Ordinarily, the role of tax and spending in smoothing economic cycles is to stand back and let monetary policy do the job. Central banks, whose instruments are more finely tuned than those of finance ministries, are traditionally the ones to steer the economy.
But these are not ordinary times. In the advanced world, weak growth and the threat of deflation have driven monetary policy towards its limit. And in many emerging economies, a five-year flood of capital inflows and booming commodity prices, now being reversed, has left inflation and external deficits worryingly high.
In such circumstances, fiscal policy has an important counter-cyclical role. Sadly, across much of the world, there is a dysfunctional symmetry. In some advanced economies, fiscal stances are tight where they should be loose. In some emerging markets, fiscal policy is loose where it should be tight. In both cases, too much of the burden has fallen on central banks which have taken extraordinary measures to deliver economic normality.
Within the rich world, the US recently exited QE3, its third bout of quantitative easing. It might not have had to go so far had fiscal policy, expansionary immediately after the crisis, not encountered severe congressional dysfunction with fights over the debt ceiling and the fiscal cliff. Estimates by the Brookings Institution suggest fiscal policy subtracted nearly a percentage point of US gross domestic product growth a year between 2011 and 2013. Congressmen and senators complaining about the effects of QE3 might reflect on their own part in making it necessary.
Today’s equivalent is the eurozone, where the European Central Bank has to struggle against the tide of contraction imposed by the EU’s budget rules. Mario Draghi’s show of determination this week to push ahead with asset purchases is admirable. But the ECB chief’s task is made much tougher by Germany’s wrong-headed determination to eliminate its fiscal deficit next year despite its own – and the eurozone’s – economy crying out for investment.
Japan, while its position is much less clear-cut, does need to be careful. The Bank of Japan is right to have expanded its own version of QE. Now Shinzo Abe must assess whether proceeding with a second increase in consumption tax next year risks creating a headwind.
By contrast several emerging markets, notably Brazil and Turkey, have the opposite problem. Past fiscal profligacy and structural rigidities have created wide current account and budget deficits together with high inflation. The overvaluation of the Brazilian real between 2011 and 2013 owed less to a global currency war than to loose fiscal combined with tight monetary policy, a recipe for appreciation.
With investors now having lost confidence, the real and the Turkish lira are under pressure. Investors showed what they thought of Dilma Rousseff’s commitment to fiscal consolidation and structural reform by selling Brazilian assets and the real immediately after she was re-elected as Brazil’s president.
As long as fiscal policy remains loose, Brazil’s and Turkey’s central banks need to resist political pressure and raise interest rates as necessary to control inflation. Such action is likely to weaken their slowing economies. This is unfortunate but inevitable. The fault is not with them but with the populist governments that have bought public support with borrowed money.
Normal times will not resume across the world economy for a while to come. Governments need to grasp the fact that fiscal policies matter for growth and inflation in the short as well as the long run.
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