Apart from a brief splurge in the immediate aftermath of the
financial crisis, western governments have generally adopted a tight fiscal
stance over the past decade with the result that it has been left to central
banks to do nearly all of the policy easing. In my last post, I noted that we
have broadly reached the limit of what monetary policy can be expected to
achieve and that during the next cyclical downturn fiscal policy will have to
play a much bigger role. This raises two questions: (i) how much impact will
fiscal easing have and (ii) how much fiscal room do governments have?
With regard to the first issue, the now accepted wisdom is
that fiscal multipliers are higher than expected prior to the last recession.
Much of the evidence available prior to the Great Recession suggested that
fiscal multipliers in the developed world were significantly less than unity.
In other words, a one percentage point fiscal injection produced a long-run
increase in output of less than 1%. If that is indeed the case, the economy
would be relatively unresponsive to a fiscal injection and the resultant
increase in debt could be judged to be too costly.
But four years after the crash, the IMF concluded that it
had underestimated fiscal multipliers by between 0.4 and 1.2. On the assumption
that the pre-recession average was around 0.5, the updated research suggests
that the true multipliers are in the range 0.9 to 1.7 which is a whole
different ball game. Furthermore, they concluded that the efficacy of fiscal
policy is greater when interest rates are at the lower bound, as they have been
for the past decade but which was never seriously considered prior to 2008 as
it was not an outcome that many people foresaw. However, on the basis of the latest
empirical evidence it appears that a fiscal expansion will deliver a decent
bang for the buck.
But can governments afford to expand fiscal policy when
government debt levels are already very high? Obviously, the current position
in which public debt levels across Europe average more than 80% of GDP is not a
great place to start. But an environment in which interest rates remain low has
created a significant degree of fiscal space for governments. The concept of
fiscal space is defined as how much governments can borrow without losing
market access or facing sustainability challenges. Conventional economic wisdom
suggests that markets will limit their purchases of sovereign debt if it is
rising at a rapid pace, and require compensation in the form of higher yields.
Higher yields raise the cost of debt servicing and increase outlays on interest
income which, if they cannot be offset by spending cuts in other areas, result
in higher deficits and debt. There is thus a dynamic link between interest
rates and debt. But in today’s environment interest rates are lower for any
given level of debt than we might have thought possible in the past, hence the
idea that fiscal space has increased.
The well-known solvency conditions for public debt depend on
the primary deficit (i.e. excluding debt servicing costs), the rate of nominal
GDP growth and the interest rate on debt (see chart). The higher the deficit or
interest rates the greater the upward pressure on debt-to-GDP ratios, whilst
the faster is GDP growth the more downward pressure there is. Getting the
balance of these factors right is an important consideration in fiscal
solvency, as it suggests it is possible to run a public deficit and still
broadly keep the debt ratio stable, depending on the extent to which GDP growth
exceeds the interest rate.
This growth/interest rate nexus thus becomes crucial. To
look at this in a long-term context I have taken data for the UK going back to
1700. During the 18th and 19th centuries on average, the
interest rate on debt was higher than the rate of GDP growth. Even though the
UK did run a primary surplus over the period, the debt ratio continued to creep
upwards from around 20% of GDP in 1700 to 200% by the end of Napoleonic Wars
and only fell back below 100% in 1861. On average during the 19th century
the debt ratio averaged 120%. But although the UK ran a primary deficit on
average during the 20th century, the rate of GDP growth exceeded the interest
rate with the result that the debt ratio tended to fall. Even though the debt
ratio hit almost 250% in the wake of the Second World War, a combination of
solid growth and financial repression which put a lid on interest rates, was
sufficient to produce a significant reduction in the debt ratio to just above 20%
by the early-1990s.
The takeaway is that high debt levels need not be the
obstacle to fiscal expansion that many politicians seem to think. Admittedly,
GDP growth has slowed over the last decade compared to what we were used to
prior to 2008, but even if trend real growth is in the range 1% to 1.5% and
inflation remains stuck at 1.5%, this implies nominal GDP growth of around 2.5%
to 3%. Meanwhile central banks are currently engaged in a policy of financial
repression (though they would never call it as such). Right now, 10-year yields
in the UK are just above 0.8% and in Germany they are well into negative
territory at -0.3%. Clearly, therefore, nominal GDP growth is higher than the
interest rate on debt and a quick calculation allows us to estimate the size
of the primary deficit that will allow the debt-to-GDP ratio to remain stable[1]. Current
figures for the UK, for example, suggest that a deficit of 1.9% is eminently sustainable.
To those politicians who argue that reducing the debt ratio is
an objective of itself, I pose the question why? The demand for long-term
government paper has never been higher as investors who are flush with the
liquidity created by central banks fall over themselves to find a place to
invest it. This is not to say that governments should be opening the taps with
no regard for the future. After all, if rates do rise the cost of servicing
high debt levels will also increase. But there is scope for a judicious
loosening of the reins, and there has never been a better time to use the
opportunity afforded by low interest rates for social purposes. Those European
governments who are passing up this opportunity (and not just those in the euro
zone) are guilty of sloppy economic analysis, and perhaps even more
egregiously, impoverishing their citizens for no good reason. Fiscal
opportunities like this have historically not come around often.
[1] Primary
deficit = (Debtt-1/ GDPt-1)*(1-(1+it)/(1+yt))
(assuming stock-flow adjustment equals zero)
No comments:
Post a Comment