Deficit spending has gone from scourge to panacea. The word “austerity” seems to have been removed from the policy dictionary. Economists have written what seem like love letters calling it our best and possibly only hope if the economy were to slow down. 1 1 Close If Star Wars were made today by macro strategists, Princess Leia might hide a message that said, “help me unfunded mandates, you’re our only hope.” Counter-cyclical fiscal policy has always had its advocates, but we are starting to see calls for stimulus during times when the economy is expanding. 2 2 Close Some would call these advocates “Keynesians.” We’re seeing a full-on onslaught of pro-growth policies, yet we’re not seeing the kind of reaction in inflation or growth we might expect. This creates challenges for forecasters and investors because they haven’t seen this type of environment in developed economies.
There is a natural relationship between growth and fiscal deficits. When growth and employment are strong, individuals and companies earn more, and as a result, tax revenues rise. This helps to shrink deficits even if spending increases moderately. 3 3 Close In its simplest form a deficit is spending in excess of revenues. We won’t worry about interest payments here. When growth slows or an economy goes into recession, tax revenue collapses and deficits grow. While this relationship exists almost everywhere, it is frequently exacerbated by counter-cyclical fiscal policy. Many economists and politicians think that in times of recession, government spending can replace lost private sector investment and consumption, so policymakers often propose fiscal stimulus during downturns. This can result in higher deficits during those periods. Many of the economists who advocate this policy also argue that governments should cut spending and run surpluses during expansions to create savings. 4 4 Close Economics professors like to point out that counter-cyclical macroeconomic policy has its origin in the Book of Genesis, when Joseph proposed saving grain for seven years of famine. He might have been called a perma-bear if he were a strategist today. However, since the European sovereign crisis, politicians seem to have lost interest in fiscal responsibility – or perhaps the public has lost interest in electing fiscally responsible representatives.
It may seem like politicians have always struggled to deliver on their budget promises, but if you look at the chart below comparing the U.S. fiscal deficit to the unemployment rate, you see something has indeed changed. The relationship for most of the period was unmistakable – higher unemployment meant larger deficits. In the past five years though, you see the two lines diverge. We’ve had higher deficits AND record low unemployment.
This means that spending is so high, or taxes are so low, as to overcome the tailwind of rising wages and earnings. You see a similar but more muted pattern in Canada right now. There have been a few examples of the reverse, where countries have made efforts to cut deficits during periods of weak growth. 5 5 Close In some cases, it may have been that aggressive austerity measures caused the slowdown in growth. We are unlikely to see that type of policy in the developed world any time soon.
The closest equivalent in the U.S. during the Post-War Era to the current fiscal situation was the famous guns and butter period of the mid-1960s. During that time the U.S. was fighting the Vietnam War and funding big social programs such as Medicare and Medicaid. This was followed by a period of high inflation. Some economists blame the inflation on what they say was irresponsible spending and later Fed accommodation. This experience may give investors some pause.
Another example was the U.K. in the early 2000s. Under the “Cool Britannia” administration of Tony Blair, the U.K. opened markets and spent aggressively. Unlike the current U.S. environment, the U.K. had built up surpluses in the preceding years. Public employment expanded rapidly, with almost 3% YoY growth in 2002. 6 6 Close Public sector employment in the U.K. grew from 5.63mm at the end of 2001 to 5.78mm at the end of 2002. Source: UK Office for National Statistics. Growth in the U.K. was quite strong, and the deficit shrank in 2006. However, in 2008, the expansion ended with the worst recession of the Post-War Era.
So both of the previous examples of deficit expansion during periods of falling unemployment ended badly. But if you listen to macro analysts, everything seems to end badly. That is because the economy is cyclical, and we like to define periods as the time between recessions. This allows us to make cynical comments about everything.
In the case of the U.K., the shock that brought down the economy was financial, at least partly external, and came several years after the deficit spending slowed, so it’s difficult to blame it on fiscal expansion. The 1960s was also very different from today, in that inflation was far more volatile even before the fiscal expansion. And the number of examples are too few to find patterns. Unfortunately, in this case, the past provides little precedent for investors to follow.
