The case for policy coordination
We previously discussed helicopter money, which is essentially a very strong form of coordination between fiscal and monetary policy. The main lesson is that in a world where monetary policy is running into diminishing returns, the increased use of fiscal policy can enhance its effectiveness. What’s more, there may be synergies between monetary and fiscal policy but the size of these will depend on the specific circumstances. These synergies may not be very big in circumstances where fiscal policymakers are constrained by high debts or high term premiums and/or in which monetary policy is not running into diminishing returns. Still it is useful to pay some more attention to them. Before we do this we should ask ourselves how fiscal and monetary policy came to be so separated in the first place. After all, we live in a world where independent central banks are purely focused on price stability and financial stability, while fiscal policy is concerned with sovereign debt sustainability and stimulating potential growth through tax incentives and public investment. However, there are very clear links between the policy levers as both affect overall spending and safe Treasury yields while both involve changes in public sector liabilities (bonds and central bank money).
For a long time these links were not deemed important enough to aim for more explicit coordination, because there was one overriding problem which made the separation of fiscal and monetary policy desirable. This problem was the high and variable inflation expectations created in the 1970’s and early 1980’s which could only be tamed by divorcing monetary policy from the political business cycle. This was achieved by delegating the attainment of price stability to experts who could not be put under pressure by politicians seeking short-term electoral gain. The war on inflation was won convincingly by the late 1990’s but the strategy remained in place because the Great Moderation seemed to prove its continued success. Meanwhile, the role of fiscal policy as a stabilizing factor for the business cycle was downgraded further by the notion that recognition, decision and implementation lags made the effect of fiscal policy on growth long and very variable. This implies a risk that a fiscal action which is meant to be anti-cyclical will end up working in a pro-cyclical manner. In that case monetary policy would have to be adjusted to maintain price stability so it was best to leave the management of the business cycle to central banks in the first place. Before 2008 we thus had clear monetary dominance over fiscal policy.
The case for more coordination
While all this seems pretty convincing in a world where GDP is mean-reverting to trend over a relatively short horizon, the argument for strong monetary dominance loses at least some of its power in a world of persistently disappointing growth rates with little evidence of the level of GDP returning to some stable trend. In this world it is clearly pretty useless to continue to fight the last (anti-inflation) war and we should ask our-selves the question whether the chances of victory in the current anti-stagnation war will be increased by more explicit coordination between fiscal and monetary policy. In the strictest sense of the word, some coordination was present even in the era of monetary dominance. The central bank could work under the assumption that monetary policy would not be used to ensure fiscal solvency in the case of an irresponsible government (which will be forced into responsibility by rising borrowing costs). Similarly, fiscal policymakers could count on relatively predictable outcomes in terms of the output gap and inflation (both of which are prime drivers of tax revenues). Nevertheless, it may be useful to step up the degree of coordination, especially in DM regions where monetary policy has not been able to push nominal GDP back on some kind of upward trend. Such a trend exists in the US, even though it is below the pre-2008 trend. Also in Europe nominal GDP has embarked on a renewed upward trend, but in a much more subdued way than in the US. By contrast, Japanese nominal GDP is still below the 1997 and 2008 peaks.
At the minimum, this enhanced coordination should imply that monetary and fiscal policy do not reduce each other’s effectiveness. Between 2010 and 2013-14, fiscal policy in many DM economies clearly reduced the degree of monetary policy accommodation for any policy stance set by the central bank. At times, strong and concerted fiscal consolidation in this period reduced neutral real policy rates (i.e. the real policy rate consistent with full employment). Since then, the fiscal stance has turned broadly neutral to slightly supportive, so in this respect fiscal/monetary coordination has clearly improved. A further step on the road to more coordination could be taken if fiscal policy made a more explicit ex-ante commitment to support aggregate demand in the event of a downturn, especially if the recession causes monetary policy to hit the effective lower bound again. In some form, such a promise already exists to the extent that the private sector believes that the government will allow the automatic stabilisers to work and will refrain from discretionary tightening during downturns. Such commitments could be further enhanced by creating a mechanism which triggers automatic increases in infrastructure or other discretionary spending once some well specified set of thresholds for the policy rate and the unemployment rate are hit. If such a mechanism is credible it could help in allowing private sector expectations to play a stabilizing role, i.e. in anticipation of fiscal easing nominal growth expectations would then receive some support.
