In this four part series titled No Economic Bullets Left?, former investment banker Satyajit Das sets out why it will be difficult for the world economy to get back to previous levels of growth. The first part looks at the failure of fiscal policies of governments around the world, and why available policy tools cannot address the underlying problems.
The stubborn refusal of the global economy to respond to policy initiatives is reminiscent of an obstreperous teenager. There is now renewed focus on using government spending on infrastructure to stimulate the global economy. It is not clear whether such a policy will work. Efficacy of stimulatory fiscal policy depends on a number of factors. If additional spending finances consumption, it needs to be ongoing to remain effective. If it finances investment such as infrastructure, then the long-run effect depends on the project. If the investments produce low-investment returns then the effect on the economy can be negative with capital tied up in poorly performing assets.
Ghost cities, empty buildings and airports, roads and bridges to nowhere in Japan, China and Europe highlight this problem. Once completed, investment projects also require ongoing maintenance which absorbs scarce financial resources, compounding the problem of low-return investments. In globally integrated economies, demand from stimulus spending can ‘leak’ into imports in the absence of co-ordinated national policies. The boost to domestic economic activity is reduced, creating or exacerbating trade imbalances. Misallocation of capital, motivated by political and ideological factors, can also diminish the benefits of stimulatory government policy.
In investment matters, governments are no more or less incompetent or inefficient than private businesses. Ultimately, the effectiveness of fiscal stimulus depends on the multiplier effect, the end increase in economic activity resulting from an additional dollar of government spending. If the multiplier is greater than one then it can potentially start a self-sustaining recovery. If below one, then it may have social benefits but will detract from growth, especially in the longer run. John Maynard Keynes famously argued for a scheme where workers were employed to dig holes and then fill them in.
The essence of the argument is government spending or public investment can restore economic health even where spending has no social value other than to provide employment. The consumption spending by newly employed workers is assumed to trigger a virtuous cycle of economic growth, increasing income and employment. Multipliers are poorly understood, difficult to measure and unstable, highly dependent on the broader economic context. International Monetary Fund (“IMF”) Chief Economist Olivier Blanchard and his colleague Daniel Leigh controversially found that the multiplier was considerably larger (up to 1.7) than expected (0.5) when fiscal austerity programs were implemented in many developed economies in 2010.
Simultaneous reduction of debt by governments as well as the financial sector, corporations and individuals led to a sharper contraction than expected. × Expansionary fiscal policy in an environment of contracting private sector demand and general reduction in debt may result in lower multipliers as the government cannot fully offset the fall in economic activity. Fiscal policy stimulates the economy via government spending in excess of tax revenues. Budget deficits require governments to borrow.
Empirical studies show a negative association between debt and growth, although a definitive maximum level of debt is not evident. As government debt rarely ever gets repaid, the ability to borrow is a matter of servicing the debt and maintaining investor confidence allowing refinancing. The level of tolerable sovereign debt depends on a multitude of factors. Where it borrows in its own currency, a sovereign’s capacity to borrow is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.
Where the borrowing currency is also a major reserve currency such as the US dollar, used in global trade or favoured investment of central banks, the scope for borrowing is higher. A large domestic saving pool, like Japan, enhances the ability of the government to borrow. Low interest rates enable higher level of borrowing. Ultimately, the crucial factor is expected economic growth. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attractive investment, can maintain a higher level of debt than one with lower growth prospects. Unfortunately, discussion of further fiscal stimulus ignores the high levels of debt, structural budget deficits, low growth rates and increasing borrowing costs that now make the public finances of many countries unsustainable.
After 2007/ 2008, most governments ran significant budget deficits, expanding borrowings to boost demand and/ or recapitalise the weakened financial system. The government debt would only be sustainable if growth returned quickly to high levels. As the global economy stagnated, bond vigilantes targeted weak countries, making it difficult to finance and forcing up financing costs. Nations were forced to implement austerity programs, cutting spending and increasing taxes to stabilise public finances and reduce debt, trapping them in recessions or low growth which only aggravated problems. It is not a problem of debt but of growth. Given recent economic growth was debt fuelled, reduction in credit growth slows economic activity making the borrowings unsustainable, feeding a deadly negative feedback loop into a financial crisis.