The recent financial and economic (crisis) has underscored the limits of monetary policy, and endowed fiscal policy, severely mauled several years ago by Milton Friedman and the Chicago School, with the new-found halo of macro-economic tool of last resort. What is less prominently underscored, however, is that beyond restoring growth, the crisis has also defined entirely new spheres for fiscal policy, such as financial stability and correcting global imbalances. These new roles would make fiscal exit, already complicated by the confluence of rising (crisis related) cyclical and (ageing related) structural deficits, even harder. They also compound the difficulties of keeping public debt, including contingent liabilities in the form of effective public guarantees, within sustainable levels.
Some emerging markets had no doubt been using fiscal policy as part of their overall strategy to counter the destabilising impact of large capital inflows. Financial stability, however, has traditionally been addressed through regulation that ensured transparency, avoided conflicts of interest through firewalls, protected consumer and shareholder rights, ensured liquid and competitive markets, put limits on leverage, and mandated adequate capital buffers to avoid liquidity traps and provision for losses, etcetera. The recent crisis has now underscored how fragile and procyclical financial markets can be and, with several financial institutions being considered too systemically important to be allowed to fail, taxpayers’ money and guarantees are likely to be used to bail out what are essentially public utilities.
One way of addressing the issue is to break up financial institutions too large to fail, and raise capital buffers, including fee-based contributions by financial institutions to Federal Deposit Insurance Corporation (FDIC)-type insurance bodies that can resolve individual failures. The international consensus, at least in advanced economies, however, appears to be veering in the direction of taxing the financial sector to recover, and provide for future, public bailouts in the belief that, consequential moral hazards notwithstanding, these are eventually unavoidable. The underlying belief is that it is neither desirable nor practicable to break up big financial institutions. The International Monetary Fund (IMF) has lent its considerable authority and influence to this viewpoint. These taxes may initially be a new source of revenue but have the potential of distorting markets, fuelling new public expenditures and subjecting taxpayers to greater risks in the long run.
Despite the fact that the global economy has rarely been balanced, and current account imbalances reflect developmental, demographic and cultural asymmetries across nation states, the recent crisis has painted global imbalances as the fall guy whose disciplining is essential to reduce future risks to the global economy. Reducing global imbalances has become the subject of a raging debate amongst economists, in financial daily OpEds and within the G20.
Unfortunately, the debate has focussed excessively on economies with the biggest current account imbalances and the role of pegged exchange rates. Simplistic solutions like tweaking the dollar-yen exchange rate under the Plaza Accord did little to reduce Japan’s current account balance. Neither did the appreciation of the Chinese yuan post-2005 diminish China’s. Since a disproportionate share of China’s exports involves processing of imported goods, Chinese exports are likely to be less affected by currency appreciation that would only make imports cheaper. Moreover, in the absence of other adjustments, the US may simply end up importing similar but costlier goods from other countries less competitive and productive than China, but more competitive and productive than the US. Even countries with floating exchange rates, such as Germany and Japan, have significant external imbalances, and there are imbalances even within the eurozone. Indeed, given the vast differences in productivity between Germany on the one hand and Southern Europe on the other, an appreciation of the euro could actually worsen current account imbalances of the latter.
External imbalances simply mirror domestic savings and investment imbalances, and can ultimately be adjusted only through changes in domestic consumption and investment patterns. While public policy can influence both, consumption patterns are largely cultural and behavioural in nature, whereas investment responds more to economic opportunities and policies. Thus, the loose monetary policy in the noughties in the US fuelled an asset-based consumption boom, while similarly low real interest rates fuelled an investment boom in China. US households are increasing their savings to repair their asset price-inflated balance sheets, but this is being partly offset by rising public sector government dis-savings as the government tries to compensate for the fall in private demand to stimulate growth, and takes on the liabilities of the over-leveraged financial sector. While changes in monetary policy may be required to prevent a relapse into overconsumption through future asset price booms, short-term interest rates may be too blunt a policy instrument for this, as there is likely to be collateral damage to investment and growth. Over the medium to long term, beyond reducing government’s own deficit, fiscal policy may be required to dampen private consumption, as the current US debate on the introduction of a new value added tax indicates.
In surplus countries, on the other hand, either government expenditures would need to rise, or taxes lowered, to increase consumption. The jury, however, is still out debating whether such policy changes would induce the behavioural changes necessary to reduce savings and enhance consumption, especially since these would need to counter the logic of demographic transition and cultural preferences. Japan’s burgeoning fiscal deficits have not resolved external imbalances. Would putting extra money in the hands of a Swabian housewife induce her to spend more or save more? Would increased government expenditure on social security nets in China induce Chinese households to collectively spend more of their current income even as dependency and poverty ratios fall? If fiscal adjustments simultaneously enhance fiscal deficits, as is likely although theoretically not necessary, there would be the additional pitfall of ricardian equivalence, as consumers may simply save more to offset higher taxes in future.
Ironically, despite being discredited for contributing to economic crises in the recent past, and question marks on its efficacy, since monetary policy has also been found wanting, the recent crisis has not only crowned fiscal policy as the macro-economic policy tool of last resort, but is also resurrecting it for new functions to address financial stability and global imbalances. This could bring fiscal policy under increasing pressure not only in deficit countries, where it is already an issue, but also in surplus countries, where it is presently not an issue. While the tool itself may be robust, policy-makers would need to use the tool adroitly, especially since there could be conflicting objectives at the best of times. Moreover, experience indicates that fiscal policy tends to get emasculated by the political minefield it has to necessarily navigate. Going forward, this does not bode well for either inflation or interest rates.
The author is a civil servant.The views expressed are personal