Regime shift: the return of “fiscal activism”
We expect governments to more actively tax and spend as they attempt to combat higher inflation. This is just one aspect of a new regime in policy and market behaviour that we anticipate in the years to come.
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In our view, we are now entering an economic phase where inflation is higher and more volatile than it has been in the recent past.
Under this new regime, monetary policy (which is the responsibility of central banks and includes changing interest rates to manage inflation) will have to remain focused on controlling inflation, potentially leaving a void for fiscal (government tax and spend) policy to manage growth, or a lack thereof.
We have termed this “the return of fiscal activism” and it will have far-reaching economic implications, including risking serious conflict with central banks and the markets. As a consequence, increased fiscal activism may involve other more radical changes to the policy framework.
The return of “big government”
The pandemic experience has been a key factor in bringing about a shift towards fiscal activism. Governments around the world successfully supported household incomes through furlough schemes and direct transfers while organising the roll-out of mass vaccination programmes. The return of “big government” has led many to call for authorities to be more active in other areas and more willing to use public spending to solve other problems.
Monetary policy has become less effective
The desire for a more active fiscal approach also reflects increasing discontent with monetary policy. After years of driving growth, monetary changes seemed to lose their potency after the global financial crisis (GFC) – since the GFC, the world has witnessed some of the weakest growth ever, despite the lowest interest rates on record for many economies.
However, we believe inflation will prove to be more difficult to control in the new regime and that interest rates will need to be higher over this decade than they have since the GFC.
Consequently, the regime shift will mean that monetary policy will prioritise controlling inflation (the subject of part 1 of the series), potentially leaving a void for fiscal activism to manage growth. The balance between monetary and fiscal policy is set to shift away from a combination of loose money and tight fiscal, towards one of tight money and loose fiscal policy.
Potential conflicts
Replacing monetary policy with expansionary fiscal policy to drive growth is not straightforward. The combination of restrictive monetary policy and expansionary fiscal policy has been likened to driving a car with one foot on the accelerator and the other on the brake. The return of fiscal activism to generate stronger growth risks a conflict with central banks’ attempts to control inflation.
Ways governments can be more fiscally active
In the new regime, governments will be testing the limits of their ability to be more fiscally active. Many will simply accept the impact of additional spending on monetary policy and decide that greater public borrowing for political priorities is worth the pain of higher interest rates.
Others would be concerned about the increase in the size of the state and the burden of higher taxes on incentives to work and invest.
Another, less contentious, route would be to fully implement the OECD’s 15% minimum tax rate on corporations designed to capture the evasion of tax by many multi-nationals, particularly large tech companies.
Clearly there are political choices to be made and as well as higher taxes or spending cuts, there would be renewed interest in questioning the limits of the state and privatisation. If none of these are acceptable, the alternative is to be more radical and look to change the existing system.
Radical changes
This might mean altering central banks’ mandates to one which would tolerate greater inflation. For example, increasing the inflation target, or adopting a more explicit dual mandate of inflation and employment goals. The ultimate sanction would be to rescind central bank independence and for the authorities to take back control of monetary policy.
Of course, any of these measures would provoke a violent reaction from financial markets. Governments would also have to think hard about the consequences, particularly higher inflation.
Conclusion
We should expect economic policy to be more politically charged as fiscal policy means more decisions on spending and tax, creating winners and losers.
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