Article / 12 September 2016 at 14:00 GMT

Bond markets signal a period of fiscalism

Managing Partner / Spotlight Group
United Kingdom
  • Accommodative monetary policy has drawn wide-ranging criticism
  • Fiscalism being claimed as the solution for generating economic growth
  • Time-lags will reinforce price inertia, reduce quantities and qualities
  • Debt is too high already and we do not need more.

By Stephen Pope

In recent months there has been a slowly rising level of debate as to the relative economic effectiveness of monetary policy accommodation. Of the major central banks that dramatically eased rates since 2008, only the US Federal Reserve has made a gesture toward returning rates to “normal”.

Despite the high levels of liquidity on offer, it is fair to say that economic growth has not developed at a firm pace as the latest QOQ data from several developed economies would indicate:

USA 1.10%, Japan 0.2%, UK 0.6%, Eurozone 0.3%. To break down the latter yet further, we see the following:

  1. Germany 0.4%
  2. France 0.4%
  3. Italy 0.0% 
  4. Spain 0.8%

This lack of GDP growth has relaunched the issue of reapplying Keynesian policies through the practice of “fiscalism”.

What is fiscalism?

Fiscalism is a term used to refer to the economic theory that the government should rely on fiscal policy as the main instrument of macroeconomic policy. Fiscalists target income as they contend that income is the basis of effective demand. They would argue that demand draws forth supply since private sector firms invest in response to effective demand for their goods. 

In short, effective demand sends a signal to firms to invest.

Looked at via an equation, we see that:

Gross National Product ≡ Gross National Expenditure ≡ Gross National Income (Y) =
Consumer Expenditure + Private Sector Investment + Government Expenditure + (Exports – Imports)

Or as is commonly written: Y = C + I + G + (X – M)

The main method of using fiscalism is to boost government expenditure, i.e. “G” in the Keynesian identity above. This is achieved by increasing G, financed through higher taxation or increased state borrowing or even both simultaneously. 

Alternatively, direct or indirect taxes can be reduced in an attempt to stimulate consumer expenditure. Another option is for corporation tax to be reduced and enterprise zones created to encourage an increase in private sector investment.

In the international capital markets there is a fear that governments will grab the easiest lever to control, i.e. boost, government expenditure (G), and do so by increasing borrowing. Raising taxes on struggling consumers will prove ineffective and unpopular. Left-leaning lawmakers will hold a deep-rooted suspicion about anything flowing from the private sector.

Politicians always have an eye on the electoral clock. That clock is running with elections due in the US in November this year, in France in May, and Germany by October of next year. Even in Italy, if the prime minister fails in passing his reforms there could be a new poll which may prove as inconclusive as the last two elections in Spain.

In the UK, where a general election is not due until 2020, the eventual agreement of the UK’s exit from the European Union could trigger a call for an election or least a public referendum to ratify the terms.

In all cases, increasing taxes on the consumer – i.e. the voter  – is unlikely. Therefore, a dawn of fiscalism appears to have only one method of being financed... more state borrowing and the steepening of each key markets yield curve between the two- and 10-year maturities shows just what the bond markets think of that.
Yields Spreads Source: Bloomberg, Spotlight Ideas
2-10 spreads
 Source: Bloomberg, Spotlight Ideas

The chart and table above illustrate how over the past year the provision of highly accommodative monetary policies and central bank acquisition of government debt has allowed the yield curve to flatten, driven in part by central bank purchases. 

However, in the last month through to last Friday’s close each yield curve has experienced a steepening.

This clearly reflects the view that with rates so low, new government debt issuance would be at the longer end of the yield curve. Long duration debt would appear to be back in vogue, but increased supply depresses prices, hence long-dated yields will rise not just once. 

Rather, they will keep rising.

In each of the seven markets shown above, the steepening of the two/10 spread was driven by a greater increase in the 10-year yields as against a deep drive lower in that of the two-year. In fact, the only markets where the two-year yield did decline was seen in Japan (minus two basis points) and Germany (minus one). 

The yield was hardly plumbing new depths!

Monetarism versus fiscalism

MV = PY is an identity which states that the amount of money in circulation, i.e. the Money Supply (M) multiplied by the turnover or velocity of money (V) is identical to the amount of economic activity (Y) multiplied by the price level (P).

MV = PY also appears as MV = PT, where “T” stands for the number of transactions.
What this says, in effect, is that purchases during a period are equal to sales over the period. Or, since what is spent is someone else's income, income equals expenditure over the period.

MV represents money spent, and PY, or PT, represents money earned.

Maybe this is just as much an identity as the Keynesian aggregate demand example shown above.

Monetarists target money supply as the independent variable of economic policy. Why so? This is because we see it as the principle means to control private sector investment. In the model, supply – which comes from investment – creates its own demand.

