The attractions–and the limits–of fiscal policy

Fiscal policy can do more heavy lifting when monetary policy alone is no longer enough. Even without any coordination, governments have room to borrow and invest more – especially in a low interest rate environment – to effectively stir activity. We have argued that there has not been enough government spending globally on infrastructure, education, renewable energy or other technologies to lift total factor productivity growth back to its pre-crisis trends and boost potential growth.

The low interest rate environment increases fiscal space not only by making it cheaper to borrow, but also makes it possible for some governments to grow out of the increased debt. The ratio of interest expense to revenue for developed market (DM) governments is lower on average now than it was before the global financial crisis, even though debt levels are considerably higher. So as long as risk free rates stay below the return on capital and trend growth, it is possible to increase deficits and still see debt-to-GDP ratios fall (Blanchard 2019, Furman and Summers 2019). The chart above shows how this is true for many DM countries.

There are good reasons to expect an environment favourable to fiscal policy to persist: the deep-rooted forces underlying the global saving glut will not change quickly on their own or will need material changes to be affected. That appears to be the market’s belief.

Yet there is no guarantee this favourable wedge between interest rates and trend growth would persist in the face of a major fiscal expansion. The strength and persistence of global precautionary saving pushed real interest rates below growth, driven by the decline in both neutral rates and the term premium, according to our estimates. But a significant increase in borrowing by governments globally could absorb part or all of this saving glut, pushing real interest rates towards or even above growth.

Record debt

Furthermore, with debt to GDP ratios reaching record highs, it would not take much of a shock to growth or interest rates for the debt ratio to balloon and spark concerns about debt sustainability. Hence high existing debt levels mean fiscal policy is vulnerable to even transitory interest rate spikes. Such a surge in rates could damage the fiscal policy space. This could arise from a so-called sudden stop: a temporary drying up of liquidity due to concerns about debt sustainability or losing reserve currency status.

Typically countries that issue debt in their own currency can sustain higher debt levels and have more flexibility than countries that cannot. Yet countries borrowing in their own currency cannot completely avoid a surge in rates. If debt is on an unsustainable trajectory, the central bank can intervene by either increasing the monetary base by printing money or restarting QE. In the first case, runaway inflation would likely result at some point. In the second, it is important to realise that QE does not improve the government’s solvency: as the central bank issues reserves to buy bonds, the consolidated balance sheet of the government sector – including the central bank – is unchanged.

Record debt levels might also stoke expectations that taxes will be raised, or benefits reduced, in the future. Such expectations could reduce current private sector spending and reduce the effectiveness of any public spending increase, a phenomenon known as Ricardian equivalence.

In the final blog in this series, I will outline our proposed solution to the problems facing central banks. You can read also read our full paper on the subject: Dealing with the next downturn.

Elga Bartsch, PhD, Head of Economic and Markets Research for the BlackRock Investment Institute, is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

©2019 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

BIIM0919U-951338