In the last edition, we looked at the monetary policy actions of central banks in boosting economic recovery. The efficacy of a monetary policy in reviving the economy relies on a complementary and supportive fiscal policy.
Fiscal policy refers to the actions of government to control the aggregate output in the economy at any given point. The main tools employed are the level of government spending in the economy and taxes levied on economic participants. Government also has the legislative muscle to enact certain regulations which can have a direct impact on the level of output in an economy, without necessarily altering spending and/or tax levels. Comparing monetary and fiscal policies, the former seeks to provide a conducive environment for a healthy economy while fiscal policy actions are more direct, and it is through these that the economy will reach its intended levels of growth.
An expansive fiscal policy is one where government increases spending and/or cuts taxes to enable market participants to have more funds available to spend. As spending increases, this leads to increases in production, profits, wages, and lower unemployment as more labour resources are required. The result is a booming economy as people get richer and both optimism and business confidence are restored. However, up to a certain point the increase in prices and wages will bring about the problem of inflation wherein the real value of goods and services is distorted, effectively punishing lenders of funds as the cost of living becomes unaffordable for ordinary citizens.
For the government, sustained spending coupled with lower revenue inflows as a result of reduced tax flows means a budget deficit as revenues do not match the amount of expenditure. This deficit has to eventually be financed somehow, mostly via government borrowing from both domestic and international markets. The debt levels could reach unsustainable levels, which can have a devastating ripple effect in loss of confidence from global credit ratings agencies and potential lenders, as well as in political, economic and social crises that often befall nations which are unable to manage their debt.
To reverse the effects of an ‘overheating’ economy with has reached its normal growth capacity, contractionary fiscal policy actions of reducing government spending and increasing taxes are undertaken. The effect of this will be lower inflation and rising unemployment as businesses cut back on costs of production in order to protect profit margins.
Fiscal policymakers rarely get it right, at least in comparison to their monetary policy counterparts. Afterall, the latter have more specifically defined targets and their actions are mainly driven by hard data and lord it mostly over a subset of an economy (commercial banks) to transmit policy actions into the wider economy. On the other side, the nature of government is that it serves a heterogeneous populace of differing income, education, social status levels, motivations and sensitivities. In short, government is accountable to everyone yet cannot please everyone! For example, when government increases levies and quotas on imported goods, this directly benefits local producers of the same goods in terms of price competitiveness and increased market share. However, the potential for retaliatory actions by foreign governments will hurt local exporters of different sets of goods. Tax hikes are another example: no matter the economic justification for it, nobody wants to give away any more of their income to government.
The short-termism and politicisation of government spending means there is a high chance for misallocation of funds. More often than not, government infrastructure spending is made with an eye on the next elections, hence regions are rewarded and punished for their political leaning by either extending or withholding investment. The result is a further entrenchment of inequalities in society, opening up avenues for corruption and other economic and social ills.
Given the real and perceived nature of government as an inefficient business organisation, even the most ambitious and expensive expansionary fiscal policy effort can fall flat. Governments compete with private entities when seeking funds in competitive capital markets which demand economic and productive efficiency in the use of funds, yet have overriding social objectives of providing public goods and services at the most affordable cost to as many people as possible. The challenge then for governments is to be increasingly efficient and accountable in allocating resources, and still maintain access and balance the interests of the different constituents.
Additionally, just like monetary policy, fiscal policy needs the right environment to work. Government has to ensure that the population has the right skills, training, opportunities and fair access to ride the economic growth curve, as well as to provide the right safety mechanisms to protect the most vulnerable people during economic downturns. Afterall, there is no point in sourcing funding for a world-class rail system if there are not enough skilled people to employ in the project.
Finally, sound, consistent and reliable rules and regulations have to be in place to protect the interests of all market participants. Unfortunately, given the diverse interests of market participants, certain laws will disadvantage certain groups at a point in time. Alas, government can never win.