Saturday, September 21, 2019
Let's get fiscal, but avoid the mistakes of the past
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt.

This has been a busy month for central banks. A few days ago America’s Federal Reserve cut official interest rates by a quarter of a point, citing weaker business investment and exports. A few days before that, the European Central Bank (ECB) announced what its chief economist described as a comprehensive package of measures, which included a cut in one of its rates, the deposit rate, from -0.4% to -0.5% and the resumption of quantitative easing (QE) at €20bn (£17.7bn) a month from November.

Neither decision was without controversy. The Fed split three ways, with one member of its decision-making committee favouring a bigger rate cut and two none at all. The ECB’s moves produced much tut-tutting, particularly from Germany and the Netherlands, with the head of the Dutch central bank, Klaas Knot, saying they were “disproportionate to the present economic situation”.

On one thing, however, central bankers can agree, and this also applies to the Bank of England though it, as expected, did not join in with the others in changing interest rates on Thursday, though its tone was noticeably more “dovish” than before.

It is that there is a limit to what central banks can do. Monetary policy had its moment a decade ago, when the financial crisis hit, and it has continued to have its moments since then, with ultra low interest rates and very large dollops of quantitative easing (QE). But the fact of that action, which leaves little room for rates to be cut further, and amid convincing evidence that QE has lost the potency it once had, means the focus is shifting and, according to some central bankers, should shift further. Fiscal policy – public spending increases and tax cuts – needs to play a bigger role.

Mario Draghi, the outgoing ECB president, has been most vocal on this. “It’s high time fiscal policy took charge,” he said last week. “If fiscal policy had been in place, or would be put in place, the side effects of our monetary policy would be much less.”

This is a particular issue in Europe, where a debate is raging in Germany about fiscal po0licy and the country’s balanced budget rule. Its finance minister Olaf Scholz has said that Germany is ready to provide a stimulus of “many billions” should recession make it necessary.

The argument, however, goes beyond Europe. The Organisation for Economic Co-operation and Development (OECD), in a new interim economic outlook which was downbeat about UK growth prospects – 1% this year, 0.9% next, and much worse if there is a no-deal Brexit – also made the fiscal point.

Loose monetary policy, it said, should be accompanied by fiscal policy, it said, adding: “Fiscal policy needs to assume a bigger role in supporting growth in the advanced economies. Exceptionally low interest rates provide an opportunity to invest in infrastructure that supports near term demand and offers benefits for the future.”

For the Federal Reserve and the Bank, the point barely needs making. Though Mark Carney, the Bank governor, has made the point that there are limits to what the Bank can do, particularly in the event of a no-deal Brexit, a significant fiscal relaxation is already taking place. Bank economists estimate that Sajid Javid’s spending review this month, which boosted public spending next year by more than £13bn compared with previous plans, will add 0.4% to Britain’s gross domestic product over the next three years.

As an aside about the Bank, I had in my diary November 7 for Carney’s final inflation report press conference but now it seems as if that date could come and go without his successor being announced. Political uncertainty, it appears, means governor uncertainty, with the appointment of a new one possibly delayed by the prospects of a late autumn general election. I don’t imagine that he wants to extend his stay for any longer than necessary, but the chances of his still being there when the Bank publishes its February inflation report (he was due to leave at the end of January) have increased.

The Federal Reserve, which has now switched to cutting rates, based its earlier hikes partly on the fact that Donald Trump, who putting it mildly is no fan of the Fed, had unleashed his own fiscal expansion, mainly through tax cuts. Now the president’s policies, notably his trade war with China, are slowing the US economy, but already this fiscal year the budget deficit has topped $1 trillion (£800bn).

Trillion dollar deficits now extend into the indefinite future in America, even though the president’s plan to transform US infrastructure has yet to see the light of day.

The logic of a shift towards more activist fiscal policy in Europe, including Britain, looks incontrovertible, even though Germany is moving to this understanding very reluctantly. Austerity fatigue set in some time ago, and borrowing costs are low. That is why, as well as some tax cuts later this autumn, the chancellor is keen to announce some meaty increases in infrastructure spending next year.

When, however, do we start to worry that governments are repeating the errors of the run-up to the financial crisis? Then, you will recall, public finances were vulnerable going into the downturn and the subsequent fiscal repair job was all the more demanding, and longer lasting. Only now, a decade on, have we seen a meaningful public spending relaxation in this country.

America looks to be an outlier in this; Trump’s tax cuts were big and expensive and the budget deficit is running at 4% of GDP even at the top of the cycle. Britain is different. The underlying, or “structural” budget deficit is running at just over 1% of GDP, despite what looks like an overshoot this year. That compares with an average of 3.3% of GDP in the four years leading up to the crisis. There is room for manoeuvre, which the government seems determined to use.

The main argument here is one of timing. The Office for Budget Responsibility (OBR) has warned of a £30bn annual hit to the public finances in the event of a no-deal Brexit; in other words an £30bn or roughly 1.5% of GDP boost to borrowing.
The Resolution Foundation, in a new report, suggests that a no-deal would require a £60bn policy response; £40bn as a straightforward fiscal boost to increase demand and help the economy to avoid a deeper recession, and £20bn in “emergency supply support” to help businesses through the worst of any disruption.

The actual policy response would depend on the extent of the damage. One reason why Philip Hammond, Javid’s predecessor, held back was to keep some powder dry in the event of needing it to respond to a no-deal downturn. A government that went into such a downturn with the fiscal afterburners already turned on would risk a double hit to the public finances.

One way or another we are getting a fiscal relaxation, and that is no bad thing. But, as I am sure the Treasury is reminding the chancellor, the line between a responsible loosening of fiscal policy and something that stores up big problems for the future is a narrow one.