Monday, 12 January 2015

Fiscal Policy – Not fighting back

The government has been subdued in the fight to revive the economy despite a change in strategy being long overdue

Considering the trouble we are having fighting back against the aftermath of the financial crisis, it seems strange that the government is not using its full arsenal.  Central banks have come out all guns blazing with their monetary policy but governments have held back from firing up fiscal policy.  Worries about their levels of debt were behind this tepid response by governments but such concerns have eased while the economic recovery struggles to pick up momentum.  Why should be suffer further losses while saving our ammunition?

Hit and miss

Central banks launched themselves into the front line while governments remained in the background due to self-inflicted wounds.  Monetary policy had been enough to deal with past recessions and resulted in a belief that central banks were infallible in this regard.  High levels of debt along with a banking sector under attack meant that low interest rates had little effect and quantitative easing was not much better.  Along with not making much headway, monetary policy also caused considerable collateral damage in the form of financial instability.  This was a sign that central banks were being asked to do too much in the face of a once-in-a generation economic slump.

Most governments were happy to sit back having mismanaged their finances resulting in high levels of government debt prior to the crisis.  The Eurozone crisis prompted governments to further retreat amid worries that investors would shun any government with too much debt.  This pushed governments off on a trajectory of austerity which continued even though fears about government debt abated within several months.  The economic recovery has been muted due to weak demand with companies not willing to invest despite low interest rates and consumers hurting due to large debts and stagnating wages.

Time for a new battle plan

Monetary policy was always likely to struggle to make much ground while there is little impetus to spend, let alone borrow.  This shortfall could be overcome by the government which fixes problems, from crime to pollution, that are caused by others.  Keeping the economy ticking over when spending would otherwise be weak would prevent more damage being done to the economy.  Otherwise, the economy becomes less productive as firms stop investing in new technologies and the skills of people out of work deteriorate.

It seems an even more obvious solution at a time when there is so much that the government could spend its money on such as improving Internet access, accelerating the uptake of renewable energy, and updating transport infrastructure.  The low interest rates provide the perfect opportunity to invest for the future especially when companies are not up to doing so.  Investment projects could be set up to boost output in the economy for a few years until spending from other picks up the slack. 

A winning strategy

Despite the still faltering economic recovery, governments loathe changing direction and austerity continues to reign in Europe and the UK (as well as US to a lesser extent).  Moves to fix government finances made sense following the jump in interest rates on government debt in the Eurozone but this turmoil in the financial markets has long passed.  Weak overall spending and the threat of deflation setting in is now the dominant problem facing many countries. 

Higher spending by the government that lifted the productivity of the economy could be funded through borrowing at low interest rates and repaid through higher taxes that a more efficient economy would generate.  This is the opposite of what is happening in the UK where austerity is hurting the economy and efforts to reduce the government deficit are being thwarted due to a fall in money from taxes. 

There is still time for a change of strategy to have an impact in the fight for an economy recovery that improves the lives of us all.  Even if it is too late, investing for the future when interest rates are at record lows seems like a no brainer.  A change is due as this is a battle that no one wants to lose.

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