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GLOB
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GLOBAL MACRO RESEARCH NEOFISCALISMIMPLICATIONS OF BIG GOVERNMENT IN A POST-COVID WORLD
AUGUST 2020
FOR PROFESSIONAL CLIENTS, QUALIFIED INVESTORS, INSTITUTIONAL INVESTORS, WHOLESALE INVESTORS AND LICENSED FINANCIAL ADVISORS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL.PLEASE REFER TO THE IMPORTANT INFORMATION AT THE BACK OF THIS DOCUMENT.
A NEW PARADIGM OF BIG GOVERNMENT – NEOFISCALISM – COULD HAVE BEGUN // 3
• Outstanding sovereign debt is about to increase dramatically
• This time, austerity is unlikely to be the solution
• A shift to a new economic regime could already be underway
THE IMPLICATIONS OF NEOFISCALISM // 6
• Government effectiveness could become more important to investment returns
• The business cycle will change, driven by central bank liquidity
• The future of taxation remains uncertain for now
FIVE WAYS WE THINK NEOFISCALISM COULD IMPACT MARKETS // 9
1. Yields are likely to remain low by historical standards
2. Inflation could trigger spikes in bond yields if it causes quantitative easing to be tapered
3. For sovereigns without full control over the currency they issue in, government effectiveness could be key
4. Identifying governments able to maximize trend growth is likely to become important for equity markets
5. Corporates with state support could have an advantage during funding droughts
EXECUTIVE SUMMARY
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NEOFISCALISM IMPLICATIONS OF BIG GOVERNMENT IN A POST-COVID WORLDTHE NEOLIBERAL POLICY PARADIGM OF SMALLER-GOVERNMENT INVOLVEMENT IN THE ECONOMY IS UNDER
THREAT. LONGER-TERM TRENDS WERE ALREADY MOVING IN THIS DIRECTION, BUT EMERGENCY POLICIES
IMPLEMENTED TO DEAL WITH THE COVID-19 CRISIS HAVE CREATED A POTENTIAL TIPPING POINT. A NEW PARADIGM
OF BIG GOVERNMENT COULD HAVE BEGUN, WHICH WE ARE CALLING NEOFISCALISM. IF WE ARE CORRECT, THEN
NEOFISCALISM COULD LAST FOR DECADES JUST AS NEOLIBERALISM AND KEYNESIAN FISCALISM DID.
OUTSTANDING SOVEREIGN DEBT IS ABOUT TO INCREASE DRAMATICALLY
The COVID-19 crisis has pushed fiscal and monetary policy to
extraordinary levels. With large parts of the economy locked down
for up to three months, the damage to growth has been
unprecedented outside of wartime. Governments have stepped in
with a variety of spending programs to keep economies afloat
until the private sector can be reopened. Some recovery is likely in
2021, due to automatic stabilizers and the removal of emergency
programs, but fiscal deficits will be higher in 2021 than in 2019,
and debt/GDP levels will materially increase in many countries.
Table 1: Government debt/GDP is forecast to soar1
Fiscal balance (% of GDP) Debt to GDP (%)
2019 2020 (f) 2021 (f) 2019 2020 (f) 2021 (f)
US -4.6 -20.0 -12.5 106.9 132.0 136.0
China -5.5 -12.0 -9.0 54.4 65.0 72.5
Japan -2.8 -10.0 -5.0 237.4 255.0 252.0
Germany 1.4 -7.2 -1.9 59.8 75.8 71.8
France -3.0 -10.0 -4.2 98.5 116.5 111.9
Italy -1.6 -11.0 -5.8 134.8 158.9 153.6
UK -2.8 -12.5 -5.0 80.0 98.0 98.0
AUSTERITY IS UNLIKELY TO BE THE SOLUTION THIS TIME
HIGHER DEFICITS APPEAR HERE TO STAY
Governments are likely to be forced to maintain fiscal deficits at
elevated levels for a prolonged period:
• Austerity measures introduced after the global financial crisis to
reduce deficits were controversial, suppressing growth. In
some smaller eurozone countries, which faced the most severe
austerity measures, they proved counterproductive, leading to
deeper social problems. For many politicians, implementing a
new round of austerity would be deeply unpalatable.
• A yet-to-be-determined proportion of private sector activity has
been permanently lost, and it could be many years before
private sector activity returns to pre-COVID levels. This may
require a sustained period of government support to underpin
the economic recovery.
• It is apparent that there is a need for a permanently higher
capacity within healthcare systems in order to be able to cope
with future pandemics, likely accelerating an already upward
trend in healthcare spending.
• Other long-term trends are adding to spending pressures, as
governments attempt to restructure their economies to deal
with issues such as climate change and digitalization.
1 Source: Insight. Data as of June 30, 2020.
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AN ALTERNATIVE REGIME IS GROWING IN ACCEPTANCE
Following the global financial crisis, there was not an established academic alternative to
the neoliberal model. The shift in economic and political thinking towards Modern Monetary
Theory (MMT)2 means that there is now the academic underpinning necessary for a new
policy regime.
