should rely on a multi-faceted approach using various other indicators and tools like the composition and path of public debt; financing needs; assets that can be drawn upon; future spending commitments; effectiveness of fiscal policy; and strength of fiscal institutions and fiscal rules to enhance credibility, market access, and ultimately fiscal space itself.

A well-executed fiscal stimulus will boost the dynamics of economic activity and outweigh the initial deterioration in its fiscal position, potentially lowers public debt-to-GDP and create additional fiscal space.

Government spending can increase the velocity of money which is the rate at which money circulates in the economy and even more if used well. Higher velocity of money is good as it shows the robustness of economic activity – with companies and individuals feeling confident and spending accordingly.

In summary, regardless of why or when the next slowdown or recession will be, it is important to use every effective tool at disposal to end a potential slowdown as soon as possible and pin the economy back on a growth track.

The tools will need to boost the spending of households, businesses and governments to relieve the aggregate demand shortfall that is the fundamental cause of recessions.

Expansionary fiscal policy, which is the stronger government intention, to support the economy is necessary. It must be large enough, temporary and targeted and focus on the key trends reshaping the global economy i.e. shifting demographics, rapid technological progress, and deepening global economic integration. Those with limited budgetary room should adopt inclusive and growth-friendly strategies.

To avoid fiscal stimulus from raising interest rate and crowding out private investment, this is where monetary policy comes into place. It needs to create ample liquidity and keep interest rates low to support private sector. Also, it needs to create and facilitate better credit growth in targeted areas that synchronises with the fiscal policy.

Anthony Dass, chief economist/head of AmBank and Adjunct Professor, Faculty of Economics, UNE, Sydney, Australia. The view expressed here are solely that of the writer.

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