The risks of blind fiscal expansion to generate growth are too great. The priority should fall upon fiscal consolidation and improving the quality of public finances instead.

Ludger Schuknecht

We live in exceptional times. The global economy continues to operate under ultra-loose monetary policies in advanced economies, yet investment dynamics remain moderate, labour productivity growth low and medium-term economic prospects modest.

The International Monetary Fund (IMF) proclaims this state to be the “new normal” and recommends a new dose of fiscal stimulus. This approach is based on the old idea of macroeconomic fine-tuning and debt-driven growth.

Its relevance today is questionable; it would perpetuate financial imbalances, high debt and risks of crisis. Hence, we need to rethink the role of fiscal policy.

High sovereign debt

First, public finances are nowhere near as healthy as current financing costs suggest. With debt ratios averaging 120% of gross domestic product (GDP), the Group of Seven (G7) economies have accumulated the highest levels of sovereign debt since the Second World War.

Deficits are still quite high in quite a few advanced economies, despite several years of recovery. Ultra-low interest rates facilitate the servicing of public debt today. This gives rise to complacency about the sustainability of debt dynamics. Deleveraging in the public sector has yet to start in earnest, therefore, and has a long way to go in many advanced economies.

Second, linkages between banks and their sovereigns continue and in some cases have intensified as banks have increased their sovereign holdings in recent years. For example, in some countries banks hold about onequarter of domestic sovereign bonds on their balance sheets. As a result, distress can spread from the public to the private sector and vice versa, potentially generating destabilising feedback loops – a lesson we had to learn during the European financial crisis and again during the Greek crisis in 2015.

Third, vulnerabilities remain from the unfinished clean-up of the euro area’s banking system. The high amount of non-performing loans in some member states undermines lending to healthy enterprises and thereby growth. This, together with potential fiscal costs (despite European bail-in rules), could undermine debt sustainability. Low interest rates encourage low productivity investments and prevent the emergence of more competitive entities at the expense of future productivity, investment and output growth.

Risk of asset bubbles

Fourth, there are also risks from sovereign debt on central banks’ balance sheets. Unconventional monetary policies have helped raise the market value of government debt via lower short- and long-term interest rates. This has calmed financial markets and changed market conditions for agents in both the public and private sectors.

This was a desirable effect as it improved financing conditions and helped the recovery. But the boost on asset prices has raised the risk of asset bubbles – with consequences for financial stability. Central banks may be prevented from normalising monetary conditions if they fear that, by doing so, they will suffer losses and see fragile market conditions undermined – economists call this fiscal dominance.

Fifth, rising political risks, together with increasing support for political forces that are less reform-orientated, could translate into higher risk premia and lead to debt sustainability concerns for sovereigns. Add to this the fiscal challenges from ageing populations and the need for more expenditure on security and development.

Sixth, this additional expenditure would be on top of already-high public expenditure ratios in advanced economies. Large governments, welfare states and bureaucracy have driven this ratio to well over 40% (or even over 50%) of GDP in many advanced economies. The issue of government efficiency becomes even more important given that some of our global competitors have a size of government of only 20% to 30% of GDP, and correspondingly lower tax rates.

Fiscal illusions

Finally, with the current ultra-loose monetary policies, central bankers have created windfall profits for national budgets and the false impression of 'fiscal space'. Even dubious debt levels and dynamics look financeable at zero rates. Worse, these fiscal illusions tempt further calls for deficit spending, as we can hardly recall the time of significantly positive nominal and real rates.

As the mountains of debt we see today leave public finances vulnerable to interest rate hikes and weaken their resilience to foreseeable and unforeseen events – both economic and political – what should and shouldn’t be done?

In the current macroeconomic environment, it is not credible to call for an additional coordinated spending boost by countries that appear to have 'fiscal space'. Most major economies – including China, Germany, Japan, the UK and the US – are approaching full employment, and G7 output gaps are near their long-term average.

For Germany, what would justify further expansion? The IMF has said that, in full employment periods, stimulus has little effect. Given Germany’s limited size and modest cross-border effects, a boost from Berlin would have little influence on European demand.

The right debate would be a discussion about the future course of fiscal policy. This includes fiscal consolidation as well as improving the quality of public finances. Deficits in advanced economies need to be brought to levels that are in line with a sustainable debt path. After several years of recovery, this suggests a broadly balanced budget.

Reduce bureaucracy

Most countries still have quite some way to go. Moreover, budgets need to be more growth friendly with less bureaucracy, more emphasis on high-quality spending such as education, and fewer untargeted transfers that undermine incentives to work.

Another challenge will be the creation of an institutional environment that is conducive to sound public finances. For decades, the European Commission, the IMF and the Organisation for Economic Co-operation and Development have thrown their weight behind rules that create hard budget constraints and avoid runaway expenditure.

This is especially important in Europe, where the Stability and Growth Pact is essential for anchoring medium-term expectations. Credible rules build confidence and sticking to one’s promises builds confidence; the opposite behaviour creates uncertainty. It is short-sighted of these institutions to start calling for more discretion and flexibility to the rules in order to justify fiscal stimulus. Once credibility is gone, it is very difficult to rebuild.

Quality of public finances and sound rules are linked with the need for a favourable business environment and smart regulation for sustainable growth. There are plenty of issues: improving vocational training for young people in Europe, adapting pension systems to demographic trends, liberalising professional services, streamlining administrative procedures, and bringing industry and the public sector up to speed in the digital age. Financial sectors need to be strengthened further.

In summary, governments need to reform their core functions: sound public finances, high-quality services and a favourable economic environment are guarantors for growth and sustainability. In other words, we need a rethink on fiscal policy and a return to more fiscal normality, spending one’s money wisely and not living beyond one’s means.

Ludger Schuknecht is the chief economist and director general for fiscal policy and international financial and monetary policy at the German ministry of finance.


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