Era of Fiscal Consolidation Starts Here

Gavyn Davies Financial Times October 8, 2010

ft.com/gavyndaviesAll times are London time

News

Reading through the latest IMF economic forecasts, I was reminded of one very obvious fact: the expansionary fiscal response to the credit crunch is now well and truly over. The global economy is about to pass through an important inflexion point, in which the fiscal stance of the major developed nations is changing from broadly expansionary to broadly contractionary. Of course, everyone who has been paying the slightest bit of attention to economic events since 2007 knows that already. But the era of fiscal consolidation could be with us for a very long time, and the financial markets are only now begining to pay close attention to what this could imply.

During the credit crunch, governments found that they had little choice but to allow budget deficits to widen, both through the automatic effects of the recession, and through some (though much smaller) Keynesian fiscal expansion. According to my estimates (based on IMF calculations for structural budget deficits), the deliberate policy easing from 2006 to 2010 in the G7 amounted to 4.3 per cent of GDP. Two countries embarked on particularly large expansionary packages: the US (6.0 per cent) and the UK (5.2 per cent). The eurozone did much less (2.4 per cent) while Japan was in the middle (3.6 per cent.)

The relative positions in this league table seem mainly to reflect the size of the financial sector in the various economies. Because of their large financial sectors, the crisis caused a bigger collapse in tax revenues in the UK and US, and much of this has been scored by the IMF as a deliberate fiscal adjustment.

The vast bulk of the G7 fiscal easing happened in 2008-09, and fiscal policy in 2010 has been little different from neutral in any of the major economies. But many governments have spent this year planning to tighten policy in the medium term, and the medium term starts in 2011. In some cases, including the US, the extent of the tightening is not yet fully known, but we do know that it will not be zero. The state and local government sector is already set on a path to tighten fiscal policy by about 1 per cent of GDP in 2011, and the federal government will surely add to this tightening, even if the Republicans extend the Bush tax cuts after sweeping Congress in November.

In general, a good rule of thumb is that the extent of the tightening planned for the next two years is about half of the easing which countries chose to adopt during the credit crunch. Therefore the US and the UK are planning to do the most (about 3 per cent of GDP in each case), and the eurozone and Japan are doing much less (around 1 per cent).

The effects of this fairly sizeable fiscal tightening are hard to predict. Until recently, there were some optimists in the economics community who thought that the effects of this tightening could be fairly negligible for global GDP growth, because the beneficial effects on private sector confidence could out-weigh the contractionary impact of higher taxes and lower public spending. But some detailed research at the IMF points in the other direction, concluding that GDP tends to fall by around 0.5 per cent for every 1 per cent of fiscal tightening over a two year period. And that assumes that interest rates and the exchange rate can both be reduced in the countries which tighten fiscal policy. With interest rates already at zero, and several large economies contracting their fiscal stance at the same time, these two offsetting channels seem to be partially blocked at present. That being the case, the IMF says that the damaging impact on real GDP could be greater than suggested above, maybe even twice as big.

Having said that, senior figures at the Fed and (probably) the Bank of England have taken very definite note of the fact that the fiscal tightening in in the US and the UK will be bigger than elsewhere, and they see it as their responsibility to conduct more quantitative easing to try to maintain GDP growth as the budget deficit is brought down. This stands in sharp contrast to the attitude of the ECB, which is still strongly of the view that tighter budgetary policy does not need to be accompanied by much, if any, monetary easing. Whether they can maintain that view in the context of a much higher euro exchange rate seems doubtful, but there is no sign of any imminent change in their thinking.

In the aggregate, then, there will be a marked shift in the global policy mix, involving tighter fiscal policy and easier monetary policy, and that change will be bigger in the US and the UK than in the eurozone. In the short term, a tighter fiscal/easier monetary policy mix is usually somewhat damaging for immediate GDP growth, good for bonds, bad for the exchange rate and ambiguous for equities. We are already seeing many of these effects being played out in the markets, though equities are currently choosing to take the optimistic view that more QE from the Fed will dominate the impact of tighter fiscal policy. In the longer term, this policy mix can lead to asset price bubbles. As explained in this earlier column, the emerging markets seem to be the prime candidates for new asset price bubbles as the new policy mix takes effect.

Era of Fiscal Consolidation Starts Here

Related Articles