The new fis­cal re­al­ity

Financial Mirror (Cyprus) - - FRONT PAGE -

“When the facts change, I change my mind. What do you do, sir?” This, re­port­edly, is how Keynes replied to the crit­i­cism that he had changed his po­si­tion on the pol­icy re­sponse to the Great De­pres­sion. Prag­ma­tism of this sort is not that com­mon: pol­icy views are of­ten char­ac­terised by con­sid­er­able in­er­tia. Too fre­quently, to­day’s per­spec­tives re­main shaped by yes­ter­day’s facts.

Fis­cal pol­icy is a case in point. Facts have changed in two sig­nif­i­cant ways. First, for sov­er­eign states long-term bor­row­ing costs are ex­cep­tion­ally low. At end-Oc­to­ber, the an­nual yield for govern­ment bonds is­sued by France, a coun­try with pub­lic debt ap­proach­ing 100% of GDP, was 0.5% for ten-year bonds and 1.6% for 50-year bonds. Italy and Spain, both of which faced in­vestors’ re­luc­tance five years ago, have also been able to tap the mar­ket for 50-year bonds. As long as high de­mand for govern­ment debt se­cu­ri­ties lasts (a sub­ject of de­bate among economists), it of­fers an un­prece­dented op­por­tu­nity to fi­nance pub­lic in­vest­ment.

A key fac­tor in de­ter­min­ing whether to bor­row is the dif­fer­ence be­tween the rate of nom­i­nal GDP growth and the in­ter­est rate: if it is neg­a­tive, debt can eas­ily be re­paid, be­cause nom­i­nal in­come grows faster than the in­ter­est bur­den. Us­ing the (fairly mis­er­able) past as a yard­stick, it is hard to be­lieve that French nom­i­nal GDP will in­crease by less than 0.5% an­nu­ally over the next ten years: from 2005 to 2015, nom­i­nal growth av­er­aged 2.1%. So low in­ter­est rates are an op­por­tu­nity that should not be missed.

The sec­ond way facts have changed is that out­put growth has been dis­ap­point­ing. In its latest World Eco­nomic Out­look, the In­ter­na­tional Mone­tary Fund noted that, de­spite the drop in oil prices and favourable mone­tary con­di­tions, out­put and in­vest­ment in ad­vanced coun­tries have con­sis­tently re­mained be­low ex­pec­ta­tions over the last two years. The out­look for the eu­ro­zone is es­pe­cially un­der­whelm­ing: the IMF ex­pects out­put growth to slow from 2% in 2015 to 1.7% in 2016 and 1.5% in 2017.

With the Euro­pean Cen­tral Bank’s as­set-pur­chase pro­gram close to reach­ing its lim­its, an in­vest­ment-ori­ented fis­cal stim­u­lus would help re­verse this weak­en­ing. It would also help re­verse the slump in pub­lic in­vest­ment ex­pe­ri­enced by sev­eral coun­tries as a con­se­quence of fis­cal aus­ter­ity in re­cent years.

But, while facts have changed, minds have not. On av­er­age, gov­ern­ments are us­ing the gains im­plied by lower in­ter­est rates to spend a bit more or to re­duce taxes, rather than to launch com­pre­hen­sive in­vest­ment pro­grams. The IMF ex­pects the struc­tural fis­cal bal­ance for the eu­ro­zone to be roughly the same level in 2017 as in 2014. The same ap­plies to the United States. Some coun­tries, like the United King­dom, are still in a fis­cal tight­en­ing phase. Italy is in an ex­pan­sion­ary phase, but it is fac­ing crit­i­cism from the Euro­pean Union for non-com­pli­ance with its com­mit­ments un­der the Sta­bil­ity and Growth Pact (SGP). Over­all, there is no dis­cernible mo­men­tum in ei­ther di­rec­tion.

