Philip Cross: The limits of monetary and fiscal stimulus

Financial Post
Limits of Monetary and Fiscal stimulus Financial Post | James Alexander Michie

Continuing stimulus over the past decade has reduced the scope for more stimulus. Brent Lewin/Bloomberg files

Canada wasted its opportunity to focus on policies that raise long-term potential, which means we have fewer and less effective tools to combat slumping global growth

As prospects dim for the global economy, policy-makers reflexively turn to more stimulus — as they have done for a decade at the first sign of slowdown. Already the Federal Reserve and the Bank of Canada have cut interest rates half a percentage point, with more assuredly on the way, while governments have signalled they are planning more spending and higher deficits.

But monetary and fiscal stimulus are reaching their limits — for at least three reasons. First, continuing stimulus over the past decade has reduced the scope for more stimulus. In everyday parlance, policy-makers are “running out of bullets.” Interest rates are near zero, while the accumulation of annual deficits by all levels of government has raised their debt to over 80 per cent of GDP, which restricts the room for further increases. This is why the Bank for International Settlements (BIS) has long urged government to curb borrowing during expansions so as to preserve “sufficient room for manoeuvre during busts.”

Second, like most economic processes, monetary and fiscal stimulus are subject to diminishing returns. Repeated use has dulled their impact. Low interest rates, for example, work partly by shifting spending from tomorrow to today. Over time, the amount of spending that can be borrowed from the future falls simply because demand for housing and other big-ticket items is satiated. As the BIS puts it, “tomorrow eventually becomes today.”

The same pattern of waning stimulus exists for fiscal policy. McMaster University’s William Scarth argues that running a deficit does moderate a recession’s impact. “But over time the government debt must be worked down, so the overall speed of the economy is reduced. The initial recession is smaller, but the recovery takes longer.” One reason is that the multiplier from fiscal policy shrinks as debt levels mount. The Maastricht Treaty attempted to limit the debt of member EU nations to 60 per cent of GDP, reflecting a consensus that at some level debt becomes problematic both for government balance sheets and for stimulating growth, although there is room for debate over what is the right number.

Already we have seen the impact of stimulus diminish in recent years. As a result, despite an initial boost to growth during the 2009 recession from unprecedented stimulus, growth over the past decade was the slowest since the 1930s.

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Source: Philip Cross | Financial Post

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