The future of fiscal policy without traditional constraints

The writer is chairman of Fulcrum Asset Management

The surge in public debt in the major advanced economies caused by the pandemic continues apace.

Even on the very optimistic assumption that there will be no need for further major economic lockdowns, Fulcrum economists calculate that the ratio of gross government debt to gross domestic product in the major advanced economies will reach about 141 per cent next year, a rise of around 26 percentage points from 2019. More than half of this extra debt has been absorbed by the central banks.

Few economists argue that this remarkable policy response to a global emergency is mistaken, but it could profoundly alter perceptions about the appropriate settings for fiscal policy.

As the vast expansion of public debt has not been constrained by concerns about rising inflation or interest rates, at least in the short term, the traditional reasons given by governments for controlling their budgets will have less political force — especially in the US, if Joe Biden sweeps the board in next week’s presidential elections.

Lawrence Summers, whose speech on “secular stagnation” in 2013 was the most perceptive economic pronouncement of the past decade, has argued that macroeconomics is experiencing a “revolution” similar to the seismic shift towards inflation control in the late 1970s. From now on, there will be “a focus on assuring adequate demand and fairness in our economies”, driven mainly by expansionary fiscal policy.

Mr Summers admits that this policy choice will come with risks but, in the immediate future, it will probably bring net benefits. The medicine needed to treat the pandemic may prove appropriate in future years as well.

The structural economic changes that have shaped the policy response to the pandemic have been persistent for several decades. Real and nominal interest rates in advanced economies have trended strongly downwards since the early 1980s, mainly because private savings have been excessive relative to investment — the prime symptom of secular stagnation.

Inflation has been held at very low levels for the same reasons, encouraging central banks to expand the monetary base by acquiring government debt. This form of monetary expansion has defied the pessimists by having essentially no effect on global inflation.

Leading central bankers, including the US Federal Reserve’s Jay Powell and Christine Lagarde at the European Central Bank, are therefore demanding more, rather than less, support from fiscal stimulus. This is very different from the attitude after the 2008 financial crisis, when many leaders in global policymaking argued the rise in public debt should be brought back down.

Such has been the change of mood, even among the most orthodox of economists, such as Olivier Blanchard, that it is natural to worry lest the temptation to spend more and tax less will get out of hand. There are plenty of causes — for example, the green economy, a universal income and infrastructure renewal — that would encourage much higher budget deficits under an administration led by Mr Biden.

With the buffers of inflation and interest rates removed, how can investors tell when politicians are delivering too much of a good thing? Although solvency crises seem improbable in advanced western economies, which can pay down debt by creating money, a wise government will want to limit the risks of debt ratios rising indefinitely. Bond markets and inflation may be somnolent, but they are not comatose.

When the pandemic is over, policymakers should, therefore, seek to limit any further trend rise in debt ratios. With interest rates below the growth rate of the economy, debt sustainability models indicate this can be achieved while continuing to run deficits on the primary budget balance (ie excluding interest payments), but there needs to be a ceiling on deficits over the economic cycle.

For example, for the US to hold its debt ratio below 140 per cent of GDP, it could run an average primary deficit of about 4 per cent of GDP, assuming nominal interest rates at 0.75 per cent, real GDP growth at 1.6 per cent and inflation at 2 per cent. This is broadly in line with IMF forecasts on announced economic policy from 2022-25.

The temptation for a Democratic administration would be to run even bigger deficits than this, in which case debt ratios and fiscal risks would certainly begin to rise — even before adverse demographic trends demand still higher borrowing in the 2030s.

At some point, debt will reach a limit, but most economists are now betting that this is a very long way off.

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