But is there re­ally fis­cal space for ac­tion? With gross pub­lic debt close to 100% of GDP in the US, the UK, and the eu­ro­zone, and much higher in Ja­pan (though net debt is less fright­en­ing), there is ad­mit­tedly cause for con­cern. Mar­ket sen­ti­ment can change quickly, and some Euro­pean gov­ern­ments re­mem­ber how pre­cip­i­tously they were forced to change course in 2010-2011, af­ter hav­ing em­barked on fis­cal ex­pan­sion. It would be un­wise to as­sume that low in­ter­est rates will last for­ever and sim­ply re­lax fis­cal dis­ci­pline.

The so­lu­tion is an ap­proach that com­bines, on one hand, the con­tin­u­a­tion of fis­cal con­sol­i­da­tion, with a view to putting the debt-to-GDP ra­tio on a steadily de­clin­ing path, and, on the other hand, spe­cial in­vest­ment pro­grammes fi­nanced at ex­cep­tion­ally low in­ter­est rates. This would serve the medium-term goal of pub­lic-fi­nance sus­tain­abil­ity, while treat­ing the in­ter­est-rate level as a one-off wind­fall that can be used to ad­dress pri­or­ity in­vest­ments and strengthen growth po­ten­tial.

There are sev­eral types of in­vest­ments worth un­der­tak­ing. In some coun­tries – es­pe­cially the US – in­fra­struc­ture is in need of a sig­nif­i­cant up­grade. In oth­ers, like Spain or France, hu­man cap­i­tal should be given pri­or­ity, with an em­pha­sis on im­prov­ing school per­for­mance and the skills of the labour force. For coun­tries that must in­vest in re­forms, bud­getary sup­port would help over­come po­lit­i­cal ob­sta­cles to in­sti­tu­tional trans­for­ma­tion. Mit­i­ga­tion of cli­mate change through in­vest­ment in re­new­able en­ergy, in­su­la­tion of build­ings, and low-car­bon trans­porta­tion net­works is an over­whelm­ing re­quire­ment in vir­tu­ally all coun­tries. In sev­eral ar­eas, well-cho­sen in­vest­ment – for ex­am­ple, up­grades of equip­ment and in­for­ma­tion sys­tems in health care – could even re­duce fu­ture pub­lic spend­ing, thereby strength­en­ing long-term fis­cal po­si­tions.

In the EU, it is some­times ar­gued that the way to trig­ger th­ese in­vest­ments is to ex­clude cap­i­tal spend­ing from the SGP and mon­i­tor only the bal­ance for cur­rent spend­ing. This would not be the ap­pro­pri­ate so­lu­tion. Brick-and-mor­tar pub­lic in­vest­ment is of­ten less valu­able than spend­ing on ed­u­ca­tion or in­sti­tu­tional im­prove­ment, and can end up fi­nanc­ing “white ele­phants” of du­bi­ous so­cial worth. More­over, there are few ar­gu­ments for treat­ing cap­i­tal spend­ing sep­a­rately un­der nor­mal eco­nomic con­di­tions. What ap­plies to the cur­rent zero-in­ter­est rate en­vi­ron­ment should not be made per­ma­nent.

Rather, gov­ern­ments should bor­row now to fi­nance spe­cial phys­i­cal and in­sti­tu­tional in­vest­ment pro­grammes to be car­ried out over the next few years. Th­ese pro­grammes should be given de­fined goals and be sub­ject to strict gov­er­nance. In the EU, they should be ex­empt from SGP rules, but sub­ject to an as­sess­ment by the Euro­pean Com­mis­sion that they con­trib­ute to im­prov­ing growth and fis­cal sus­tain­abil­ity in the medium term. And they should be de­signed in such a way that they can be in­ter­rupted if bond­mar­ket con­di­tions nor­malise and in­ter­est rates re­turn to his­tor­i­cal lev­els.

We should not be hostage to a false choice be­tween bud­getary re­spon­si­bil­ity and eco­nomic re­vi­tal­i­sa­tion. The facts have changed. We can do both.

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