“Get to the choppa!” (Dutch, Predator)
With central banks purportedly running out of options, the talking heads have been desperately searching for a new dose of stimulus for a limping global economy – perhaps government spending will come to the rescue?
Residents of the United States, please read this important information before proceeding
“With interest rates set close to zero, the Federal Reserve is perceived to be running out of road”
Much recent commentary has seemed to suggest that governments are the new central banks. The case for fiscal stimulus is certainly persuasive in many countries. Take the US for example. With interest rates set close to zero, the Federal Reserve is perceived to be running out of road. Meanwhile, low measured labour productivity growth has been vexing policymakers and academics alike for several years now (Figure 1). At the same time, most seem to agree that US infrastructure is positively geriatric (Figure 2)1, with the country long overdue greater spending on infrastructure investment. Set alongside all this is the current ability of the US government to borrow for long periods of time at record low interest rates – can the US really not find projects with a positive return on investment when it can borrow for 10 years at less than 2%? We ask below whether such a context is sufficient to overcome a policy debate that has been dominated by government debt levels in the post-crisis era.
“Fiscal space’ is the amount by which an economy can safely increase its debt without significantly jeopardising its fiscal position”
The perfectly timed release of Reinhart and Rogoff ’s treatise on the relationship between government debt levels and prospective GDP growth has coloured much of the fiscal debate in the aftermath of the Great Financial Crisis2. Ninety percent debt-to-GDP was previously seen by some as a hard line in the sand for government indebtedness, beyond which output growth must invariably deteriorate. In fact, the former UK Chancellor George Osborne even quoted Reinhart and Rogoff ’s piece in providing academic justification for his austerity measures.
Of course, this is to misuse Reinhart and Rogoff’s thought-provoking, if increasingly notorious, piece of scholarship. Today, few would seriously claim the existence of an absolute and universal debt limit - say, 90% of GDP - for every economy where breaching this limit would invariably lead to a material deterioration in growth. It’s not difficult to see why. An economy’s so-called ‘fiscal space’ - the amount by which it can safely increase its debt without significantly jeopardising its fiscal position - varies by country and is dependent on many different variables unique to each economy.
Needless to say, estimating the degree of ‘fiscal space’ left in the developed world is difficult. That hasn’t stopped researchers from trying however. Recently, economists from the International Monetary Fund (IMF) have attempted to compute estimates of the degree of ‘fiscal space’ left in the developed world. For what it’s worth, their findings are promising - major developed economies like the US, UK and Germany still have considerable room to increase spending on productivity enhancing infrastructure projects3. If anything, the IMF’s exercise and resultant advocacy for greater infrastructure spending may be further supported by a cohort of central bankers far more intertwined with sovereign bond markets than at any other time in recent history. Theory suggests that as debt-to-GDP moves beyond a certain threshold, the risk premium demanded by lenders should rise. However, coordinated central bank intervention has so far ensured that the evidence for such risk premia is currently patchy - the ECB’s bond-buying programme, and the behaviour of peripheral government bond yields since its inception, is surely one such example4.
Nonetheless, all this may still be insufficient to tip the debate in favour of significantly greater borrowing. Debt ratios remain elevated (Figure 3) and the keepers of the purse, such as US Congress, are likely to remain significant impediments to the impressive spending plans promised by both presidential candidates on the US campaign trail for example.
Piecemeal but not game changing
For sure, we could easily see some relaxation of austerity in the UK – the new Chancellor has certainly hinted as much. Japan, for its part, has announced a multi-year fiscal plan worth 5% of GDP. Meanwhile, Chinese authorities have also made it clear that they are capable of stepping up fiscal efforts to keep them in line with their growth promises. In Europe, fiscal space looks limited in most countries given elevated debt loads, though austerity is already long gone on evidence of Figure 4. Germany, one of the major countries with a meaningful degree of fiscal space, remains openly reluctant to use it. For the US, we argue elsewhere in this publication that some of the more alarming campaign trail promises are unlikely to make it to policy given congressional checks and balances - the same may also be true of the potential for a marked change in fiscal direction.
For a material fiscal boost to take place, we suspect that it would probably require a significant shift in the public debate, or direct financing by central banks - so called ‘helicopter money’ - as a last line of defence in the event of a major economic downturn. So far, neither outcome seems imminent as of yet. For now, we contend that the world can surely do with a little more fiscal spending, but it is likely able to get along okay without it.
Themes can be alluring to investors and marketing teams alike - baskets of infrastructure stocks to play the upcoming surge in fiscal spending or beneficiaries of trends in obesity, scarcity or even demographics. However, it is rare that one can find the requisite confidence in one’s vision of the future to make such baskets appealing investments (as is the case for us with regards to this theme). On the other hand, when the requisite confidence can be found, it is likely that the theme is so obvious as to already be ‘in the price’. More broadly though, the world we live in happily defies such neat categorisation.
If there is a theme to invest profitably around right now, it is still that growth is the norm not the exception. With credit now being provided to households in advanced economies at the fastest pace since 2008 (Figure 5), we would argue that the protracted lull we’ve seen in economic activity in much of the developed world - in part due to the negative side effects of the commodity price plunge - is more likely to be resolved by a return of some private sector exuberance rather than the lurch into deflation and depression required by the bond market at current levels. Adherents to this theme should continue to tilt portfolios towards equity markets and away from much of the fixed income complex.
1 Failure to Act: Closing the Infrastructure Investment Gap for America’s Economic Future – American Society of Civil Engineers, 2016. It’s Time for States to Invest in Infrastructure – Center on Budget and Policy Priorities, February 2016
2 Growth in a Time of Debt – Reinhart, Rogoff, January 2010
3 When Should Public Debt Be Reduced? – Ostry, Ghosh, Espinoza, June 2015
4 Four years of the ECB doing “whatever it takes” – Anthony Doyle, Bond Vigilantes Blog, M&G Investments