The Brave New World Of Integrated Fiscal And Monetary Stimulus

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By Darren Williams

Is a more active fiscal policy really the answer to what ails the global economy? And has the great monetary experiment finally reached the end of the road? We're not so sure.

It's scarcely possible to read an article on economic policy these days without hearing that central banks have run out of ammunition and need to open the fiscal floodgates. Even the British government has joined the fray, with new prime minister Theresa May highlighting her opposition to quantitative easing (QE) and promising that "change is coming."

We concede that expansionary fiscal policies encourage economic growth while they're still in force-and that fiscal stimulus is likely to have a more direct and immediate impact on output than monetary stimulus does. So, while question marks might surround size and scope, a switch towards a more active use of fiscal policy should be positive for growth, at least in the short term.

But there are important caveats.

THE LIMITATIONS OF FISCAL FIREPOWER

Most proponents of fiscal expansion still view it through a conventional demand-management or business-cycle lens. From this perspective, a quick dose of stimulus is enough to push the economy back onto a "normal" path. And fiscal fine-tuning of this type is probably the right medicine when economies face conventional business-cycle recessions or shocks to demand, as in the case of Brexit.

But what if economies face more persistent headwinds-such as the deleveraging phase of a debt supercycle or secular stagnation? Under those circumstances, a temporary burst of fiscal stimulus is unlikely to provide much more than short-term relief, with growth slipping back again once the stimulus has worn off.

That's where the idea of permanent fiscal stimulus comes in. No country has grasped this nettle yet, though Japan comes closest. But this would require permanent support from monetary policy, which brings us to a crucial point: fiscal policy shouldn't be seen as an alternative to monetary policy but as a complement. We describe this as being joined at the hip.

POLICY ACTION: NOT AN "EITHER OR" PROPOSITION

This raises an important question: Is monetary policy supporting fiscal policy or should we think about it the other way around? In other words, can fiscal policy channel monetary stimulus into the real economy instead of driving it into asset prices, as has been the case with QE?

More and more, we think this might be the case or, at least, that the distinction between monetary and fiscal policy is blurred.

For many observers, this might seem like semantics. But with media headlines heralding the death of QE, it's vital to understand that this isn't an "either or" choice. In other words, effective fiscal stimulus will only be possible in the UK with ongoing support from monetary policy. As George Freeman, the head of the prime minister's policy unit said recently, the British government is "looking at all the mechanisms to make sure money flows properly" (in other words, into the real economy).

Until recently, we had thought that Japan was likely to lead the charge into the brave new world of joint fiscal and monetary stimulus. Now, under Theresa May's leadership and with a hard Brexit looming, the UK might be set to join it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.