Monetarists are most concerned with M rather than Y, since our focus is inflation.
So, one has to ask how inflation is looking compared to the general target of 2.0% regarded as representing “price stability”?

USA 0.80%, Japan -0.4%, UK 0.6%, Eurozone 0.2%. Breaking down the latter, we see:

  1. Germany 0.4%
  2. France 0.2% 
  3. Italy -0.1% 
  4. Spain -0.1%

Clearly this is the opposite direction of flow that is taken as true by the fiscalists. No wonder the effectiveness of accommodative monetary policy and quantitative easing is under attack. For what it is worth, I do not think central banks (apart from the Fed) have been quick enough or as aggressive as is required... that is why inflation has failed to respond.

What fiscalists would do ?

For the fiscalist, it is employment that is of primary concern. Y (income) is the independent variable in PY = MV, and changes in Y affect effective or aggregate demand. So fiscalists hold that Y needs to be controlled through deploying fiscal policy in order to increase effective demand. 

Hence the importance attached to the Keynesian identity of Y = C + I + G + (X – M).

To counter the monetarism of Friedman et cetera, the fiscalist wing of economics is pressing a view called Modern Monetary Theory.

MMT rejects the monetarist explanation by arguing it is based on an incorrect view of actual operations of interaction between the three agents of the treasury, the central bank, and the commercial banking sector.

Secondly, MMT seeks to deliver full employment by using the government to intervene and create a sectoral balance in the economy by steering aggregate activity away from excessive reliance on any one sector. It strives to maintain effective demand at a sufficient level to ensure full employment while adjusting aggregate demand in line with changes in population and productivity without risking inflation arising owing to excessive demand.

Off with the fiscal fairies

It all sounds so wonderful. A nudge of the tiller of economic activity here and a mild course correction there all paid for from increased borrowing.

What is neglected in this simplistic view of the world is that grandiose government plans have limited flexibility. They have almost no ability to cope with price inertia in the macroeconomic system, or price rigidities even if transitory and production lags.

A boost to demand from the government now is not immediately satisfied. Even if there were just a lag of one time period from the provider of the final product, the actual delivery is at risk from other lags in the supply chain.

Time lags can make policy decisions more difficult. Of course time lags can impact monetary policy, but it works through the notion of a financial market and adjustments can be made in a continuous and ongoing basis. It is dynamic.

By contrast, fiscal intervention is static. It deals in the physical world and has to make predictions running at least 18 months into the future. Experience in the US, Western Europe, and Japan shows that such fiscal fine-tuning is extremely difficult. It will tend to create inflation as government demand takes resources away from the private sector and often items ordered now have a habit of being inappropriate in 18 to 24 months’ time. 

Too many nudges on the tiller and one can be completely off course.

As a direct consequence, large-scale government demand decisions made now create requirements at precommitted prices that are transmitted from one-time period to the next with an impact that is magnified depending on the length and depth of the time lag. 

This results in a ridged price inertia that can render significant quantity and/or quality effects at the time of final delivery. 

That is why governments have a track record of wasting money, dabbling in interventions as a way of paying back political favours and they inevitably fail to get the best value from spending. 

Never forget that the road to ruin is paved with good intentions...

Given the existing level of government debt to GDP, we see:

USA 104.17%, Japan 229.20%, UK 89.20%, Eurozone 90.70%, and

  1. Germany 71.20%
  2. France 96.10%
  3. Italy 132.70%
  4. Spain 99.20%

One has to wonder how long before the seemingly sweet embrace of fiscalism leads to soaring yields, spreads and calls... especially in the Eurozone for wide-ranging debt forgiveness as a new and more painful sovereign debt crisis engulfs us once again. 

Have we learned nothing? Are we really so ignorant? Or perhaps it is arrogance...

The Burj Khalifa
...although that hardly sounds right. Photo: iStock 

— Edited by Michael McKenna

Stephen Pope is managing partner at Spotlight Ideas
vanita vanita
Nice economics article...
Stephen Pope Stephen Pope
Thank you for your kind words
andrewloz andrewloz
The consumer is tapped out, governments are pretty much tapped out (mostly, you would think, but then they have Japan as a shining example), so where does it go from here? One more desperate throw of the dice before closing time?
johnnyw johnnyw
Its either delusion and incompetence or its hunger for state power, leading to more government control, interventionism, and sorry to say, socialism. Fiscalism is just another form of government intervention aimed to control the operations of a free market economy. It will distort the market by diverting capital into areas that do not reflect the underlying real economic demands (and supplies), and will inevitably fail. The solution is scale back the intervention (fiscalism and monetarism), which are both incompetent and unethical at best, and let the free market operate totally unhampered. This will create growth that reflects economic realities, and if it means deflation along the way quicker we get it over with quicker the market can reset to reflect economic truth.


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