Home Finance The World Has Changed, and There Is a Need for Proactive Fiscal Policies

The World Has Changed, and There Is a Need for Proactive Fiscal Policies

by internationalbanker

philippe-waechterBy Philippe Waechter, Chief Economist, Natixis Asset Management

 

 

 

 

There is an economic and political malaise in many developed countries. For most of them, their growth profile is lower than what it was before the 2007/2008 crisis. In the US, the trend growth is marginally above 2 percent, and this cycle is the weakest since World War II. And even if the unemployment rate is low, close to full employment, the perception is that there are still rooms for improvement, but in an environment without wage pressures. This is a new situation.

In the Euro Area, the growth trend is much lower than before the crisis, except in Germany. It’s even dramatic for countries such as Italy, Portugal and Greece for which the reversal of the upward trend since 2009 has implied a deep drop in well-being. For these countries, the gross domestic product (GDP) level is just above its 1999 level at the inception of the Eurozone. One really important issue in the Euro Area is the fact that the private domestic demand, which is the main structural driver for growth, is still below its 2008 peak level.

There are three measures that show that the situation has dramatically changed in developed countries.

The first is the long-term equilibrium level of the federal funds that is published on a quarterly basis by the US Federal Reserve. Every quarter, the FOMC (Federal Open Market Committee) has new forecasts for GDP growth, the unemployment rate and inflation. There is also a forecast on the fed funds rate, which is the rate associated with the Fed’s monetary policy. In March 2012, the median value of this equilibrium level was 4.25 percent. The message associated with this level is simple: FOMC members believed that the US economy was able to converge to a business cycle that had the same characteristics as those seen before the crisis. In other words, they thought that the 2008 shock did not have a permanent impact on the form of the business cycle. In September 2016, the equilibrium level was at 2.9 percent. This means that now, FOMC members consider that the characteristics of the US business cycle have changed and that it will not converge to the profile that was seen before the crisis. The equilibrium long-term rate must be consistent with the growth and inflation trajectories. In 2016, the Federal Reserve tells us that it believes that these trajectories will be in the future lower than what was seen before. What the Fed says could be said also by other central banks.

The main reason for this new dynamic was recently explained by Janet Yellen. She said that constraints on demand have had a permanent and negative effect on supply. This can apply directly to what was seen in the Euro Area. Austerity policies after 2011 have pushed down domestic demand, causing a six-quarter recession from mid-2011 to the end of 2012. A direct consequence was to reduce incentives to invest. At the same time, and on top of fiscal policies weighing on households’ budgets, households’ indebtedness was still high, constraining the consumption-expenditure dynamics. The main consequence of this dramatic policy was that the private internal demand for the Euro Area was still during the second quarter of 2016 below its peak seen during the first half of 2008. During all this period, investment was too low, reducing the growth of the potential GDP. This means that monetary policies will have to remain accommodative for an extended period. It also means that the current neutral stance from fiscal policy is not enough for the past adjustment. This framework is consistent with what has been called “secular stagnation”. The domestic demand momentum has been too low for too long.

Domestic internal demand has also been lower than in the past in the US, but for different reasons than in the Eurozone. There was no recession, but the mildness of the recovery for jobs and revenues in a context of still high households’ indebtedness has led to the worst trajectory for the private internal-demand profile since World War II. Moreover, fiscal policy has been constraining, even if not in the same way as the Euro Area. At states’ level, revenues were too low, creating a situation of austerity.

The second important point in the current environment is the very low momentum of world trade. In August, using the data from the Netherlander think tank CPB, we can calculate that its yearly growth was 0 percent. In fact, since the fall of 2011, world trade growth is below a band that represents the average growth from 1992 to 2007, +/- a standard error. In other words, the world-trade framework dramatically changed at the end of 2011, and there was no reversal. More than that, the current situation is downgraded from what was seen a year ago.

In the past, there was always a country that was a growth locomotive. It was able to pull up world trade, creating an impulse for other countries. In this framework, world growth was rapidly converging to a strong trajectory. The US was generally the main source of impulse; more recently China did the job. This was a comfortable situation for Europe, which behaved like a follower. The adjustment after a shock was more rapid in the US so the shape of the business cycle was stronger, more rapidly creating an impulse that was positive for Europe.

