The cost of the fiscal stimulus - Capital Economics
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The cost of the fiscal stimulus

Global Economics Update
Written by Vicky Redwood
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In this Update, we answer some key questions about the fiscal stimulus underway in advanced economies. In short, government deficits are set to soar, probably rising by more than after the financial crisis. This is not an immediate problem, given that central banks will effectively finance those deficits. Even further ahead, higher debt levels won’t be a problem for some countries. But for others, notably Italy, they will.

  • In this Update, we answer some key questions about the fiscal stimulus underway in advanced economies. In short, government deficits are set to soar, probably rising by more than after the financial crisis. This is not an immediate problem, given that central banks will effectively finance those deficits. Even further ahead, higher debt levels won’t be a problem for some countries. But for others, notably Italy, they will.
  • How big is the fiscal support? The size currently varies a lot between countries, from barely anything in Japan to packages worth around 20% of GDP in some European countries. In all countries, though, this support is certain to rise further. For example, Japan is considering a package worth ¥30trn (5.2% of GDP).
  • What do the measures consist of? The measures announced fall into two categories. (See Chart 1.) The first is actual giveaways (e.g. cash payments to people, tax breaks for firms). The second, far bigger component, is loans and guarantees to businesses. But note that many of the costs attached to the latter may either be recouped (in the case of loans) or never realised (in the case of guarantees), depending on the level of defaults etc. Indeed, the US government ended up making a profit on its bailout of the banks in 2008.
  • How much will deficits rise? Deficits will be pushed up by two factors in the near-term. The first is the direct giveaways mentioned above, which are already up to around 5% of GDP in some countries. The second is the “automatic stabilisers” – as falling GDP reduces tax revenues and raises spending on things like unemployment benefit. These vary by country depending, for example, on the generosity of the welfare system. (See Chart 2.) Combining these OECD estimates in Chart 2 with our GDP forecasts suggests that automatic stabilisers will boost the deficit by a further 3% to 4% in countries with the deepest downturns.
  • So it already looks as though deficits could rise by 4% to 8% of GDP this year. (See Chart 3.) Indeed, deficits in some countries (including Germany and the UK) are likely, in just one year, to exceed the deterioration seen in the three years after the financial crisis. (See Chart 4.) (Continued overleaf.)

Chart 1: Discretionary Fiscal Stimulus Announced Since Coronavirus (% of GDP)

Chart 2: Effect on Budget Deficit (As a % of GDP) of Each 1 Percentage Point Rise in the Output Gap

Chart 3: Possible Effect of CV on Budget Balance in 2020 (% of GDP, Based on Fiscal Measures as at 26th March)

Chart 4: Change in Budget Balance 2007-2010 (% of GDP)

 

Sources: Refinitiv, Capital Economics, OECD

  • Moreover, this estimate should be considered a minimum. Government measures are still rising by the day. Shutdowns may be longer than the three months or so that we have assumed. And there may be some cost from the various loan guarantees and other contingent liabilities. At least if the crisis is over by later this year, deficits will shrink rapidly again next year, as the discretionary measures end and economies rebound.
  • How will governments pay for this? Obviously, they are not going to fund these packages by raising taxes, so the measures will be debt-financed. A deficit of 10%-20% of GDP for a year would boost government debt to GDP ratios by 10ppts to 20ppts, which seems manageable for most countries in this era of low interest rates. Indeed, government bond yields have generally remained low. Admittedly, the extra issuance will be concentrated in a relatively short period of time. As it is, though, markets’ ability to absorb this debt won’t need to be tested, given that most central banks have announced big (in some cases unlimited) quantitative easing (QE) programmes, meaning that they will hoover up these new bonds. (See Chart 5.)
  • What are the implications of a fiscal stimulus financed by QE? This blurs the line between monetary policy and fiscal policy to an extent not seen before. The QE during the financial crisis was designed to lower bond yields, which did make it cheaper for the government to borrow. But central banks never went so far as, in effect, to buy government debt. We do not think that this is a major blow for central banks’ credibility, though. Their independence is intact. And it would be worse for their credibility to let the economy freefall.
  • Won’t all this spending boost inflation? Certainly not in the near term. Even if fiscal policy halts the decline in demand, it will not stop a big recession. Some fear that inflation will pick up further ahead; after all, governments are pumping money in, but they cannot conjure up more supply. And it is true that some people will have pent-up money to spend after the virus. But they may want to maintain a higher saving rate. And firms will be paying back their loans. Meanwhile, supply should come back onstream quickly once the virus passes. And if signs of inflation did emerge, central banks could tighten policy – unless policymakers deliberately engineered higher inflation to erode their debt. (See below.)
  • How will governments repay this debt? The least painful option is to let the debt be eroded gradually by economic growth. (As long as the deficit is kept low enough to ensure that debt is rising slower than GDP, the ratio of debt to GDP will fall). This could be combined with some form of financial repression to keep real interest rates low (e.g. requiring banks to hold some government bonds). This is the main way in which the US and UK reduced debt from the extremely high levels reached in the Second World War, although it took several decades. (See Chart 6.) Countries such as the US and UK might choose this route again.
  • However, countries with weak nominal growth prospects (e.g. Italy) cannot do this. They would face three options, none of them appealing. The first would be austerity in order to run budget surpluses. But that didn’t exactly go well after the global financial crisis and was perhaps even counter-productive. The second would be to inflate away the debt, but this could have disastrous consequences, might not even work and is generally seen as a last resort. Italy cannot do this on its own anyway. The third would be outright default. We expect some emerging markets to go down this route, and Italy may end up doing this eventually too.
  • How would a helicopter drop change things? If policymakers permanently boost the money supply to buy government bonds, there will be no government debt to repay. That said, it is questionable whether a helicopter drop can ever be truly permanent, as central banks would seek effectively to reverse it as and when inflation picked up. And the bar to undertaking a drop could be pretty high for most countries.

Chart 5: Discret. Fiscal Stimulus & QE (% of GDP)

Chart 6: UK Government Debt (As a % of GDP)

Sources: Various, Capital Economics.

Sources: Capital Economics, HM Treasury


Vicky Redwood, Senior Economic Adviser, victoria.redwood@capitaleconomics.com