As we have seen in the years following the global financial crisis, extraordinary monetary
policy introduced in times of crisis can become normal rather than temporary. Overnight
interest rates at the zero bound or even negative, quantitative easing, yield curve control –
these are all policy tools that are likely to be in use for an extended period. Arguably, major
central banks have already reverted to their original purpose of monetary financing, funding
government deficits when necessary via an increase in the monetary base.
Neofiscalism, by which we mean a regime under which governments take a more direct and
proactive role in economic policy and management – largely through fiscal policy – could be
the way forward. This would stand in stark contrast to the current regime under which
major central banks have been generally able to make monetary policy decisions without
political interference.
FINANCIAL REPRESSION LIES AHEAD
This clearly raises questions about the potential for fiscal dominance, where endless deficits
are funded by printed money, and what this means for central bank independence.
Independent central banks and inflation targeting are both relatively recent neoliberal ideas,
so there is no guarantee that these will remain. However, even independent central banks
are unlikely to start to tighten policy unless they see inflation sustainably back at target.
So even if central banks remain independent, a period of financial repression, where interest
rates are held below the rate of inflation, seems likely. Government interest costs have fallen
in recent decades (see Chart 1), despite rising debt/GDP levels, tracking interest rates lower,
but this has probably now reached its limits. It can be argued that low interest rates have
become a necessity to keep government interest costs affordable. Financial repression is
thus likely here to stay.
Chart 1: Interest expenditure as % of government revenues3
Germany
0
5
10
15
20
25
30 US
Japan
Italy
UK
France
Germany
2017201220072002199719921987198219771972
%
France UK Italy Japan US
2 MMT is an alternative macroeconomic theory that argues that governments should create new money through fiscal policy. When there is unemployment, government spending should rise, funded by central banks, to close the output gap, with inflation controlled by changes in taxation. MMT takes ideas from various historical works. 3 Source: World Bank, FTSE, Macrobond.
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Policies such as quantitative easing and yield curve control
have now likely become necessary to keep government interest payments affordable
2 MMT is an alternative macroeconomic theory that argues that governments should create new money through fiscal policy. When there is unemployment, government spending should rise, funded by central banks, to close the output gap, with inflation controlled by changes in taxation. MMT takes ideas from various historical works. 3 Source: World Bank, FTSE, Macrobond.
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THE IMPLICATIONS OF NEOFISCALISM
We believe that neofiscalism could have a number of implications.
SOME GOVERNMENTS ARE LIKELY TO BE MORE EFFECTIVE THAN OTHERS
Governments do not always make the best and most effective choices, and
both governments and markets can deliver sub-optimal outcomes as vested
interests interfere in the decision-making process. As the scale of government involvement
in the economy grows, this risk generally increases. In extreme cases, this leads to state
capture, where a group is able to direct almost all of the resources of the state to their own
interest. This happens less in transparent democracies, but corruption and lobbying are
both avenues by which effective decision making can be subverted, and ultimately has a
negative effect on trend growth.
In order to assess relative government effectiveness, the World Bank has created an index
which captures perceptions of a range of government-related variables. This includes the
quality of public services, the effectiveness of civil service and the credibility of policy
formation and implementation. The higher the score (see Chart 2), the more effective the
government and potentially the greater the benefit to that country from an increase in
government spending.
Many corporates are likely to benefit either from indiscriminate financing from central bank quantitative easing programs, or from financial
markets desperately seeking yield
Chart 2: World Bank measure of government effectiveness4
0.0
0.5
1.0
1.5
2.0
NorwaySweden
CanadaJapan
GermanyAustralia
USFrance
UKSpain
ChinaItaly
As we investigated in our January 2020 paper5 on fiscal policy space,
there can also be significant differences in the effectiveness of
different types of government spending, known as the fiscal multiplier.
Targeted (redistributive) transfers and government investment
(infrastructure) typically have the highest multiples, such that the
effect on GDP is higher than the amount of money spent by the
government (see Chart 3). The economic outcome for different
countries could thus vary significantly depending on the policies each
GLOBAL MACRO RESEARCH DAWN OF THE FISCAL ERA? FEBRUARY 2020
GLOB
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FOR INSTITUTIONAL INVESTORS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. This strategy is offered by Insight North America LLC (INA) in the United States. INA is part of Insight Investment. Performance presented is that of Insight Investment and should not specifically be viewed as the performance of INA. Please refer to the important disclosures at the back of this document.
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4 Source: World Bank (2018). 5 https://www.insightinvestment.com/globalassets/documents/ us-redesign-documents/perspectives/global-macro-dawn-of-the-fiscal-era.pdf
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6 Source: Coenen at al (2012) Morgan Stanley Research.
government enacts. Choosing the most dynamic government may become as important as
choosing the most dynamic corporate is today.
