July 21, 2020

Macro Series

Global Letter – You wouldn’t want to start from here

BY Russell Jones

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( 4 mins)

The policy challenges facing the advanced economies are daunting, and many will fail to deliver.

No holds barred

Fiscal and monetary policy were loosened rapidly and often unconventionally in response to the COVID-19 pandemic and the stringent containment measures taken to bring it under control. Public sector deficits and debt burdens have ballooned to unprecedented peace time levels, yet interest rate term structures have declined to historical, frequently sub-zero, lows as central bank balance sheets were encouraged to expand with little thought of constraint.

The impact of these extraordinary initiatives has no doubt been broadly constructive. Asset markets stabilised, then rapidly recovered. The depth and duration of declines in output and employment were moderated. The easing of lockdowns has sparked rebounds in activity that have if anything exceeded initial expectations. And the hope is that longer-term damage to productive potential will as a result be less than it would have been otherwise.

That said, although some governments, and not least those in Europe, have begun to look to the future, most of the policy support in place can best be described as ‘filling a hole’ in final demand, rather than ‘constructing a launchpad’ for a vibrant and sustainable cyclical upswing. In the meantime, the risks to recovery remain considerable, whether they reflect the direct effects of continued flare-ups in the infection rate, or the enhanced uncertainty and precautionary savings that almost inevitably go hand-in-hand with such a large and novel shock.

This begs the question: where should policy go from here?

The virtue of patience

Perhaps the first priority is that the overall stance of macro policy not be thrown into reverse with the undue haste that marked the aftermath of the Global Financial Crisis, and which helped to embed that shallow and uneven recovery. As with the costs of war, it makes sense that the costs of dealing with the virus be spread out over an extended period, rather than be met immediately. Sub-target inflation, super-low interest rates, and the absence of significant sovereign risk premia are supportive of that course, and the contemporary political dynamic seems more sympathetic to such a Keynesian approach than was the case in 2011 and subsequently.

Nevertheless, debt levels are egregious, low interest rates seem increasingly to be fuelling unfounded exuberance in risk asset markets, and those of a more conservative disposition towards aggressive macro policy activism have not gone away. Any tendency towards rising borrowing costs, and broader financial volatility could boost pressure for a return to a less expansive stance.

Beyond this, achieving sustained growth over the longer term will require that policy evolves away from targeted income and employment support, and towards initiatives that offer the maximum ‘bang for the buck’: enhancing productivity, and easing inequalities, whether of wealth or income, region or generation. This points to a warranted focus on higher return infrastructure investment projects in transport networks, digital enhancement, climate change and the like. It also points to accelerated reforms that foster resource reallocation, including in particular Active Labour Market Policies, vocational training, and bankruptcy procedures. And all the while, social stability in some countries at least will depend upon protection being maintained for the most vulnerable.

Such priorities stand to underpin potential output, social and political stability, and address burgeoning environmental concerns, while increasing the ability to pay back the debts incurred without an undue rise in future tax burdens. However, this is not to deny that in the context of rapidly ageing population structures, there will remain an imperative for the widening of tax bases, more environmental taxes, greater efforts to address tax evasion, and the imposition of a greater burden on monopolies, not least those in the tech sector.

The good, the bad, and the ugly

The requisite policy menu is both extensive and demanding, and will reach critical mass only slowly. Some governments, especially those of a more populist bent, will not possess what it takes to deliver it. Instead, they will lean on central banks to take risks, and pursue more protectionist and corporatist intervention strategies that, while they might generate impressive short-term results both economically and politically, stand only to store up greater problems for later. 

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