How Likely Is This Regime Shift Towards More Aggressive Fiscal Policy?

While we see a more activist role for fiscal policy over the secular horizon, we are not banking on a regime shift that reduces the global savings glut enough to get us out of the New Normal’s L-shaped growth framework, globally. In a recent piece, for example, we have argued that U.S. interest rates could converge to or move below zero as the next economic downturn hits.

Still, increasing populist pressures, low borrowing rates, and limited monetary policy space and effectiveness mean that the chances of having a regime shift in the coming years is likely to rise. On a relative basis, the countries most likely to embrace this shift in our view are the English-speaking ones. Here’s our assessment region by region:

• US & UK: In terms of ability to handle a fiscal deficit, the UK’s budget deficit is at a 17-year low, giving politicians some wiggle room, while the U.S. can handle its rising debt/GDP ratio given the “safe-haven”, global demand for its Treasury notes. Both countries also have the support of their respective central banks, which provide significant anchors. In terms of willingness, and following Britain’s decision to leave the EU, most British political parties seem more open to fiscal expansion. In the U.S., meanwhile, a fiscal regime shift depends on the degree of institutional cohesiveness (President and Congress belonging to the same party) and on whether the government’s majority in Congress is sizeable enough. The bar for that to happen remains relatively high, which is why a fiscal regime shift in the U.S. is not our base case at present.

Europe: Fiscal easing has been constrained since the 1992-Maastricht treaty, and the countries that can actually afford to loosen up, such as Germany and Holland, appear less willing to so do. On the other hand, those most willing to spend, like Italy, are the least able. The Eurozone is also constrained because the ECB faces institutional and political constraints to buy national debt. In our baseline scenario, we therefore don’t expect a meaningful fiscal expansion in the Eurozone over the secular horizon.

• Japan: It is possible that fiscal policy turns more aggressive over the secular horizon. But given the lack of previous success, we think that such a move would be both less of a regime shift and probably less effective than in the U.S. Also, the very high starting debt level is already a constraint, while the VAT hike planned for later this year raises questions about the country’s willingness to embark on more fiscal easing.

What If The U.S. Goes Alone?

If meaningful fiscal easing ahead is concentrated in the U.S., we would expect the effects outlined above to be outsized for the U.S. economy relative to the rest of the world. In this scenario, the interest rate differential between the U.S. and the Eurozone could become more entrenched, the U.S. dollar would most likely strengthen and the country’s current account deficit widen (under former president Regan’s fiscal easing in the 1980s, the current account balance worsened by around 3% of GDP).

This could stall the improvement in global current account imbalances witnessed since the financial crisis, as seen in Figure 4: The U.S. has stepped up oil production, reducing energy imports and hence improving the country’s external deficit. The mirror image of that has been a fall in the surplus of the countries which exported oil to the U.S. What’s more, China has increased services imports (mostly tourism), reducing its longstanding surplus. Partly offsetting the overall global improvement in imbalances, the Eurozone’s surplus has increased, driven by a weak euro, a correction of current account deficits across the economically challenged periphery, and a sticky high surplus in export-driven Germany.