Chart 3: The economic impact of fiscal policy can vary significantly6
Corporateincome taxes
Generaltransfers
Laborincome taxes
Consumptiontaxes
Governmentconsumption
Targetedtransfers
Governmentinvestment
� EU � US
1.6
1.2
0.8
0.4
0.0
Fisc
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ultip
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byty
pe o
f stim
ulus
GOVERNMENT SUPPORT FOR KEY SECTORS AND COMPANIES IS PROBABLY HERE TO STAY
Rather than being hostage to markets, many corporates are likely to benefit
either from indiscriminate financing from central bank quantitative easing
programs, or from financial markets desperately seeking yield. However, governments may
also seek to provide additional support to favored sectors. The clear green and digital focus
of the proposed EU recovery fund is an example of this. In a shift to neofiscalism it is
reasonable to expect that many governments will develop industrial policies to favor key
sectors and national champions.
Companies and sectors that are favored by governments are likely to get better access to
government financing, potentially at more favorable terms than less favored sectors during
funding droughts.
THE FUTURE FOR TAXATION AND SPENDING POLICIES REMAINS UNCERTAIN FOR NOW
There has been a clear divergence in policy between the US and the typical
European country with regards to how automatic stabilizers for the economy
responded during the COVID-19 shock.
The US has provided greater unemployment benefits at least on a temporary basis using
reverse taxation. As a result, some individuals have seen their incomes rise relative to when
they were employed. If this sort of approach becomes standard, then it will ultimately lead
to some variety of basic income.
European countries, however, have typically either utilized existing short time working
schemes or established new ones to furlough workers and attempt to preserve
employment. This may be a more successful approach to enable the private sector to
rebound if the crisis is not too prolonged, at least for those economies with less flexible
labor markets.
MMT recommends job guarantees as part of the policy package, with a reserve labor force
used to keep inflation in check that is employed by the government instead of unemployed.
When the recovery does come, we may also see a shift in some countries back towards
more redistributive taxation polices, with higher taxation for corporates and wealthy
individuals in order to fund spending elsewhere. This would be due to a renewed political
desire to push against inequality as a result of globalization or automation. Taken to the
extreme, MMT suggests that governments do not need to finance deficits at all, so taxation
is only used for redistribution and controlling inflation.
4 Source: World Bank (2018). 5 https://www.insightinvestment.com/globalassets/documents/ us-redesign-documents/perspectives/global-macro-dawn-of-the-fiscal-era.pdf
A NEW TYPE OF BUSINESS CYCLE
If central banks remain independent and continue to target inflation, then at
the point where inflation appears on a credible path to be sustainably above
target, the central bank will start to taper their quantitative easing program
or raise their yield curve control targets. The experience of the last 12 years suggests
central banks will be in no hurry to tighten policy before they are sure inflation is a real
danger. Concerns about financial instability can be addressed by the regulation of private
(non-government sponsored) lending.
If inflation does rise to levels above target, we would expect government yields to rise, but
not to levels in excess of nominal growth and central banks would likely retain some control
over the pace of the rise. Higher yields would constrain government financing at the margin,
and support for non-critical or less favored sectors and companies would likely be reduced.
If central banks lose their independence under a regime of fiscal dominance such as MMT, it
becomes the responsibility of the fiscal authorities to manage inflation by reducing demand
in the economy via increased taxation or spending cuts.
Financial markets will also naturally tighten in either of these environments, leading to a
funding crunch for weaker companies that lack government support.
As the economy slows, or at least those parts of it deemed less strategic, output gaps
would reopen, and inflation would likely moderate. Central banks would then restart their
easing measures once inflation was sufficiently under control, or governments would start
to increase deficits again, and this would become the new form of economic cycle.
Taken to the extreme, MMT suggests that governments do not need to finance
deficits at all
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CONCLUSION: FIVE WAYS WE THINK NEOFISCALISM COULD IMPACT MARKETS
1For a long period of time, bond markets may become Japanese-like. Relatively low
volatility by historical standards could lead to a grab for yield that compresses spreads
and flattens yield curves. This environment should also be supportive for risk assets such as
corporate bonds and, all else being equal, equity price/earnings ratios should stay high.
2Inflation could trigger spikes in bond yields if it causes quantitative easing to be
tapered. Such opportunities are likely to be attractive entry points, as long as the
longer-term expectation is for inflation to return to target following the funding squeeze in
the real economy.
3For sovereigns without full control over the currency they issue in, government
effectiveness could be key. Effective governments that are able to raise
productivity and trend growth will more swiftly reduce debt/GDP ratios. This will be
particularly important for eurozone countries and emerging markets issuing debt in hard
currencies such as the US dollar. It is not at all clear that neofiscalism is compatible with a
currency union such as the eurozone unless a eurozone fiscal authority is also created.
4Identifying governments able to maximize trend growth is likely to become
important for equity markets as this will become a key driver of earnings.
Avoiding those markets where governments are captured by vested interests or looking
to raise corporate taxes could be equally important.
5Corporates with state support could have an advantage during funding
droughts, and identifying sectors and companies deemed important to the state
could be important for perceived credit worthiness. For companies without such support,
or with only occasional support, normal credit and equity metrics will still be important.
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CONTRIBUTORS
Gareth Colesmith, Head of Global Rates and Macro Research, Insight Investment
Simon Down, Senior Content Specialist, Insight Investment
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Insight Investment
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New York, NY 10166
212-527-1800
Client Relationship Management
Consultant Relationship Management
@InsightInvestUS
company/insight-investment-north-america
www.insightinvestment.com
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