Getting Fiscal Stimulus and Central Bank Independence In Synch

LONDON – Until early last autumn, the global economy seemed stuck in a deflationary trap. For five years in a row, the International Monetary Fund had downgraded its medium-term growth forecast. In February 2016, The Economist’s front cover depicted central bankers “Out of Ammunition.” In October, the IMF’s World Economic Outlook was entitled “Subdued Demand: Symptoms and Remedies,” though there seemed to be more of the former than the latter. The overhang of private debt left behind by excessive credit creation before 2008 remained unresolved.

Only six months later, prospects seem transformed, with widespread upgrades to growth and inflation forecasts. True, disappointing first-quarter growth in the United States casts doubt on the recovery’s true strength. But at least we seem to have escaped from years of serial disappointment.

Growth forecasts are up because fiscal policy has been relaxed. Advanced economies eased their fiscal stance in 2016 by 0.2% of GDP, on average, ending five years of gradual consolidation. More significantly, China’s fiscal deficit increased from 0.9% of GDP in 2014 to 2.8% in 2015 and 3.6% in 2016. Upgraded US growth forecasts assume a 2018 deficit of 4.5% of GDP, versus the 3.5% that was previously projected. As the IMF notes, this reflects “a reassessment of fiscal policy”, and a rejection of the belief that monetary policy alone can drive recovery.

In fact, fiscal policy has played a vital role ever since 2008. US fiscal deficits averaging 11.2% of GDP from 2009 to 2011 produced a faster recovery than the eurozone’s average deficit of 5.7% of GDP. After a harmful sales-tax increase in April 2014, Japan’s growth has depended on a series of fiscal stimulus packages. But from 2011 onward, US fiscal policy was slowly tightened, and from March 2012 the eurozone’s “fiscal compact” committed member countries to sustained deficit reduction. Tight fiscal policy seemed essential to limit future public debt; but ultra-loose monetary policy could still, it was assumed, ensure adequate demand growth and bring inflation back up to target.