Damned if you do – or don’t

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This post is a guest contribution by Gerard Minack of Morgan Stanley.

The obvious risk from sovereign stress is default.  A more subtle, but pervasive, risk is that the threat of sovereign stress encourages a too-rapid tightening of fiscal policy.  Tighter fiscal policy will likely be a headwind for developed-world growth next year.  Excess tightening could lead to double-dip.

Fiscal policy now has to navigate between the Scylla of sovereign stress and the Charybdis of premature fiscal tightening.  What is clear is that fiscal policy in the developed world is on an unsustainable course.  The IMF estimates that on unchanged policies, government debt in the G7 will reach 440% of GDP by 2050 (compared to under 80% now).  So, the question is not whether adjustment is required, but when and how fast policy-makers should aim to tighten policy.

This decision won’t be made in a vacuum.  If markets, rightly or wrongly, become concerned about sovereign risk, the consequent lift in public interest rates can threaten default or trigger recession – causing policy tightening – as seen now in the European periphery.

Fiscal policy is already set to tighten next year in the developed world.  The headline deficit isn’t the best measure of discretionary fiscal policy, because it includes the effects of the so-called automatic stabilizers.  Some of the deficit decline is due to cycle improvement.  The discretionary policy changes are captured by the cyclically-adjusted fiscal balance.  The IMF expects that balance to fall by almost 1% of GDP in 2011, having widened by 4.5% of GDP over the three years to 2010.

The effect of fiscal policy on growth is controversial.  The extreme view – so called Ricardian equivalence – is that the private sector adjusts its behaviour to offset the policy action of the public sector.  The data, however, suggest otherwise.  A recent study by the IMF suggests that fiscal tightening does reduce economic activity.

The extent to which fiscal tightening damps growth depends in large part on three factors:  1) the balance between tax increases and spending cuts; 2) the reaction of monetary policy; and 3) the reaction of currency markets and the global growth environment.  The simple story is that fiscal tightening, in isolation, lowers growth – but looser monetary policy and improving net exports (due to currency weakness) can provide a material, but partial, offset.

A summary of the IMF’s modeling shows the effect on growth of fiscal policy being tightened by 1% of GDP.  This cuts domestic demand by 1% (in the second year), but there is an offset from rising net exports.  The net effect is to dampen GDP by around 0.5%.

That’s the ‘good’ news.  The bad news reflects the peculiarity of the current structural problems.  The first problem is that if there is global tightening in fiscal policy then – obviously – net exports cannot provide an offset (in aggregate).  I can forecast with extreme accuracy the net export contribution to global growth: it’s zero.  Even if the developed economies were to see some net export growth to the emerging economies, that offset would likely be smaller than has been typical when fiscal tightening has been undertaken by an individual country.

Looking at the country-level shift in fiscal policy in the OECD, every major OECD country is expected to tighten fiscal policy in the coming year.  The greatest number of countries simultaneously tightening fiscal policy over the past 30 years has been 10.  Most of the historical examples of tightening were less than 1% of GDP.  In other words, the extent of fiscal tightening planned for next year – both in terms of the number of countries planning to tighten and in terms of the severity of the tightening – is unprecedented.

The second problem is the negligible scope for offsetting monetary easing.  The significance of offsetting monetary policy easing is highlighted by the IMF modeling of a typical fiscal tightening with, and without, offsetting monetary accommodation.

History includes several examples where pre-emptive policy tightening has precipitated recession after the apparent recovery from a major crisis.  In my view, this is another reason to expect that this cycle will be relatively short and stunted.

Source: Gerard Minack, Morgan Stanley, December 2, 2010.

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