Fiscal Policy: A Mega Trend Hiding in Plain Sight

One of the goals of the Franklin Templeton Investment Institute is to identify secular shifts in the world economy that will have enduring and significant impacts on capital markets, long-term investment returns, and the future of the asset management industry. While climate change, technological progress, geopolitical shifts and globalization garner the most attention as mega forces that will reshape our world for a generation, fiscal policy also belongs on this list.

The reason is simple. Two enormous crises—separated by a mere dozen years—have warranted massive global fiscal responses to prevent economic chaos and financial ruin. The result has been the highest level of government debt relative to GDP in 75 years across an array of advanced, emerging, and lower income economies.[1] Whether countries can cope with enormous debt burdens will have significant impacts on economic growth, the distribution of income, after-tax returns, inflation, interest rates, and political and financial stability in countries large and small.

First, it is important to recognize that since 2008, enormously astute and wildly successful public policies, in large part, prevented economic calamity that might otherwise have produced outcomes akin to the Great Depression. Together with extraordinary monetary policy easing, timely and effective tax cuts, large-scale government expenditures, vast income support measures, and unprecedented credit guarantees prevented the global financial crisis (GFC) from spiraling into a major economic depression. These same measures were implemented to turn an alarming pandemic slump into the shortest recession in the postwar era. When the histories of economic public policy are written decades from now, the fiscal (and monetary) policy responses to the early 21st century financial and public health crises will be deservedly praised for saving the day. Their shortcomings were small compared to their contributions.

Yet, actions have consequences. According to the International Monetary Fund (IMF), the total stock of world government debt exceeded US$225 trillion in 2020, rising that year alone by more than US$25 trillion as governments unveiled an array of emergency measures to cope with the COVID-19 pandemic.[2] In 2021, total government debt increased yet again by a similar amount. Given their economic heft and financial resources, advanced economies and China have accounted for roughly 90% of the increases in government indebtedness during the pandemic. Few countries have been spared a deterioration in their budget positions, given impairments of tax revenues and increases in government outlays related to the economic and public health consequences of COVID.

While global gross government debt is projected by the IMF to crest just below 100% of world gross domestic product (GDP) in the next few years, many countries have already exceeded that threshold. Among developed countries, debt-to-GDP now averages over 120%, with Japan (257%), Greece (207%), Italy (155%), Singapore (138%) and the United States (133%) topping the list. Yet, even traditionally more fiscally conservative countries such as Australia (62%), New Zealand (52%), and Germany (73%) have seen a sharp increase in government indebtedness in the past two years.

Budget deficits everywhere have exploded. Government revenues, predictably, fell as GDP collapsed. But the real story is government expenditures, which, according to the IMF, soared across developed countries by an average of more than six percentage points of GDP from 2019 to 2021, and peaked at nearly 47% of GDP last year.

The global scale of the discretionary fiscal response to the pandemic has been staggering. After accounting for cyclical effects (so-called automatic stabilizers) and interest expense on the debt, rich countries, on average, boosted structural budget deficits by 5% of their collective GDP in 2020 alone, which is a figure unmatched in peacetime.

Discretionary fiscal expansion in larger emerging economies during the pandemic has amounted to about 3% of their collective GDP, with China accounting for the largest share. Nevertheless, revenue losses and spending increases, relative to GDP, have led to a deterioration of emerging economy public finances. Average debt-to-GDP levels in emerging economies are expected to top 65% in 2022, up from just 37% a decade ago. Low-income economies, predominantly in Africa, the Middle East, South Asia, and Latin America have also suffered due to deteriorating public finance positions. Average indebtedness for that group of countries, as a share of their GDP, now tops 50%, up 20 percentage points from 2012.[3]

In sum, public finances have worsened, almost without exception, worldwide since the GFC. Partly, that was the inevitable consequence of massive shocks. It was also a worthy collective response that prevented economic collapse. The questions that now arise include how those legacy deficits and debt levels will impact future political decisions, policy choices, economic activity, inflation, interest rates, income distribution, economic opportunity, and profitability.

In upcoming pieces, we will delve into more detailed analyses of how the mega force of fiscal policy will impact both the global economy and capital markets. The critical aspects of the discussion include:

1.?????Is the world economy facing a potential “fiscal cliff” as supportive tax and spending policies are withdrawn in 2022 and beyond, and might reversing fiscal stimulus positions put global growth at risk? The answer largely depends on whether private sector spending—by households and businesses—can overcome the “fiscal drag” associated with slowing government spending and, possibly, higher taxes.

2.?????How will large budget deficits and debt burdens restrain social choices and redirect priorities? The answer largely depends on national politics, with an obvious preview given by the reluctance of a minority of US Democratic senators to endorse an expansion of the US social safety net (i.e., “Build Back Better”). Deficits and debt matter because they condition behaviors.

3.?????Are levels of government indebtedness sustainable and, if not, where are fiscal or financial crises most likely? As the longstanding case of Japan demonstrates, if inflation is (too) low and the government has a central bank willing to purchase a large fraction of outstanding debt, even stupendous amounts of government liabilities can be sustained. Fiscal vulnerability, therefore, is arguably highest where central bank support is in question and institutional credibility is low, or if surging inflation requires central banks to end asset purchases and tighten monetary policies.

4.?????Might high government indebtedness erode the independence of central banks? Ultimately, that is a political question. But even central banks such as the Federal Reserve, with multiple mandates to preserve low inflation, full employment, and financial stability, could face competing priorities. When public indebtedness is high, monetary policy may become less independent of fiscal policy and more interdependent with it.

5.?????Do high levels of indebtedness inexorably lead to high inflation? A generation ago, most economists would have argued emphatically that deficits and debt are inflationary. But the advent of independent central banks committed to fighting inflation changed matters. Big deficits can create transitory increases in prices, but whether heavy indebtedness leads to persistent inflation depends on whether central banks can remain independent and focused on price stability.

6.?????Is it possible to grow our way out of today’s debt burdens? History—for example the US postwar experience or that of Ireland in the 1980s—suggests that strong growth and fiscal rectitude can happily coincide. But the preconditions are demanding. They must include accelerating trend economic growth and a sustained period where nominal GDP growth exceeds nominal interest rates on public debt. Absent rapid population growth, accelerating trend growth requires significant productivity gains. Subdued interest rates require quiescent inflation. Alternatively, debt burdens can be sustained via “financial repression,” including laws and regulations that would force financial intermediaries to hold large stocks of government debt.

7.?????Can the political courage be found to establish a long-term feasible roadmap for fiscal consolidation? Governments must be willing to “tie the hands of their successors.” That has happened before; for example, in Europe during the Maastricht convergence period to a single currency and in the Budget Enforcement Act of 1990 in the US. But long-term fiscal discipline is rare. “Kicking the can down the road” is the norm for governments not facing financial distress. Yet “can kicking” is little more than intergenerational and social disobedience, pushing the burden of adjustment on those unborn or those with less political power.

To uncover what our investment leaders are watching for in global markets for the year ahead, read the collection of our 2022 outlooks.

US readers: 2022 Outlooks

Readers outside the US: 2022 Outlooks

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[1] Source: IMF Fiscal Monitor, October 7, 2021, available at https://www.imf.org/en/Publications/FM.

[2] Ibid

[3] Ibid.