The next front is fiscal
Oct 30th 2008
From The Economist print edition
Interest-rate cuts are welcome; but as a global recession looms, the case for fiscal stimulus grows
THE good news is that the world seems to have dodged a catastrophic banking collapse. It is too early to know for sure—some emerging markets are in trouble and stockmarkets are behaving violently (seearticle). But interbank and commercial-paper markets suggest that the blind panic is abating.
The bad news is that the world economy is weakening fast. Across the globe falling asset prices, tighter credit and declining confidence have left firms and consumers unable or unwilling to spend and invest. In America consumer confidence has collapsed to its lowest-ever reading (see article). In Germanythe Ifo index, a gauge of business confidence, has sunk to a five-year trough. Because the downturn is now global, it is harder for exports to make up for weak domestic demand. The odds of a long, nasty recession are growing. So, too, is the case for more government action to counter weak private demand.
The usual mechanism is through interest rates. Economic orthodoxy looks to central bankers tosmooth demand, because short-term interest rates are easier to calibrate than tax and spending and are controlled by technocrats rather than politicians. America’s Federal Reserve cut its policy rate by a further half point, to 1%, on October 29th. Held back by fears of inflation, Europe’s central banks have cut much less—a timidity that ought to be abandoned now that the risk of inflation isevaporating: both the European Central Bank andthe Bank of England should cut rates boldly at their meetings next week
But it would be a mistake to expect too much from rate cuts. The financial system’s stresses have made them less effective, as banks hoard cash and scale back lending. And in America, at least, short-term rates have little room to fall further. So the next policy front should befiscal (see article).
When credit markets are dysfunctional, private demand is fading and confidence weak, a fiscal jolt is a good option. Cutting taxes puts extra cash straight into people’s pockets. By stepping up their own spending, governments can directly boost demand and employment. True, stimulus increases short-term government deficits—but the fiscal damage from a prolonged slump would begreater still, as Japan showed in the 1990s. With the private sector unwilling to spend and nervous investors clamouring for safe government bonds, there is little risk of crowding out private investment.
Some countries have more scope for fiscal stimulus than others. Many governments in emerging markets, especially those with big external deficits, will be limited by investors’ unwillingness tohold their debt. That is why Hungary tightened its budget this week. At the other extreme lies China—with huge foreign-exchange reserves, and a current-account and budget surplus. Within the rich world, countries such as Italy, with ageing populations and high debt burdens, have less room. So, too, do those with smaller, less liquid debt markets.
America has the greatest scope for short-termstimulus, despite running the world’s biggest current-account deficit. That is because dollars and Treasuries rank as safe havens nowadays. Also, because its taxes are lower and social-safety nets less generous, America has fewer “automatic stabilisers” than Europe, where spending on unemployment benefits automatically rises further in a downturn. America’s fiscal federalism tilts in the oppositedirection: most states must run balanced budgets and so cut spending in hard times. It has already had a boost worth $168 billion or just over 1% of GDP (mainly through tax rebates). Sensibly, Congress is planning another, of 1-2% of GDP, soon after the election.
Europe, too, may need a fiscal stimulus before long. Spain already has a package; Germany is considering one. Britain’s Chancellor,...