Ever Closer to Dependence Upon Fiscal Policy

Published: August 2019 (5 Min Read)

I have written previously about the need for UK macroeconomic policy to shift towards fiscal expansion and both Conservative and Labour policies are headed in that direction. Boris and Jeremy are really intoxicated by the thrill of promising largesse, and last night’s by-election results will only encourage them further.

There is ample evidence now that lower for longer interest rates benefit the “haves” more than the “have-nots”, and the public has noticed too. Without policy intervention the inequalities will inevitably grow. Jeremy definitely understands this, but I am not sure if Boris does. He needs to. His largesse is more oriented towards the “haves” currently.

Let’s assume that substantial fiscal expansion in the UK is in the offing. What would happen to interest rates? Historically they would have risen under these circumstances, but I am not sure that they would in today’s economic environment.

Long term economic stagnation seems to be a real risk in the West of strong growth despite significant stimulus from central banks.

Recently papers from leading economists, Olivier Blanchard and Larry Summers, which underpin this point of view have been published – “Evolution or Revolution? Rethinking Macroeconomic Policy after the Great Recession”.

Their line of thinking is as follows:

“The notion that low rates were largely an after-effect of the financial crisis and would slowly rise has simply proven wrong. In the United States, 10-year real interest rates have declined significantly in recent months and are about where they were 18 months ago despite the passage of major tax cuts. In response to concerns about a possibly weakening economy and the absence of inflation pressure, the Federal Reserve chair has signalled that the current tightening cycle may be over with short rates below 2.5 percent.

“In Europe, in response to economic weakness, the authorities have pushed back the date at which interest rates will return to positive territory for several years and have now shifted to discussing restarting quantitative easing (QE). In both Germany and Japan indexed bonds suggest negative real rates as a feature of economic life for the next generation.

“At the same time, fiscal policy has continued to be expansionary—in Japan, the United States (strongly), and Europe (mildly)—without leading to anything like overheating. Despite this fiscal stimulus, inflation has barely reached the Fed’s inflation target, and market expectations are for less than 2 percent inflation even for 30-year forecasts. In the euro area and Japan, inflation remains below target, with little indication that the target will be met any time soon. This weak inflation suggests that despite aggressive monetary and fiscal policies, either expected inflation is still below target, or output is still below potential, at least in these two economies.

These two developments lead to the inevitable conclusion that fiscal policy will have to play a much bigger role in the future than it has in the past.”

I am probably guilty of confirmation bias, but it makes sense to me.