So far markets seem to be responding positively to expansionary fiscal policy. The logic behind the markets’ embrace of what previously seemed reckless is fairly simple. Fiscal expansion is a transfer from public to private – any public deficit is a private surplus. Most economists admit that government spending creates short-run stimulus. The big concern is that the fiscal expansion leads to payback, which at its worst results in nominal default or in the monetization of the debt. In the past, governments have run up inflation to reduce the value of the debt it owes. Governments don’t seem to be doing this now, or if they have tried, they are really bad at it. 7 7 Close Governments can’t even successfully destroy their own currencies these days. Inflation markets have been tame and realized inflation has been low. The bigger threat to markets would be a near-term retrenchment in spending rather than deficit-induced panic. Some have argued that the composition of the fiscal expansion matters – whether the money is spent productively and whether there are incentives for investment. Investors don’t seem to care as long as they keep spending. 8 8 Close If you see a government spending $13 billion for a banana taped to a wall, maybe investors will start to worry about misallocation of resources. If we start hearing words like “fiscal cliff,” the market may react negatively. It may seem hard to believe, but investors have stopped worrying and learned to love fiscal irresponsibility. We may have to wait a few years for austerity to make its return.
What We Are Watching
China Industrial Production, Retail Sales, Fixed Investment (Monday) The Chinese economy has decelerated significantly this year, with indicators such as industrial production, retail sales, and fixed asset investment showing growth at or near multi-decade lows. However, there have been tentative signs of improvement in recent weeks, as Manufacturing PMIs have bounced and credit growth has picked up. If November activity data shows stronger growth, it would bolster investor hopes that the worst of the slowdown has passed.
Eurozone PMIs (Monday) The preliminary eurozone PMIs for December will be closely watched to assess nascent signs of stabilization in the European economy. The latest release of these data prompted some optimism as both the manufacturing and services surveys exceeded economist forecasts on the back of unexpected improvement in the German subcomponents. Even though the manufacturing index continues to point to contraction in industrial activity, a sequential gain in the PMI would mark the third consecutive increase since September and would likely be interpreted as a positive omen for the economy. A positive surprise would support the euro and domestic stocks as well as weigh on core government bonds.
Central Bank Meetings (Thursday) This week will feature a “Super Thursday” of central bank meetings before activity quiets down for the holiday period. Central banks in Japan, Sweden, Norway, the U.K. and Mexico will conclude monetary policy meetings, making for a busy day of analyzing policy statements and parsing central banker rhetoric. Deviations from expectations could lead to meaningful market moves.
- The Bank of England is expected to keep its key policy rate at 0.75%, where it has been since mid-2018. Market participants will be looking for any change in forward guidance following this month’s general election. The outlook for the U.K. economy remains uncertain, as growth has slowed and Brexit risks have lingered.
- The Bank of Japan is expected to maintain its current policy stance, but could provide a more optimistic outlook. The Japanese yen has remained relatively stable since its last meeting, global trade concerns have moderated somewhat, and the Japanese government recently announced a larger than expected fiscal stimulus.
- Sweden is expected to hike its key policy rate out of negative territory for the first time since early 2015. Given ongoing concerns around the growth outlook in Sweden, the Riksbank is expected to hedge its hike with relatively cautious language and suggest a continued accommodative stance going forward.
- Norway’s Norges Bank has been among the most hawkish central banks lately, hiking its policy rate three times in 2019. While no change is expected this month, analysts will watch for any changes to the Norges Bank’s economic data forecasts or forecasted policy rate path.
- The Mexican central bank (Banxico) is expected to continue its easing cycle and cut its key policy rate by 0.25% this month. While the outlook for Mexico has become marginally brighter after the U.S. Congress agreed to pass the USMCA trade deal, growth has been slowing recently and inflation has moderated, encouraging Banxico to pursue more accommodative policy.