The politics of normalisation (& the return of fiscal policy)

Bill Clinton’s political advisor James Carville once famously said that if reincarnated, he wanted to come back as the bond market because ‘you can intimidate everybody’. It has been some time since bond vigilantes roamed the world sanctioning government fiscal policy.  Remarkably, US 2-year government bond rates are now over 60bp higher than their Greek equivalents.  And German 10-year government bond rates are only 150bp higher than Italian rates despite a public debt share that is only half of Italy’s 130% of GDP.

Much of this is due to aggressive central bank action, and is despite ongoing indebtedness of many sovereigns.  The collective large central bank balance sheets have risen to over $15 trillion, from about $4 trillion in January 2008, suppressing interest rates.

But as we start 2018, the end of QE is getting underway in the US and markets are pricing in tightening in Europe.  Government bond rates are moving up, and there is talk of the structural reversal of the 35 year long bond bull market.  Normalisation will have significant economic, fiscal – and political – effects.

Monetary policy has been more prominent than fiscal policy over the past several years. But we are transitioning from monetary policy primary to a period in which fiscal policy is also in the spotlight.  And this means a transition from a relatively technocratic decision-making process to one in which politics is more prominent. The salience of fiscal policy will rise for a few reasons.

First, normalisation will cause government debt servicing costs to increase.  Net interest payments by OECD governments (currently 1.8% of GDP) are about half of what they were 20 years ago even as the public debt stock has increased by around 50%.  The average G7 gross public debt load is about 100% of GDP, even excluding Japan: a 100bp increase in interest rates would lead to an additional 1% of GDP in debt servicing costs on average, or about 2-3% of government spending, constraining available funds for other uses.  Monetary accommodation has allowed governments to spend more than they otherwise could have.

Second, as QE unwinds, bond yields will be increasingly sensitive to the fiscal position.  Large scale purchasing of government securities by central banks has reduced the intensity of bond market discipline on many governments, compressing yield differentials between low and high public debt countries. The ECB has purchased about €1.9 trillion of Eurozone country government securities since 2015. In some countries, this accounts for a large proportion of the government debt available.

Third, there will be more demand for the contribution of fiscal policy.  Fiscal instruments will be needed to manage some of the likely economic volatility associated with the unwinding of QE, as well as to respond to future economic shocks.  There are structural pressures emerging across advanced economies, notably the fiscal costs of aging populations.  And the disruptive effects of new technologies will increasingly impact on advanced economies: fiscal resource will be required to respond to these effects (social insurance, skills and education initiatives, and so on).

So fiscal policy will move into the foreground again.  In general, small advanced economies – such as Switzerland, the Nordics, New Zealand, and Singapore – are relatively well placed to respond to such fiscal pressures.  Small economies have exercised fiscal discipline since the global financial crisis; many are running at or above fiscal balance, and have relatively low, stable public debt levels.  However, even well-rated small countries will need to work hard to sustain fiscal space.

However, there are other more indebted governments that are deeply exposed to a changing fiscal policy context. For example, the UK (~90% of GDP) and the US (~110% of GDP) have high gross public debt levels, as do France and Spain (both ~100% of GDP); and Japan is an outlier (gross debt of 240% of GDP, net debt of 120% of GDP).  Several of these countries are likely to attract greater bond market scrutiny as well as to be constrained in responding to new economic dynamics and shocks.

And the impact of normalisation extends beyond public sector debt.  The BIS reports consistently rising levels of private sector debt worldwide (household plus corporate debt), just off record levels at around 150% of GDP in Q2 2017.  Higher interest rates will have a material impact on households and corporates as well.

This means that this process of normalisation will be as much political as economic and financial.  Rising interest rates combined with existing fiscal constraints provides fertile ground for political conflict over choices between higher taxes and reduced spending (or higher debt), even in the context of improving GDP growth.  Monetary accommodation has had distributive consequences over the past several years.  But as we transition to a greater role for fiscal policy, the politics of economic management will become increasingly heated.

These political pressures also create risks to central bank independence, with likely demand for interest rates to remain lower for longer.  It is worth noting that central bank independence was developed (initially by small economies like New Zealand and Sweden) in a declining interest rate environment.  We shall see how sustainable it is in a different environment.

So although the idea is for an orderly normalisation process, political realities may intrude.  Economic management is unlikely to be a purely technical exercise.  As I wrote this time last year, there is a global shift underway from rules-based policy systems to more policy discretion and control.  In short, less Hayek, more Keynes.