"The pre-crisis consensus was, and remains, very strong – the business cycle would be managed by monetary policy, while fiscal policy would focus solely on debt sustainability. In a world of zero interest rates, however, fiscal policy has to contribute to supporting aggregate demand and protecting against deflationary risks. This column outlines three ways in which a well designed expansionary fiscal policy stance can contribute to better economic outcomes.
Expansionary fiscal policy is back in vogue. According to Bloomberg, the number of news stories with the keywords “fiscal stimulus” skyrocketed this summer to levels not seen since 2008. It is not just words. Fiscal policy has already become more stimulative in some countries. Canada led the way after the election of Prime Minister Trudeau, and Japan recently announced a large multiyear fiscal package. Quietly, fiscal policy has started to contribute positively to growth even in the US and the Eurozone, after years of austerity. Recent G20 statements all contain a version of the sentence, “We will use fiscal policy flexibly”.
What does ‘‘using fiscal policy flexibly’’ mean? It should be obvious, but it is not. The reason it is not obvious is that there is a strong intellectual anchoring effect in economic policy that has led to a very asymmetric view of fiscal policy. The pre-crisis consensus on the use and scope of fiscal policy was very strong, and remains strong today. The business cycle would be managed by monetary policy, while fiscal policy would focus solely on debt sustainability. In that world, fiscal policy was asymmetric. A smaller deficit and a smaller debt/GDP ratio were always better. That was a world of growth near potential, inflation at or above target, and positive nominal and real interest rates. That was the Great Moderation. That world created economic rules like the Eurozone’s Stability and Growth Pact, and many of the heuristics that economists use today.
The problem is that we remain anchored in the past, and we continue to apply today the same pre-crisis rules and heuristics about fiscal policy, ignoring the fact that we no longer live in that world. We live in a world of persistent insufficiency of demand, too low inflation, and neutral real interest rates that are likely to be zero or even negative.
And this new world is expected to persist. Looking far into the future, financial markets expect a continuation of very low interest rates. For example, Figure 1 shows the US real 10year swap interest rate, 10 years forward. It has declined markedly, from around 2.5% during 2004-2007 to about zero today. And the pattern is similar for the rest of the G7. Markets could certainty be wrong. But this pricing implies a very long period of zero real interest rates, a rather depressing outlook.
A well designed expansionary fiscal policy stance can contribute to better economic outcomes in three ways.
First, it can boost potential growth with multi-year public investment packages that raise productivity.
The multiyear nature of public investment would contribute to credibly lifting growth and inflation expectations. Public investment does not have to be limited to bricks and mortar; it can be anything that a given country needs to eliminate bottlenecks, including investment in human capital and spending to support those displaced by the reforms. With long-term interest rates at zero, there are surely many long-term public investment opportunities that can deliver positive returns and boost potential growth. In addition, at a time of excessive risk aversion, risk taking via public investment can catalyse private investment and unleash a virtuous circle. It will crowd in private investment, rather than crowd it out. With very low interest rates, the multiplier of fiscal policy is likely to be very large. As DeLong and Summers (2012) argue, public investment that boosts potential growth is self-financing.
Second, it can help monetary policy become more effective by increasing the supply of government bonds and raising the equilibrium real interest rate.
With very low neutral real interest rates, central banks have had to buy large amounts of government bonds to reduce long-term interest rates to zero, or even below, in order to provide enough stimulus. These central bank purchases are facing the constraint that financial institutions are facing to keep the needed monetary accommodation. A fiscal expansion would, in addition to boosting demand, increase the supply of government bonds and alleviate this scarcity (see also the discussion in Caballero et al. 2015). By reducing global savings, it would also increase the equilibrium real interest rate, amplifying the stimulus provided by monetary policy.
Third, it can contribute to reducing income inequality.
The strategy of focusing only on monetary policy to support demand may have contributed, at the margin, to the recent increase in inequality, as the main transmission mechanism of monetary policy at the zero bound has been asset price appreciation, which benefits dis-proportionally asset holders. Employment income growth has been steady in this recovery, but it has been a combination of solid job creation and stagnant wage growth. There is a risk that economies fall into a low wage growth trap, as has happened in Japan during the last two decades. A welldesigned public investment programme could generate higher-paying jobs and boost productivity. Combined with an expansion of income policies, as the IMF recommends to Japan in its 2016 Article IV report, it would lead to increasing wage growth, reducing inequality and buying political goodwill for reforms (see, for example, the proposals in Enderlein, Letta et al. 2016).
A typical criticism of this call for active fiscal policy is that there is no fiscal policy space, especially in the Eurozone. This is a debatable statement, given the very strong demand for government bonds that is pushing long-term interest rates to record low levels. And, in any case, it is time to create the fiscal space by accelerating the creation of a European fiscal policy, including Eurobonds (see the discussions in Ubide 2015, 2016b).
This call for a more active fiscal policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring effect of the Great Moderation that creates an asymmetric bias against fiscal policy. This need for symmetry in fiscal policy to support monetary policy is not just old fashioned Keynesianism, as it appears in a variety of theoretical frameworks, such as the fiscal theory of the price level (Sims 2016). Once growth and inflation pick up in a sustainable manner, it will be the time for fiscal consolidation. But, for now, with interest rates expected to be very low for a very long period of time, fiscal policy will have to be the main economic policy to support growth in the foreseeable future."