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The end of fiscal conservatism? The largest shift in economic policymaking in a generation

A politician seen not advocating for fiscal conservatism is to flirt dangerously close with the label of being fiscally irresponsible. For decades now, policymakers in the US kept a tight rein on public finances to ensure the public debt ratio stays low, while the central bank routinely seeks to contain economic booms and busts. Exercising fiscal discipline has always been synonymous with good governance, or so we thought.

The world may be precipitating on the brink of the largest gravitational shift in economic policymaking in a generation, with the US paving the way towards looser fiscal policy after decades of practising fiscal conservatism. Persistently low inflation is allowing central banks to keep interest rates down, which eases the cost of servicing the public debt. This led many policymakers and economists to urge governments to capitalise on what they perceive to be a long term trend, arguing that there is much more to gain from loosening fiscal shackles.

The Congressional Budget Office’s latest outlook projected deficits to average 4.4 percent of GDP in 2020-2029, exceeding the average of 2.9 percent over the last 50 years. If this trend persists, this estimate will mean that public debt as a share of GDP will eventually surpass records set immediately after the second world war. In 2017, the US recorded a government debt equivalent to 105.4 percent of the country’s GDP. Econometric models from Trading Economics project US’s public debt-to-GDP ratio to trend around 110 percent in 2020.

US politicians on both sides of the divide may publicly deplore deficits, but their actions say otherwise. President Donald Trump led his party to embrace a deficit blowout that will soon take its annual budget shortfalls above the $1 trillion mark. On the opposing end, Bernie Sanders, a frontrunner for the Democratic presidential nomination, proposed major spending increases on public health and environmentally friendly investments such as the Green New Deal. Researchers from the American Action Forum, a self-described “center-right policy institute”, estimate the deal might cost between $51 trillion to $93 trillion.

Bernie Sanders, the Democratic Senator for Vermont and presidential hopeful, runs a socialist campaign that backs free college tuition and higher tax rates for the rich

It is not only politicians that are shifting away from the practice of tightly controlling public borrowing. In a January presidential address to the American Economic Association, Oliver Blanchard, former IMF chief economist and a Professor at MIT, argued that fiscal policies should be given a greater emphasis since interest rates appear to be persistently low. In a clever twist against Thomas Piketty’s argument that inequality will increase if interest rates were higher than growth rates, he argued that so long as the growth rate exceeds long-term, risk-free interest rates, countries can have higher debts as it becomes easier for countries to service their debt as their economies grow. “The issuance of debt without a later increase in taxes may well be feasible. Put bluntly, public debt may have no fiscal cost,” Prof Blanchard said.

One radical view proposed by Mr Sanders is the Modern Monetary Theory (MMT), which starts from a simple observation that the US dollar is a public monopoly controlled only by the United States administration. Unlike a household, which is dependent on the government for spending and investments, the federal government is only dependent on itself. “The federal government cannot run out of money, thus it cannot face a solvency problem. It never has to worry about finding the money it wants to spend,” said Stephanie Kelton, Professor of Economics at Stony Brook University and Mr Sander’s previous economic advisor. Mrs Kelton explained that instead of a budget constraint, the government is only constrained by the growth of inflation, and the only limiting factor on government spending is the availability of real resources.

Stephanie Kelton, a staunch supporter of MMT, advocates for deficit spending during recessions and when monetary policy has lost its power to stimulate spending

But proponents for continued fiscal consolidation are not standing by idly. Professor Kenneth Rogoff of Harvard University has cautioned against the optimism that interest rates and inflation will stay persistently low in the long run, allowing for the financing of MMT as public debt becomes cheaper. “You can have much more debt when interest rates are low. In MMT, the debt is all very short term, so [the debt] is cheap, but risky,” he said. “It’s very cheap until it’s not.”

The consequences of a high debt ratio are still very real, of course. A high debt ratio would fuel concerns of a sovereign default risk, increasing the positive risk premium, resulting in the government facing a higher interest rate on its borrowing. In a vicious cycle, it may further dampen investment, worsening the debt ratio and perpetuate the risk of a sovereign default. Especially for an advanced economy with a large public debt ratio, fiscal restraint is an important priority for the government in order to maintain a stable and manageable public debt ratio.

The stage is set, then. In the upcoming years, the world is prepared to witness a major fiscal battle between fiscal conservatism and looser fiscal policy. And the stakes? The financial and economic health of the world.

Christopher Lim



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