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.

12/07/2023
Picture of treasury building

Authors

Keith Wade
Chief Economist & Strategist

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.

Authors

Keith Wade
Chief Economist & Strategist

Topics

Follow us.

Please ensure you read our legal important information before visiting the rest of our website.

Issued by Schroder Investment Management (Singapore) Ltd, 138 Market Street, #23-01, CapitaGreen, Singapore 048946

For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.

Schroder Investment Management (Singapore) Ltd is regulated by the Monetary Authority of Singapore. Reg. no. 199201080H

Important notice: Schroders does not make unsolicited requests through emails, calls, messages, WhatsApp, WeChat, Facebook, Instagram applications. Any contact other than via Schroders’ official channels for personal or financial information is likely to be false and fraudulent. Please stay vigilant and refer to our Fraud Alert Notice for further details. If you have doubts about the person, platforms, websites or institutions that claim to be associated with Schroders, please contact us via +65 6800 7000 and inform the local police.