One can even imagine stronger forms of coordination which involve fiscal and/or monetary policy subordinating the objectives they target in normal times to the achievement of some wider common goal. Logically, this overriding common objective would be sustained and solid positive nominal growth at the current juncture. This objective is currently pretty much in line with central banks’ goal of anchoring inflation expectations to the target which is why it is mostly fiscal policy that needs to deviate from its normal objective of debt sustainability. Perhaps we should make the latter more precise: It means that fiscal policy will have to refrain from fiscal tightening as an instrument to achieve debt sustainability. That is a good thing anyway. Fiscal austerity is an effective way to bring down debt in times of healthy private sector demand growth. However, it will backfire big time in the presence of a large output gap and constrained monetary policy. In such an environment, by far the best way to ensure debt sustainability is to put nominal GDP on a sustained steeper path.
Even though it is mostly fiscal policymakers that will have to do most of the adjusting at the current juncture, one cannot exclude that monetary policymakers will have to deviate somewhat from their goals in the more distant future as well. While fiscal expansion works to raise the neutral real policy rate, it is the central banker’s job to keep actual real rates low. If the output gap is still large and inflation is still well below target, they will have little trouble doing so. However, there may come a point when it is in the interest of overall economic welfare to allow for a moderate inflation overshoot for some time. Last week, we already discussed how the promise of an inflation overshoot can be used as a commitment device to convince the private sector that QE will not be reversed any time soon. This inflation overshoot is essentially necessary to prove to the private sector that inflation will be equal to the target on average in the long run, i.e. the past years of undershooting need to be made up for in a sense. The concomitant expectation that QE will not be reversed within the planning horizon of the private sector will essentially prevent a taper tantrum-like scenario.
Still, the argument can be taken further than that. In the case of a very high sovereign debt to GDP ratio, medium-term macro performance as well as financial stability may be best served by a combination of persistent above-target inflation and financial repression. In this case, the actual real rate will be kept below neutral for a prolonged period of time and regulation can be used to create a larger “captive audience” for sovereign bonds. This strategy was essentially used by the US after WWII and it ensured that an initially very high level of sovereign debt was quickly and relatively painlessly eroded in real terms. Of course, this came at a cost in the form of an inflation tax levied on bond holders and the holders of cash. By contrast, Britain after WWI was determined that its bond holders should not lose out in real terms. During the war, the UK price level had risen and Sterling had depreciated relative to its Gold Standard exchange rate. To reverse these trends, the government had to pursue a combination of tight fiscal and monetary policy with disastrous consequences in terms of economic stagnation, high rates of unemployment and deflation. All of these ensured that fiscal deficits remained at a high level, despite severe policy tightening.
A closer look at Japanese fiscal and monetary policy
One of the economies where closer coordination between fiscal and monetary policy is most called for – given its high sovereign debt-to-GDP ratio and lack of nominal growth – is clearly Japan. In fact, it could well be that Japan will not be able to achieve a sustained reflation (defined as a sustained upward sloping nominal GDP path) without going the same way the US did after WWII. This means aiming for a persistent if moderate inflation overshoot while keeping bond yields low via monetary policy and regulation. This means that that bond holders will lose out, but this loss should be put in perspective because these same bond holders have benefited big time from the era of deflation which delivered years of very decent real returns. If one bears in mind that these bond holders tend to be among the older age cohorts in an ageing society, one can understand why the reflation effort in Japan is still met with resistance in some parts of society.
