Hong Kong Economic Journal (09.2022) - The global economy is now increasingly dominated by fiscal policy, creating a hugely different investment landscape.

Though markets’ attention has been focused on the absence of a pivot from the US Federal Reserve, coupled with aggressive hikes from their counterparts at the Bank of England and the European Central Bank (ECB), a more important shift seems to be taking place as the global policy balance moves away from monetary policy primacy to the growing dominance of fiscal policy.

It should not be forgotten that, as the global financial crisis (GFC) unfolded, the US Federal Reserve led the response by cutting interest rates to zero and deploying its balance sheet for the first time in its history to battle the deflationary shock. Indeed, though the US Congress did eventually act in October 2008 with the Emergency Economic Stabilization Act, which funded the better-known Troubled Asset Relief Program, this only came after their initial attempts a month earlier failed and precipitated a collapse in markets.

Indeed, though the US Congress eventually did act in October, 2008 with the Emergency Economic Stabilization Act which funded the better known Troubled Asset Relief Program, this came only after their initial attempts failed a month earlier precipitating a collapse in markets.

The 2011 echo of the GFC – the eurozone sovereign debt crisis – saw a similar imbalance in policy leadership. The ECB took its place alongside the IMF and European Commission in the “Troika” to manage the bailout and restructuring of Greek sovereign debt. More critically, though, it fell to the ECB President, Mario Draghi, to commit to do “whatever it takes” to save the single currency while national governments and the European Union were hamstrung by their own fiscal straitjackets.

The one-sided policy leadership at the start of the 2010s turned into more of a partnership near the end of the decade as policymakers battled the global pandemic in 2020–21. Once again, central banks in Europe, the United States and by then around the world moved to deploy the GFC playbook by cutting interest rates sharply, towards, and in some cases, below, 0%, and kicking off bond-buying at a pace and size well in excess of that seen in the aftermath of 2008–09.

This time, however, monetary authorities were joined by fiscal authorities which moved to cushion the collapse in demand as populations sheltered at home amidst the viral storm. US fiscal authorities authorised more than USD 6 trillion in spending, with the US Federal Reserve deploying another USD 4 trillion from its balance sheet to help prop up the economy. This coordinated monetary-fiscal response led to the shortest, sharpest recession in US history.

In Europe, the fiscal constraints that historically limited fiscal largesse were suspended “temporarily” to allow members to deal with the pandemic. Just as in the US, fiscal spending in the European Union reached nearly EUR 6 trillion, with the ECB expanding its balance sheet by EUR 4 trillion.

The past month in Europe in particular has shown that this monetary-fiscal balance is beginning to evolve once again as the energy crisis unfolds on the continent.

Central banks find themselves in a similar position to that of the fiscal authorities during the European sovereign debt crisis – hamstrung from responding to the demand shock, this time by a fear of losing their inflation-fighting credibility.

National fiscal authorities have instead taken a leadership role, with Germany announcing a package of over EUR 60 billion – or nearly 2% of GDP – in support for households and companies affected by the near-threefold increase in natural gas prices since the start of the year. Not to be outdone, the new UK prime minister has announced a GBP 100 billion programme to address the more widespread national cost of living crisis. In both cases, the new spending has led to further bloating fiscal deficits that had already been called upon to deal with the pandemic response.

The cost of the fiscal action beyond the euros and pounds already committed has been swift and sizable: long-dated bond yields have risen by nearly 100 bps in both the euro area and UK in the past month, and by almost 200 bps in the past year. The UK in particular will be presented with a fiscal challenge from these rising rates, as its large stock of outstanding debt increases national interest expenditure and compounds the overall fiscal burden on the economy. Beyond this, with the energy crisis triggering inflation not seen since the early 1980s, with over 20% of UK sovereign debt linked to inflation, the already immense fiscal weight on the economy will be added to further.

In the euro area the pressure will come from a different direction. While Germany’s fiscal spending will be funded by its history of saving, Italy lacks a similar reserve to draw on and, like the UK, will see a growing interest burden amidst the sharp rise in euro area yields. Beyond this, Italy is looking to shift funding away from the EU Recovery Fund towards energy crisis relief, raising the prospect of a conflict between Rome and Brussels. All of this takes place against a backdrop in the UK and euro area of their central banks raising interest rates to combat inflation.

In the US, which lacks the same scale of energy shock taking place across the pond, interest payments are poised to rise, with 2-year yields at levels not seen since before the GFC, when the US government’s debt-to-GDP ratio was a mere 65% compared with over 100% today. Perhaps because of this, the US government has passed a USD 400 billion green spending programme to begin transforming its infrastructure, although this is being funded through higher taxes. What is notable, however, is that despite a contentious Congress, a sizeable fiscal spending programme was passed without the threat of a new crisis, unlike the spending bill that failed in September 2008 during the GFC.

This pivot from a global economy dominated by monetary policy to one that is increasingly led by fiscal policy means policy will probably be slower to respond to anything but pandemic-scale shocks.

Moreover, the global coordination of policy, such as that by central banks in the 2009, is unlikely among legislatures around the world compared with their central bank counterparts.

When fiscal policy does respond, invariably it will end up being too large (as it was following the pandemic) or too small (due to political wrangling), resulting in larger booms and deeper busts in economies in an era of fiscal dominance.

Such a lack of global policy coordination is likely to bring about greater shifts in FX markets as a balancing mechanism, as seen with the post-pandemic monetary policy divergences that have resulted in an historic strengthening of the US dollar.

While more active fiscal authorities are welcome in light of the multitude of shocks buffeting the global economy, investors must recognise that a more dominant fiscal narrative creates a very different investment backdrop from the one they had grown accustomed to over the past decade, and they must adapt their investment approach accordingly.