Standard boil-in-the-bag open economy macroeconomics tells us that expansionary fiscal policy, under conditions of perfect international capital mobility and a floating exchange rate is an ‘enrich-thy-neighbour’ policy as regards aggregate demand spillovers. If the country is a price taker in the international financial markets, and if the fiscal action does not affect the foreign exchange risk premium, the fiscal impulse will be crowded out completely as regards any net impact on domestic aggregate demand, by an appreciation of the nominal and real exchange rates. The external trade deficit increases by the same amount as the fiscal impulse, so the domestic fiscal expansion ends up spilling over 100% into a boost to aggregate demand in the rest of the world.
We can qualify somewhat this stark full crowding out of a fiscal stimulus by a larger trade deficit, if the country in question is large enough to put upward pressure on the global risk-free real interest rate when it expands domestic demand. In that case there will be a partial crowding out only. That may be true for the US, which still accounts for about 25 percent of world trade and world GDP, or for the Euro Area, but not for any other economies. If the fiscal expansion is debt financed and puts upward pressure on the domestic sovereign default risk premium, the degree of crowding out will be higher.
If this Mundell-Fleming view of the international transmission of fiscal policy is correct, the US and the UK, the two countries gearing up most emphatically for a fiscal stimulus, are exactly the two countries that ought not to do so, or at least ought not to do so without an assurance that the rest of the world will engage in a commensurate fiscal stimulus. Both the US and the UK continue to run unsustainable external primary deficits (the primary deficit is the current account deficit excluding net foreign investment income). These deficits are flattered by the fact that the UK and the US are tanking faster at the moment than most of the rest of the world. Their structural or full-employment external imbalances are still unsustainable. Another American fiscal stimulus of $200 billion, let alone one of the $400 to $500 bn that could become a reality if and when Obama gets elected President of the US and if the Democrats achieve a filibuster-proof 60 Senate seats, would be warmly welcomed by the rest of the world, but would do little for economic activity in the US. The government debt and net external debt position of the country would be dangerously impacted by the massive increase in the government deficit and in the external primary deficit that would result from a significant fiscal stimulus. Default risk premia on US government debt would rise sharply and risk-free longer-term nominal interest rates would also rise as the markets recognise that future monetisation of government deficits could be a politically attractive alternative to sovereign default, higher future taxes or large future public spending cuts.
The UK’s underlying fiscal position is also weak, not so much because of the current levels of the gross and net public debt to GDP ratios, which are modest by international standards, but because of the underlying structural public deficit, the ongoing major cyclical increases in that deficit and the likelihood of an early discretionary boost to the structural deficit.
The contingent financial exposure of the UK government to the half-dead UK banking sector (balance sheet just under 450 percent of annual GDP) is massive. The quality of the assets on the balance sheet of British banks is anybody’s guess. While it is possible that the capital injected by the British government in the UK banking sector will turn out to be a good investment, it is also quite possible that the state and the tax payer will take a bath.
Britain is fiscally stretched. Its sovereign debt default risk premia are rising steadily. A large fiscal expansion, coming from a government with a poor record, since the beginning of Labour’s second term, for fiscal responsibility and for its willingness and ability to raise taxes or cut spending during good times, could lead to a loss of confidence in the fiscal-financial sustainability of the British state. The result could be a sterling crisis and a further steep rise in UK sovereign default risk premia. In the worst case, new UK sovereign debt issuance could be rationed out of the markets.
So the UK, even more than the US, is not a country that should plan a large debt-financed discretionary fiscal stimulus. The US is partly sheltered by the fact that the US dollar remains the world’s leading reserve currency. The UK may pay the price for having stuck with its own currency, sterling – a minor-league legacy reserve currency – rather than enjoying the relative comfort and protection that would have been gained from adopting the world’s second reserve currency – the euro – as its own. I hope that this will be the last financial crisis that the UK faces with the handicap of an independent small currency.
Since fiscal expansion worsens the trade deficit and therefore the primary deficit, it should be undertaken by countries that have excessive primary external surpluses or at least sustainable external positions. The most obvious candidates are China, Germany and the Gulf states. China can afford to give a huge fiscal boost to domestic demand, through tax cuts, increased transfer payments (social security benefits come to mind) and through increases in current spending on goods and services, say for health and education. China appears to be preparing to do the right thing for itself and for the world.
The German mountain appears to be about to give birth to a fiscal mouse. A 5 billion euro fiscal stimulus is being rumoured – an amount not visible with the naked eye in the German national accounts. Perhaps the decimal point was in the wrong place and a 50 billion euro stimulus is really being contemplated.
Other large external primary surplus countries can be found mainly in the Gulf. Either through their own fiscal expansions, or by providing the IMF with additional resources to lend to financially challenged emerging markets, Saudi Arabia and the other GCC members could make a positive contribution to global rebalancing and to mitigating the global business cycle.
Here’s to hoping for a global fiscal stimulus of the right magnitude and in the right places. Regrettably, too little in the aggregate and too much in the wrong places looks, at the moment, like the more likely outcome.