Fiscal intervention is, again, a vital part of the government policy toolkit, supporting plans to boost domestic industries and fight climate change. But while well-intended, such measures will add to already elevated debt levels, with significant implications for investors, as Michael Grady explains.
Read this article to understand:
- Why governments appear to be rediscovering their taste for fiscal intervention
- Why various developments look set to add to debt burdens
- Potential implications for bond markets
At the end of the 1980s, governments around the world began to cede cyclical demand-management of their economies to central banks as they attempted to correct the policy failures of the previous decade. Some pointed to the success of Germany, which had managed to sidestep the inflationary episodes that plagued other nations.
Its success was widely seen to be down to having an independent central bank that had pursued monetary stability after the breakdown of Bretton Woods. Before long, economic orthodoxy maintained central banks, not governments, were best placed to deliver low and stable inflation and, with it, satisfactory growth and employment.
Beyond providing automatic fiscal stabilisers as the economy moved through different stages of the economic cycle, there was little merit in governments intervening via fiscal policy, according to the new prevailing wisdom. Instead, their focus should be on making the economy more efficient and productive via so-called supply-side reforms.
This view began to change in 2008 with the onset of the global financial crisis. While governments continued to rely heavily on central banks to do much of the heavy lifting, they also intervened forcefully themselves, bailing out banks that would have otherwise collapsed.
The scale of state intervention during this episode may have been unprecedented, but the record did not last long. It was comfortably exceeded by the fiscal support offered during the COVID-19 pandemic.
Figure 1: General government net lending (per cent)
Source: Aviva Investors, Macrobond, May 2023
Is a new consensus emerging?
Having controversially bailed out banks during the financial crisis, many governments no doubt thought they had little option but to support to households and non-financial businesses in response to a pandemic they had neither caused nor had any control over.
That support was largely warranted to provide a bridge for households and businesses to the point at which an effective vaccine had been rolled out. Nonetheless, from an investment perspective, it is right to wonder whether a consensus has emerged around more state interventionism and whether it is here to stay. After all, governments will not be unaware that financial markets barely flinched at the huge cost of the COVID-related bailouts. It is possible they will not hesitate to make available equally generous schemes to compensate households and other economic actors as and when the next crisis occurs.
Major structural developments will go on adding to the upward pressure on deficits
In the meantime, major structural developments will go on adding to the upward pressure on deficits. Governments around the world need to undertake considerable spending programmes to decarbonise their economies to tackle climate change. In Europe, where climate change targets are particularly ambitious, significant public spending and investment is required. While smaller in scale, proposed US spending to tackle the same problem, as outlined in the Inflation Reduction Act (IRA), is far from trivial either.
Governments are simultaneously ditching free market economics in favour of developing domestic industrial bases, a process that once again will likely necessitate sizable fiscal outlays. The IRA is the most clear-cut example, but the EU is looking to follow the US’s lead with its Net-Zero Industry Act and changes to state aid rules.
This urge is being driven partly by the need to shore up supply chains that were found badly wanting during the pandemic and to ensure the continued supply of vital items, most notably microchips, amid Chinese sabre-rattling towards Taiwan and rising animosity between China and the West. In an increasingly protectionist era, it is also being driven by fear of missing out on nascent technologies that could play a crucial role in the future.
It also appears defence spending will rise appreciably in much of the world. This is most obviously evident in Europe, where several countries, including Germany, have vowed to increase spending in response to what they perceive to be the growing menace of Russia following its invasion of Ukraine in 2022.
Balancing the books
Governments have little ability to find the money needed from elsewhere in their budgets, given inexorable pressure for increased spending on health and pensions as populations age. Making even marginal changes to entitlements citizens have grown accustomed to is hugely difficult. Witness recent events in France, where President Emanuel Macron’s plans to raise the retirement age from 62 to 64 and increase the level of contributions required to receive a full pension have caused the worst social unrest in years. Trying to sell a net increase in taxation to voters will be no easier.
In a broader context, greater use of fiscal policy should alleviate some of the burden on central banks. With real rates of interest still uncomfortably low, as and when the next recession arrives central banks may find it hard to stimulate economic activity given their reluctance to take rates into negative territory.
Should trend economic growth rates decline, there is a danger this becomes problematic
However, negative side effects may also result. For a start, debt-to-GDP ratios are already uncomfortably high in many countries. Should trend economic growth rates decline, there is a danger high debt-to-GDP ratios become problematic. Then again, warnings fiscal deficits are on an unsustainable path are nothing new and the experience of countries with robust institutional frameworks and their own currency suggests such fears can be overblown.
Any shift to greater fiscal intervention raises various other risks. Governments began to refrain from fiscal activism in the 1980s owing partly to the view they had not been very successful at it. All too often it was used for political rather than economic reasons, leading to policy interventions being badly timed. There is no reason to think fiscal interventions that attempt to smooth economic cycles or pick winning industries would be any more successful now.
Arguably, Joe Biden’s $1.9 trillion fiscal boost, announced shortly after he assumed office in January 2021, was unnecessary. With limited spare capacity and tight labour market conditions, it added to inflation and forced the Federal Reserve to raise rates even more aggressively than it might otherwise have needed to.
Rising economic volatility
The likely consequence of rising fiscal intervention is greater economic volatility in activity and inflation, as well as increased policy uncertainty. That may seem counterintuitive if fiscal policy is being deployed to mitigate the impact of economic shocks. However, the danger is that intervention is badly timed, too big and/or used for political reasons. That would risk more uncertainty and variability, not less, especially in instances where fiscal policy is pulling in the opposite direction to monetary policy. The fallout from the disastrous ”mini budget” in the UK last autumn was a case in point.
At present, there is little to no term premia being built into the yield curves of major bond markets
To the extent fiscal intervention fuels risk-taking behaviour by households and companies, it is likely to add to economic volatility. For example, should households start to believe governments will pay their wages every time a big shock happens, they may start to see little or no need to set money aside and build up a savings buffer.
Rising economic volatility and uncertainty, combined with the potential for higher long-term inflation and rising deficits, all argue in favour of an appreciable steepening of bond curves. At present, there is little to no term premia being built into the yield curves of major bond markets. If increased intervention is here to stay, the likelihood is investors will eventually begin to demand compensation for the increased risks they are taking.
That would argue for a cautious approach to holding longer-dated government bonds, despite the highest yields on offer in over a decade, until term premia shifted up. But it could make longer-dated inflation-indexed bonds more attractive if inflation remains elevated and more volatile. Steeper yield curves would also likely weigh on valuations for other assets, due to higher discount rates. Long-duration assets, such as equities and real estate, would likely be most impacted.