As we noted in a previous article, monetary and fiscal policy, as well as legislation and military actions, establish the environment in which the economic machine operates. To understand the long-term landscape and understand the potential effects of policy makers ’decisions, we it is necessary to consider the combined effects of fiscal and monetary policy and not to analyze them in isolation.
This is how traders can get a bird’s eye view of the current situation and possible future changes in macro trends.
Effectiveness of monetary policy
For example, current monetary policy remains extremely stimulating: interest rates remain at or near historic lows, and the CF, ECB, BOE, and BOJ are still pumping QE into the system. I now say this with the warning that markets have already begun to discount the next rate hikes and to exit QE, with falling public bond prices and rising yields.
The interesting thing is that the total monetary base (an ideal measure of the potential for credit expansion) has been positive since the 1960s, which means that this monetary policy has been quite accommodating throughout this time., to varying degrees. And yet GDP has been volatile and has shrunk over time (the United States is now struggling for an annual growth rate of 3% compared to 6-7% in the 1990s. increases, means that loans decrease and banks park more money with Fed.When the monetary base goes down, it means that more credit is distributed to the system, similar to the excess of meaningful reserves.
After 2009, the central banks of the US, Europe, Sweden, Denmark and, of course, Japan (which started many years ago) have effectively imposed commercial banks: with negative interest rates, commercial banks not only do not earn anything with excess reserves, but pay to keep them. However, this has not encouraged much lending.
But another observation should stand out as a sore thumb: the fact that Fed funds (e.g., the monetary policy tool) have a fairly low correlation with effective lending (red line).
One of the reasons could be the level 1 capital requirements, which have been increasing recently, and which force banks to maintain a little more domestic capital compared to recent history.
However, we are still miles away from historical levels of capital demand, as the following graph illustrates.
Source: Young Research
But that still doesn’t explain why so many monetary stimuli haven’t really helped the economy. The following graph will probably explain why.
There seems to be a much more stable (and inverse) relationship between Fed funds (monetary policy) and government tax revenue. It basically looks like that when the FOMC tries to stimulate the economy, the government finds a way to increase tax revenues, thus offsetting the monetary stimulus.
There is a reason why Mario Draghi often says that “fiscal stimulus is also necessary” in his speeches. The positive effects of relatively easy monetary policy and prudent lending policies are often largely offset by fiscal policy. The most important stimulus is taxation and government spending plans.
Public debt expenses and deficit
The deficit is the difference between government spending (on national defense, social security, health care, etc.) and the amount of revenue it receives (from taxes) each year. If the government spends more than it spends, it will have a deficit. If the government does more than it spends, it will get a surplus.
The last time the U.S. government did not function with a deficit was in 2001 and before, in 1969! Because governments tend to live beyond their means, and have deficits more often, they accumulate debt.
The government (through treasury auctions) borrows money from the public (whenever you buy a government bond, you are financing its expenses) or from the central bank itself.
When the government sells bonds to the private sector, the cash goes from the citizens to the government, and then redistributes in some way at the expense of the government. No inflation to see here.
When the government sells bonds to the central bank, it is created effective from scratch and is an inflationary process that, over time, erodes purchasing power. Inflation is the reason why today an espresso costs more than one euro (in Italy), compared to the 1000 lire of the late 90’s (therefore around 0.50 €) and less than the years 70/80.
But while debt financing alone can be inflationary and allocate poor resources, there is a growing problem that governments will not face.: Debt interest expenses.
This is like interest expense and unlimited credit card: it keeps growing and growing as long as you keep living out of your reach (on credit). Sooner or later, all these interests will have to be repaid and the debt extinguished. The problem is that interest spending has gone far beyond any reasonable measure. Interest expenses have to be amortized in some way each year, or things will be exponential. Viously, if the government needs to allocate tax revenue to repay the interest on its own debt, it cannot allocate these funds to other programs that would help the population. In essence, it is a bottomless pit for taxpayer money.
Austerity or tax increases are not the way to go. Taxation has risen steadily around the world, but debt has continued to grow. The only way to eliminate debt and therefore reduce interest on debt is to spend less on government programs, reduce the size of government (therefore, absorb less in terms of GDP), and reduce taxation. (in order to stimulate savings in the private sector, which can fuel investment and therefore growth).
More to you
It should be clear now how easy it can be to really understand the effects of policymakers ’intervention.
- An expansionary monetary policy increases excess reserves and allows banks to lend more (potentially). Negative interest rates have been another deterrent to keeping capital parked in central banks.
- Increasing taxation (austerity) diminishes any stimulating effect of monetary policy because the (artificial) growth of the economy does not fill the pockets of employers, firms and workers. Most of the increase in productivity goes back into government pockets.
- If that weren’t bad enough, G10 governments have a habit of “living beyond their means,” having constant deficits, and building a mountain of debt. This is a misallocation of resources because it is clear that the government is inefficient in redistributing the money it contributes through taxation and the money raised through the issuance of debts.
- Living in debt has increased government interest expenditures, which have reached incredible proportions.
As traders, we know the trend is your friend until it ends. Looking at the graphs of
- government spending
- public debt
- debt interest
there seems to be no change in trend in sight. However, hyperinflation in Mexico and Brazil in the 1980s (when interest payments rose by more than 100% in annual tax revenue) has set a precedent: this behavior cannot continue forever.
But until something changes materially, it makes sense to expect an ever-increasing drag on GDP with lower growth rates and higher living costs.
Taxation is potentially easier to change and has been a bit more volatile in the dead. However, the old adage seems to hold in all G10 countries: “We work from January to June for the Government, then we work from July to December for ourselves.” Businesses have been better off in the United States and some other countries, which is good because a lower tax burden means more free disposable income to hire and pay salaries.
Tax cuts would increase productivity and spending within the economy, but governments around the world always seem to oppose tax cuts. Just look at how difficult President Trump is with his tax reform! And the final bill is unlikely to resemble your initial plan.
Tax cuts, lower (and more efficient) government spending, and reasonable debt issuance are the key to a sustainable macro environment for any country. But this recipe has not been applied. Traders around the world and Market Wizards have known this for decades. And now you are also equipped with this information: use it wisely.
About the author
Justin is a forex trader and coach. He co-owns www.fxrenew.com, a Friday signal provider of banks and hedge fund traders (get a free trial), or get FREE access toT the advanced currency exchange course for smart traders. If you like writing it, you can subscribe to the newsletter for free.
Sometimes we include links to online retail stores. If you click on one and make a purchase we may receive a small commission.