This is no longer the case. Neither the US nor China have the capacity to be a locomotive. This means that growth must mainly come from inside, and the impulse on the economy must come from domestic demand. That’s why the dynamic of startup companies is important as it is able to provoke a new impetus for economic activity. With this in mind, we clearly perceive the error that has been made in economic policy in Europe. By adopting very severe fiscal policies, there was no room to create growth. That’s the reason for the recession in the Euro Area in 2011-12. This situation is also complex for the US as part of their activity in the manufacturing sector moved to Asia. This sector was too small to be a source of recovery by itself.

The third marker of this new environment is the new balance between developed and emerging countries. This can be measured by two types of metrics. The first is the “elephant graph” that was created by Branko Milanović. It shows that during the last two decades and a half, income in some emerging countries (China mainly and India) have grown much more rapidly than elsewhere in the world. This was at the detriment of people with low incomes in developed countries. The trump of the elephant shows that high incomes in developed countries have continued to grow strongly and rapidly.

There are at least three consequences of this. First, it shows that free trade can have a permanent and an important cost for developed countries when a large country, such as China, enters the game. The second point is that low-income people are no longer able to be a strong and durable source of recovery in developed countries. This is particularly true when households’ indebtedness is high. The third consequence is that it creates everywhere a source of political reaction. People have the perception that the weakness they perceive in their jobs and in their income comes from outside competition, mainly from emerging countries. The political impact is to say that governments were not able to prevent that. That’s a framework that can be seen in the US with Donald Trump and in Europe with the extreme right.

The second element linked to the change in balance between developed and emerging countries can be read in the development of economic activity. To make things simple, the world industrial production index rebased at 100 during the first half of 2008 (before the Lehman moment) was at 115 in August 2016 (source CPB). The geographical distribution of this production shows a specific point. Every large country or large geographical region, except one, had an index close to or below 100 in August 2016. The exception was Asia. Its index was at 179 in August 2016. This means that the distribution of production has dramatically changed during the last 10 years, to the benefit of Asia. This is a challenge for developed countries. If they want to keep their production on their territories, they have to create strong incentives in order to push companies to invest locally so as to limit their investment in Asia.

The world has dramatically changed during the last 10 years. The balance between developed and emerging countries has been deeply modified at the expense of developed countries. But for the latter, there is a lack of strong internal momentum due to private indebtedness, errors in fiscal-policies stance and to the new balance of income with emerging countries. One important and long-lived consequence is a lower potential growth, because in this environment companies’ incentives to invest have been low even with very favorable financial conditions. There was also an error in the equilibrium of economic policies. Monetary policies were the main tool in Western countries to initiate the recovery. In recent years, fiscal policies were too tight.

In the framework that has been developed, there is a need for an impulse to change the trajectory of growth. There are two possibilities. One is to anticipate that innovations will at last have a strong macroeconomic effect by improving productivity. We currently see innovation at the microeconomic level, and this changes everyday life for thousands of people; but the macroeconomic impact is still to come, without knowing when. Will it be in two, in five or in ten years? Nobody knows. Therefore the sole source of impulse can come from fiscal policy. There is a role for fiscal policy at different levels. First, governments have to take advantage of very low interest rates. The cost of the public debt will be low for an extended period. Second, governments are able to take risks in the long-term; they are the only actors who are able to take risks in this horizon. It’s important as there is a need for stronger private investment. We saw that spontaneously—current companies’ investment is too low to improve potential growth. The role of the government is to take actions in the long-term to create incentives for private-sector investment. This means that there is a role for government in innovations and in its financing. It must have a stronger role beside the private sector, as was the case in the 1960s.

The main point is that developed economies have a growth trajectory that is too low to create a large number of jobs, to improve revenues and to finance the social safety net. The arbitrage is to accept this fact with a risk of social and political instability or to imagine that there is an impulse that will hasten the positive impact of innovations on productivity at a macroeconomic scale. I think that the second part of the arbitrage is the good one. It gives a stronger role for government in the management of the economy in order to provoke an impulse that could push growth onto a higher trajectory. Public debt could be higher, but high private debt is currently a constraint for improving the current momentum. The arbitrage is that it is easier to manage the public debt than the private one.

The world has deeply changed and doesn’t seem to be able to spontaneously converge to a stable and strong profile. That’s the reason government has a new role to play, as it is the only actor that is able to take risk in the long-term.

 

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