A global experiment in the fiscal/monetary mix
"the change in the mix between fiscal and monetary policy which started last year. Progressively tighter fiscal policy, accompanied by aggressive QE by the central banks, is the order of the day. This is intended to reduce fiscal deficits while allowing aggregate demand to grow at least as fast as its trend rate. No one can be confident that the strategy will succeed – the evidence from last year is indecisive – but at least it constitutes a clear plan."
A global experiment in the fiscal/monetary mix
February 19, 2012 2:25 pm by Gavyn Davies
A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings.
I refer, of course, to the change in the mix between fiscal and monetary policy which started last year. Progressively tighter fiscal policy, accompanied by aggressive QE by the central banks, is the order of the day. This is intended to reduce fiscal deficits while allowing aggregate demand to grow at least as fast as its trend rate. No one can be confident that the strategy will succeed – the evidence from last year is indecisive – but at least it constitutes a clear plan.
First, how much fiscal tightening is planned? This varies between countries, and is something of a movable feast, especially in the US. In the first graph, I assume that countries adopt the fiscal policy which was assumed in the IMF’s Fiscal Monitor for January, 2012, updated for events since then.
For the advanced economies as a group, the cyclically adjusted budget deficit (a measure of the overall fiscal thrust) is now scheduled to tighten by about 0.7 per cent of GDP this year, which is roughly the same as last year. The largest tightening of 1.4 per cent of GDP will come in the eurozone, concentrated in the peripheral economies, where it will exceed 2 per cent of GDP.
In 2012, the overall outcome will depend largely on what happens in the US after the November elections. Based on what is currently legislated, fiscal policy would tighten by 2.7 per cent of GDP next year, a development which the Fed would certainly find hard to offset through additional QE. However, given Washington’s recent reluctance to raise taxes or cut expenditure, this does not seem likely to occur, unless a Republican sweep in the elections changes the political climate entirely. I have assumed that the eventual tightening in 2013 is about half of the 2.7 per cent which is currently legislated. 
Overall, this would represent a medium sized global fiscal tightening, which would be sufficient to slow the rate of increase in the public debt/GDP ratio, but not to halt it altogether. For the advanced economies as a group, the debt ratio would rise from about 103 per cent of GDP in 2011 to over 110 per cent in 2013.
Despite rising debt, the IMF now seems to think that this is the maximum fiscal tightening which can be absorbed in the short term without risking a renewed recession. They may well be right about this. If implemented, the fiscal shift is likely to reduce the growth of global demand by about 1 per cent per annum. In a demand constrained developed world, that would ensure sub trend GDP growth at best, unless the central banks can boost demand through monetary expansion.
They are certainly trying very hard to do so. The second graph shows the recent behaviour of the balance sheets of the major central banks, which are now expanding very rapidly in unison: 
The graph uses the size of the central bank balance sheet as a metric to measure the extent of the monetary injection which is occurring now that short term interest rates are at the lower bound. This metric is far from perfect, since different types of QE will certainly have very different impacts on the economy. And some actions by the central banks, such as the Fed’s Operation Twist, have the same effect as QE without changing the size of the balance sheet.
In calculating the figures shown in the graph, I have made a notional upward adjustment of $600m to the size of the Fed’s balance sheet to represent the impact of Operation Twist and recent changes to communications policy. I have also assumed that QE3 will be launched in April at a size of $100m per month, though the probability that this will occur may be declining. For other central banks, I have assumed that announced policy measures will be followed, and have assumed a size of E400bn for the ECB’s forthcoming LTRO.
Whichever way the numbers are calculated, the overall message is clear. The central banks are engaged in a second burst of QE which will take effect more slowly than the initial round in 2008/09, but which will eventually prove somewhat larger in size. A rough order of magnitude is that QE1 increased balance sheet size by about 5 per cent of GDP, while QE2, spread over a period which will be twice as long, will be around 9 per cent of GDP. This is almost twice as large as QE1, and is far more co-ordinated across the developed world.
The central banks are certainly acquiring quite an appetite for this kind of monetary easing. Because it is happening in all the major economies simultaneously, it may not have the large effects on exchange rates which were such a key part of the UK plan to change the fiscal/monetary mix in 2008. But the effects on global bond yields have been profound, and this seems to be having significant effects on the price of risk assets like equities.
In an earlier blog , I presented (extremely uncertain) economic evidence which suggested that the impact of QE1 was to raise GDP by around 1-1.5 per cent. The effect of QE2 might well be proportionately less, but it could still be about 2 per cent of GDP over two years, which, as a broad order of magnitude, would offset the effect of fiscal tightening in 2012/13.
This could all go very wrong if commodity prices, or inflation expectations, start to rise in response to QE. But at the moment the developed economies seem set to grow at roughly their trend rate for the next couple of years, despite the onset of fiscal tightening. That represents a start.
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