More Fiscal, Less Money: The Forthcoming Rebalancing of the Global Policy Mix

Summary

• The IMF expects strong fiscal consolidation in 2022. This seems unrealistic because economic normalization appears unlikely until well into 2022 outside of the US.
• But even in 2023 and beyond, fiscal policy may not return to ‘normal’ because the pandemic has demonstrated that government issuance can expand with limited short-term market consequences.
• This could lead to a medium-term rebalancing of the policy mix towards greater reliance on fiscal policy. That could be positive for economic growth, negative for bonds and ambiguous for risk assets.

Market Implications

• Medium term, negative bonds.

Large Fiscal Consolidation Unlikely in 2022

2020 saw unprecedented fiscal policy easing, reflecting the economic collapse caused by the policy response to the pandemic (Chart 1). With global mass immunization underway, the IMF expects a similarly unprecedented pace of fiscal consolidation in 2022. In the largest four developed bond markets, the US, Japan, the euro area (EA) and the UK, the government deficit would fall by 4.9ppt of GDP on average. These numbers appear unrealistic.

The Broken Austerity Taboo

The pandemic has catalysed many pre-existing trends, such as the move from brick and mortar to online retailing. That could also apply to policymaking: for many years, several economists argued that fiscal policy with very low rates could be much more expansionary than consensus assumed. But somehow this view failed to enter mainstream policymaking before the pandemic.

The pandemic has vindicated support for more expansionary fiscal policies. The US, which has relied on fiscal policy more than most economies, is clearly outperforming in the recovery. Also, massive issuance has impacted yields little across most categories of issuers. For instance, Italy, rated Baa3/BBB, has seen a large decline in its cost of borrowing since the pandemic, while Australia, one of the last few sovereigns rated Aaa/AAA, has seen a large increase.

Germany and the EA Could Withdraw From Perma-Austerity

The EA is the part of the world where fiscal policies could loosen most in the medium term. Germany has elections in September, and early polls suggest the next governing coalition could involve the Greens and the CDU. The CDU recently chose Armin Laschet as candidate for the chancellorship, who is less popular with voters than his rival Markus Soder, adding to the risk that the Greens could become the main coalition partners. A CDU/Green coalition would likely withdraw from the zero deficit and try to address the infrastructure deficit. A less austerian Germany would also allow its EA partners to run more expansionary fiscal policies.

Greater Fiscal Activism Could Become a Global Trend

Since the GFC, yields have fallen by more than nominal GDP growth in many advanced economies, with the possible exception of Japan. This post-GFC change in debt dynamics could be one driver of the US shift to more expansionary policies that started under the Trump administration. The Biden administration continued this trend with a budget deficit at 15% of GDP for the second year in a row. Also, while the current administration plans to fund its infrastructure plan with tax increases, the increases are backloaded. In other words, the plan will add to the deficit in the first six years of its implementation.

Other countries could follow the example of the US and likely EA with more activist fiscal policies. A generalized deficit increase across most advanced economies could increase investors’ tolerance for loose fiscal policies, for lack of alternatives. Of the 12 countries with AAA sovereign ratings, only the US and Germany are large economies with deep bond markets, and negative bund yields suggest a shortage of bonds. Issuance in other countries rated AAA such as Australia, Canada, Denmark, Norway, Sweden or Switzerland is limited and low (if not negative) yielding.

Market Consequences

A rebalancing of the global policy mix towards greater reliance on fiscal policy would be negative for bonds. Net bond supply would be higher due to both greater government issuance and fewer central bank bond purchases. And because fiscal policy would shoulder a greater share of the burden of stabilizing economies.

The impact of a shift in the policy mix on risk assets is ambiguous. Higher trend growth could lift earnings growth, while higher yields could lower multiples since changes in government bond prices tend to influence financial asset prices across classes. Much could depend on the drivers of larger deficits with, for instance, investment in infrastructure more supportive of equities than tax cuts or transfers.