The Allure and Limits of Monetized Fiscal Deficits

With the global economy experiencing a synchronized slowdown,
any number of tail risks could bring on an outright recession. When that
happens, policymakers will almost certainly pursue some form of
central-bank-financed stimulus, regardless of whether the situation calls for

NEW YORK – A cloud of gloom hovered over the International
Monetary Fund’s annual meeting this month. With the global economy experiencing
a synchronized slowdown, any number of tail risks could bring on an outright
recession. Among other things, investors and economic policymakers must worry about a renewed escalation in the
Sino-American trade and technology war. A military conflict between the United
States and Iran would be felt globally. The same could be true of “hard” Brexit
by the United Kingdom or a collision between the IMF and Argentina’s incoming
Peronist government.

Still, some of these risks could become less likely over time.
The US and China have reached a tentative agreement on a
“phase one” partial trade deal, and the US has suspended tariffs that were due
to come into effect on October 15. If the negotiations continue, damaging
tariffs on Chinese consumer goods scheduled for December 15 could also be
postponed or suspended. The US has also so far refrained from responding
directly to Iran’s alleged downing of a US drone and attack on Saudi oil facilities in recent
months. US President Donald Trump doubtless is aware that a spike in oil prices
stemming from a military conflict would seriously damage his re-election
prospects next November.

The United Kingdom and the European Union have reached a
tentative agreement for a “soft” Brexit, and the UK Parliament has taken steps
at least to prevent a no-deal departure from the EU. But the saga will
continue, most likely with another extension of the Brexit deadline and a
general election at some point. Finally, in Argentina, assuming that the new
government and the IMF already recognize that they need each other, the threat
of mutual assured destruction could lead to a compromise.

Meanwhile, financial markets have been reacting positively to
the reduction of global tail risks and a further easing of monetary policy by
major central banks, including the US Federal Reserve, the European Central
Bank, and the People’s Bank of China. Yet it is still only a matter of time
before some shock triggers a new recession, possibly followed by a financial
crisis, owing to the large build-up of public and private debt globally.

What will policymakers do when that happens? One increasingly
popular view is that they will find themselves low on ammunition. Budget
deficits and public debts are already high around the world, and monetary
policy is reaching its limits. Japan, the eurozone, and a few other smaller
advanced economies already have negative policy rates, and are still conducting
quantitative and credit easing. Even the Fed is cutting rates and implementing
a backdoor QE program, through its backstopping of repo (short-term borrowing)

But it is naive to think that policymakers would simply allow a
wave of “creative destruction” that liquidates every zombie firm, bank, and
sovereign entity. They will be under intense political pressure to prevent a
full-scale depression and the onset of deflation. If anything, then, another
downturn will invite even more “crazy” and unconventional policies than what
we’ve seen thus far.

In fact, views from across the ideological spectrum are
converging on the notion that a semi-permanent monetization of larger fiscal
deficits will be unavoidable – and even desirable – in the next downturn.
Left-wing proponents of so-called Modern Monetary Theory argue that larger
permanent fiscal deficits are sustainable when monetized during periods of
economic slack, because there is no risk of runaway inflation.

Following this logic, in the UK, the Labour Party has proposed a
“People’s QE,” whereby
the central bank would print money to finance direct fiscal transfers to
households – rather than to bankers and investors. Others, including mainstream
economists such as Adair Turner, the former chairman of the UK
Financial Services Authority, have called for “helicopter drops”: direct cash
transfers to consumers through central-bank-financed fiscal deficits. Still
others, such as former Fed Vice Chair Stanley Fischer and his colleagues at
BlackRock, have proposed a “standing
emergency fiscal facility,” which would allow the central bank to finance large
fiscal deficits in the event of a deep recession.

Despite differences in terminology, all of these proposals are
variants of the same idea: large fiscal deficits monetized by central banks
should be used to stimulate aggregate demand in the event of the next slump. To
understand what this future might look like, we need only look to Japan, where
the central bank is effectively financing the country’s large fiscal deficits
and monetizing its high debt-to-GDP ratio by maintaining a negative policy
rate, conducing large-scale QE, and pursuing a ten-year government bond yield
target of 0%.

Will such policies actually be effective in stopping and
reversing the next slump? In the case of the 2008 financial crisis, which was
triggered by a negative aggregate demand shock and a credit crunch on illiquid
but solvent agents, massive monetary and fiscal stimulus and private-sector
bailouts made sense. But what if the next recession is triggered by a permanent
negative supply shock that produces stagflation (slower growth and rising
inflation)? That, after all, is the risk posed by a decoupling of US-China
trade, Brexit, or persistent upward pressure on oil prices.

Fiscal and monetary loosening is not an appropriate response to a permanent
supply shock. Policy easing in response to the oil shocks of the 1970s resulted
in double-digit inflation and a sharp, risky increase in public debt. Moreover,
if a downturn renders some corporations, banks, or sovereign entities insolvent
– not just illiquid – it makes no sense to keep them alive. In these cases, a bail-in
of creditors (debt restructuring and write-offs) is more appropriate than a
“zombifying” bailout.

In short, a semi-permanent monetization of fiscal deficits in
the event of another downturn may or may not be the appropriate policy
response. It all depends on the nature of the shock. But, because policymakers
will be pressured to do something, “crazy” policy responses will become
a foregone conclusion. The question is whether they will do more harm than good
over the long term.
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Nouriel Roubini is a professor of economics at New York University’s Stern School of Business. He is also CEO of Roubini Macro Associates, LLC, a global macroeconomic consultancy firm in New York, as well as Co-Founder of Rosa & Roubini Associates based out of London. At a 2006 address to the International Monetary Fund, Roubini warned of the impending recession due to the credit and housing market bubble. His predictions of these upside-down balance sheets became a reality in 2008, with the bubble bursting and reverberating around the world into a global financial crisis – a recession we’re only recently rebounding from after a decade climb. Dr. Roubini has extensive policy experience as well as broad academic credentials. He was Co-Founder and Chairman of Roubini Global Economics from 2005 to 2016 – a firm whose website was named one of the best economics web resources by BusinessWeek, Forbes, the Wall Street Journal and the Economist. From 1998 to 2000, he served as the senior economist for international affairs on the White House Council of Economic Advisors and then the senior advisor to the undersecretary for international affairs at the U.S. Treasury Department, helping to resolve the Asian and global financial crises, among other issues. The International Monetary Fund, the World Bank and numerous other prominent public and private institutions have drawn upon his consulting expertise. He has published numerous theoretical, empirical and policy papers on international macroeconomic issues and co-authored the books “Political Cycles: Theory and Evidence” (MIT Press, 1997) and “Bailouts or Bail-ins? Responding to Financial Crises in Emerging Markets” (Institute for International Economics, 2004) and “Crisis Economics: A Crash Course in the Future of Finance” (Penguin Press, 2010). Dr. Roubini’s views on global economic issues are widely cited by the media, and he is a frequent commentator on various business news programs. He has been the subject of extended profiles in the New York Times Magazine and other leading current-affairs publications. The Financial Times has also provided extensive coverage of Dr. Roubini’s perspectives. Dr. Roubini received an undergraduate degree at Bocconi University in Milan, Italy, and a doctorate in economics at Harvard University. Prior to joining Stern, he was on the faculty of Yale University’s department of economics.