Despite this resistance, Abe still seems determined to achieve sustainable reflation and his government announced a new fiscal plan earlier this month to the tune of around 5.5% of GDP. This is smaller than the crisis fiscal packages of 1998 and 2008-09, but still the third biggest package in the post-war period. Nevertheless, in Japanese fiscal policy space the devil is always in the detail and the detail is very complicated indeed. A lot of this package contains previously announced measures, double counting, guarantees for private sector loans and direct loans to the private sector. So called ‘fresh water’ fiscal measures (i.e. the true underlying ease in fiscal policy) amounts to only around 1.5% of GDP and it is unclear how this will be distributed over the next few years. Nevertheless, combined with the earlier announcement that the VAT hike will be postponed, the package means that fiscal policy will be around 1% of GDP easier than seemed at the start of this year. This is significant for an economy with a potential growth rate closer to 0.5%. Despite this, there may be a big fiscal cloud on the horizon for 2018 because Abe maintains his target for a balanced primary budget for FY2020. If the government follows through on this promise, this means that fiscal policy may need to be tightened substantially from 2018 onwards. Because 2018 may well be within the planning horizon of parts of the Japanese private sector this, in turn, could mean that consumers and businesses start to save more in anticipation of future tax increases. To the extent that this happens, the effectiveness of 2017 fiscal easing for 2017 will be lower.
Hence, it is important that this fiscal constraint of a balanced primary budget by 2020 will be relaxed. When thinking about this, one has to bear in mind that the objective underlying this constraint is that the government wants to improve its solvency. Operationally this amounts to a reduction in the ratio between JGB’s outstanding in the private sector and nominal GDP. We hope to have made it abundantly clear that a sustained steeper upward sloping path for nominal GDP is very much a necessary condition for this. In practice, this means that Japanese fiscal policy should give up on using fiscal tightening as a means to achieve debt sustainability and fully cooperate with monetary policy in achieving sustained reflation. One way to do this would be to give up on the FY2020 balanced primary budget goal. In our view, that would be desirable but I can see that this may come at the cost of lowering the credibility of fiscal policymakers (given the fact that they have been so vocal about this target until now) or a downgrade by the rating agencies. Another avenue would be to limit the growth rate of the stock of JGB’s in the hands of the private sector and to credibly promise that this situation will be maintained at least until reflation has been well established. The way to do this would be for the BoJ to continue to buy large amounts of JGB’s and to promise to keep them on its balance sheet until inflation has been above 2% for long enough to make the target of achieving 2% inflation on average in the long run credible.
Emerging markets: a modest EM growth pick-up
The main theme in emerging markets currently remains the improving economic growth momentum. Our own EM growth momentum indicator has been showing a convincing positive trend already for several months. In recent weeks, the growth improvement has received an increasing amount of attention in economic research and in the financial media.
With financial conditions in the emerging world getting looser and looser thanks to improving capital flows, there is more room for EM growth to benefit. But improving growth momentum does not mean that strong growth is returning to EM. The slowing Chinese fixed asset investment growth and still weak global trade picture – earlier this week, Taiwan published again weaker export orders, at -3% year-on-year – remain important headwinds.
Some countries have found their way in lifting infrastructure investment, but this is not a broad theme yet. For now, Indonesia, India and Mexico are the only convincing examples. Fixed asset investment growth in most emerging economies remains negative or far below long-term averages.
For now, we see ample room for EM growth to improve, on the back of the very favourable global liquidity environment. But more reforms are required in more countries, to strengthen or rebuild the endogenous drivers of growth. Only then we can expect EM growth to move back to levels above 3% simple average, where we have not been for years. To get a better idea where growth momentum is, what the level of improvement from the trough is, we prefer to use a simple average of the 15 main emerging economies. This because a weighted average is always dominated by China, which represents 40% of the total. With China on a structural growth decline path, the weighted average EM growth number has limited room to improve.
The trough in the simple average of EM growth was reached in Q4 2015, at 2.3%. In the past quarters, growth has picked up to 2.5%. We expect this recovery to continue – modestly – to 3.2% by the end of 2017.
Willem Verhagen, senior economist and Maarten-Jan Bakkum, senior Emerging Markets strategist at NN IP