The dawn of fiscal reality?

The week in markets ended on a volatile note as they began to digest the full economic implications of President Donald Trump. Emerging markets took the full brunt as it dawned upon them that the protectionist rhetoric which passed for economic debate during the election campaign was now a step closer to being realised. But bond markets also sold off sharply. The yield on 10-year Treasuries has risen by 30 basis points since Tuesday, dragging other industrialised markets in their wake. This in turn was triggered by fears of higher inflation stoked by a significant expansion of US fiscal policy.

According to analysis by the Tax Policy Center (here), Trump’s tax proposals would boost growth but cut Federal revenues. They include reductions in marginal tax rates; increases in standard deduction amounts; lower personal exemptions; caps on itemised deductions and allowing business to expense investment rather than depreciating it over time, though businesses doing so would not be allowed to deduct interest expenses.

A simple static calculation of the costs suggests this would  cut revenues by $6.2 trillion over the first decade. But a looser fiscal stance would boost output, with simulations indicating an increase in output of between 0.4 and 3.6 percent in 2017, 0.2 and 2.3 percent in 2018, and smaller amounts in later years. The analysis indicates that over the first eight years, higher activity partially offsets the static revenue losses. But in the longer-term higher interest rates resulting from bigger budget deficits begin to crimp investment, thus leading to slower GDP growth and even higher revenue losses. All told, the plan would increase the debt-to-GDP ratio by 25.4% over a ten-year horizon and by 55.5% by 2036. Faced with these kinds of numbers, it is hardly surprising that bond markets are worried.

But just as a Trump presidency raises fears about the long-term prospects for free world trade, so it could also mark a pivotal moment in the mix between fiscal and monetary policy. Although the attacks by politicians on the independence of central banks in recent months have overstepped the mark, both the Brexit and US presidential votes suggest that electorates are fed up with what they are getting from governments. Indeed, households in all industrialised economies are not paying any less tax but they are receiving less back from the state as outlays are cut. With the UK government due to present its Autumn Statement on 23 November, the expectations are that it will adopt a much less aggressive approach to eliminating the public deficit than we have seen over the last six years.

Some of us would say that it is about time governments recognised that fiscal policy has a role to play in helping to get the economy back on its feet. It is certainly one of the key lessons of the 1930s, when the policy of monetary orthodoxy in the wake of the crash of 1929 contributed to the severity of the Great Depression. My own efforts to get this message across have fallen on deaf ears in recent years, with continental European economists particularly hostile to the view. But in a paper in early 2015, I pointed out that IMF research indicated that fiscal tightening could – under certain circumstances – prove to be counterproductive. Everything depends on how high we believe the fiscal multiplier to be. In simple terms, the multiplier measures the proportional change in economic output for a given change in the fiscal stance. Thus, if a fiscal tightening (expansion) of 1% of GDP produces a reduction (increase) of less than 1% in GDP the multiplier is less than unity. This can be used to justify a policy of fiscal austerity to tackle excessive fiscal imbalances.

But if a 1% fiscal tightening produces a decline of more than 1% in GDP, the multiplier is greater than unity and a policy of austerity becomes self-defeating. Prior to the Great Recession, the standard view was the multiplier was less than unity. However, much of the recent academic evidence indicates that pre-recession estimates may have been too low, which should give pause for thought in the fiscal policy debate. I will highlight the empirical analysis resulting from this paper on another occasion, but suffice to say that for countries such as Greece the multipliers appear to have been larger than initially assumed. This in turn has contributed to what can only be described as a Greek economic depression.

Governments and policy makers across Europe woke up this week to the fact that popular resentment is rising. The EU may have been able to dismiss the Brexit vote as a little local difficulty in a country which has never bought into its ideals. But it cannot ignore the message from the US electorate. It may be too late for Italy, which heads to the polls on 4 December.  But the French election next spring now assumes even greater relevance for the future of the EU project.