Now that the Federal Reserve has brought its programme of quantitative easing to a successful conclusion, while the French and German governments have ended their shadowboxing over European budget “rules”, macroeconomic policy all over the world is entering a period of unusual stability and predictability.
Rightly or wrongly, the main advanced economies have reached a settled view on their economic policy choices and are very unlikely to change these in the year or two ahead, whether they succeed or fail. It therefore seems appropriate to consider what we can learn from all the policy experiments conducted around the world since the 2008 crisis.
The main lesson is that government decisions on taxes and public spending have turned out to be more important as drivers of economic activity than the monetary experiments with zero interest rates and quantitative easing that have dominated media and market attention. Fiscal decisions on budget deficits, taxes and public spending have mostly been debated as if they were largely political choices, with much less influence than monetary policy on macroeconomic outcomes such as inflation, growth and employment.
Yet the reality has turned out to be the opposite. While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks.
Countries that took emergency measures to reduce public borrowing have mostly suffered weaker growth. In more extreme cases, fiscal tightening has plunged them back into deep recession and aggravated financial crises. Meanwhile countries that ignored their deficit problems, or where governments decided to downplay their fiscal tightening plans have generally done better, both in terms of economics and finance.
The one major exception has been Germany, where budgetary consolidation has managed to coexist with decent growth, largely because of a boom in machinery exports to Russia and China that is now over, pushing Germany back into the recession its stringent fiscal policy suggested all along.
Thus the six years since 2008 have provided strong empirical support for the supposedly outmoded Keynesian view that government borrowing is more powerful than monetary policy in stimulating severely depressed economies and pulling them out of recession. In a sense, it is odd that the power of fiscal policy has come as a surprise.
The underlying reason why fiscal policy is so important in recessions, and has now come to dominate over monetary policy, is a matter of simple arithmetic that should not be open to debate.
Recessions generally occur when private business and households decide to spend less than their incomes in order to reduce their debts or increase their savings. If this process of “deleveraging” is happening in the private sector, then simple arithmetic shows that economic balance can only be restored if some other sector of the economy spends more than its income — and such excess spending is only possible if that “other sector” is willing to increase its debts.
Disregarding the role of exports and imports, which must sum to zero for the world as a whole, the government is the only possible candidate to play the crucial balancing role as the “other sector.” It is therefore a mathematical certainty that governments must increase their borrowing whenever businesses and households decide to boost their savings by spending less than they earn.
Despite this indisputable arithmetic, there has been surprisingly little interest in the macroeconomic impact of budgetary policies in contrast to the endless debates about every twist and turn of monetary policy. The explanation lies in the monetarist theories that came to dominate standard economic models of the pre-crisis period — and the related institutional changes that elevated central bankers above finance ministers as the supreme arbiters of economic policy.
Monetarism overturned the Keynesian fiscal consensus that prevailed from the 1930s to the 1970s, by introducing one simple assumption into the models that guided governments and central banks. The case for Keynesian fiscal stimulus in deep recessions was simply assumed away by asserting that interest rates could always be reduced sufficiently to stimulate private investment, discourage private savings and so restore growth.
As a result, the private sector as a whole would never suffer for long from a shortfall in spending. Therefore government borrowing would never be needed to balance inadequate private demand.
As a result of these assumptions, interest rate decisions by central banks came to be seen as the only effective tool of macroeconomic management, while fiscal policy was relegated to a microeconomic supporting role. Tax structures and public spending levels were seen as supply-side issues influencing incentives and resource allocation, but the demand impact of government borrowing was largely ignored.
Whether government borrowing expanded or contracted, interest rates would rise or fall to offset the Keynesian demand effects. Independent central bankers would manage macroeconomic demand with monetary policy, leaving governments to set taxes and spending plans to achieve political or supply-side objectives.
In the era of high inflation when monetarism was introduced, the idea that interest rates could always be cut by enough to revive private economic activity was reasonable enough. After all, when inflation is running at 5 per cent, an interest rate of 1 per cent is equivalent to minus 4 per cent in real terms, imposing a massive tax on savers and offering a big subsidy to private investors.
But this argument fails completely when inflation falls to negligible levels or disappears completely. Ironically, therefore, the very success of monetarism and central banking in conquering inflation now means that the era of monetary dominance is over.
Keynesian fiscal thinking has triumphed and finance ministers are again more important than central bankers, even though most of them have not yet noticed.
Reuters
