As we have noted in a previous article, monetary and fiscal policy – as well as legislation and military actions – set the environment within the economic machine operates. In order to understand the long-term picture, and understand the potential effects of policymaker decisions, we need to consider the combined effects of fiscal and monetary policy and not analyze them in isolation.
That’s how traders can obtain a bird’s eye view of the current situation and future potential macro trend shifts.
Monetary Policy Effectiveness
For example, current monetary policy is still extremely stimulative: interest rates are still at or near historical lows, and QE is still being pumped into the system by FED, ECB, BOE, BOJ. Now I say this with the caveat that the markets have already started discounting the upcoming rate hikes and exit from QE, with government bond prices dropping and yields rising.
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 that monetary policy has been rather accomodative all this time, to various degrees. And yet GDP has been volatile and shrinking over time (the USA now fights for 3% annual growth rates vs 6-7% in the ’90s. When the monetary base increases, it means lending is dropping and banks are parking more money with the FED. When the monetary base drops, it means there’s more credit being distributed throughout the system. Similar to excess reserves in meaning.
After 2009, the central banks in the USA, Europe, Sweden, Denmark and of course Japan (which started many years ago) have been effectively taxing commercial banks: with negative interest rates, commercial banks not only do not earn anything on their excess reserves – they actually pay to maintain them! Yet this has not encouraged much lending at all.
But another observation should stick out like a sore thumb: the fact that Fed Funds (so the monetary policy tool so to speak) has a rather low correlation with effective lending (red line).
One reason might be Tier 1 Capital Requirements which have been rising recently, requiring banks to keep a tad more capital in house compared to recent history.
However, we’re still miles away from historical capital requirement levels, as the chart below illustrates.
Source: Young Research
But that still doesn’t explain why so much monetary stimulus has not really helped the economy. The next chart will probably explain why.
There seems to be a much more stable (and inverse) relationship between Fed Funds (monetary policy) and government tax income. Basically it seems that when the FOMC tries to stimulate the economy, the government finds a way in increase tax revenue, therefore offsetting the monetary stimulus.
There’s a reason Mario Draghi frequently says “fiscal stimulus is also necessary” within his speeches. The positive effects of a relatively easy monetary policy and prudent lending policies are often offset to a significant degree by fiscal policy. The single most important stimulating factor is government taxation and spending plans.
Government Debt and Deficit Spending
The deficit is the difference between how much the government spends (on national defense, Social Security, healthcare, etc) and how much revenue it receives (from taxes) each year. If the government spends more than it makes, then it runs a deficit. If the government makes more than it spends, it runs a surplus.
The last time the U.S. government didn’t operate at a deficit was 2001 and before that, 1969! Since governments tend to live beyond their means, and run deficits more often than not, they accumulate debt.
The government (via Treasury Auctions) borrows money either from the public (whenever you buy a government bond, you are financing their expenses), or from the central bank itself.
When government sells bonds to the private sector, cash goes from the citizens to the government – and then it is redistributed in some fashion through government spending. There is no inflation to be seen here.
When government sells bonds to the central bank, cash is created from scratch and it is an inflationary process which, over time, erodes purchasing power. Inflation is the reason why nowadays an espresso costs upwards of 1 Euro (in Italy), compared to 1000 Lire in the late 90s (so around €0.50) and less than that in the 70s/80s.
But while debt financing alone can be inflationary and misallocate resources, there is an ever-growing problem that governments just won’t confront: interest expenses on debt.
This is like the interest expense on and unlimited credit card: it keeps growing and growing so long as you keep living beyond your means (on credit). But sooner or later, all this interest will need to be paid off and the debt extinguished. The problem is: interest expenses have gone way beyond any reasonable measure. Interest expenses need to be paid off in some form each year, or things will go exponential. Obviously, if the government needs to allocate tax income to repaying interest on it’s own debt, it cannot allocate those funds to other programs that would assist the population. In essence, it’s a bottomless pit for taxpayer’s money.
Austerity, or tax increases, isn’t the way to go. Taxation has increased steadily around the world, but debt has continued to grow. The only way to eliminate debt and thus reduce interest expenses on debt is to spend less on government programs, cut the size of government (so it absorbs less in terms of GDP) an reduce taxation (in order to stimulate savings in the private sector, which can then fuel investments and hence growth).
Over to You
It should be clear by now, how easy it can be to actually understand the effects of policymaker intervention.
- Expansive monetary policy enhances excess reserves and allows banks to lend more (potentially). Negative interest rates have been a further deterrant to keep capital parked with central banks.
- Increasing taxation (austerity) dampens any stimulative effect of monetary policy because the (artificial) growth of the economy does not replenish the pockets of entrepreneurs, businesses and workers. Most of the increased productivity flows back into the pockets of the government.
- If this weren’t bad enough, G10 governments have a habit of “living beyond their means”, running constant deficits and building a mountain of debt. This is a misallocation of resources because clearly government is inefficient at redistributing the money it brings in through taxation, and the money raised through debt issuance.
- Living in debt has been increasing the government’s interest expenditures which have reached incredible proportions.
As traders, we know that the trend is your friend, until it ends. Looking at the charts of
- government spending
- government debt
- interest on debt
there seems to be no change of trend in sight. However, hyperinflation in Mexico and Brazil in the 1980s (when interest payments rose beyond 100% of tax income per year) has set a precedent: this behaviour cannot go on forever.
But until something materially changes, it is logical to expect an ever larger drag on GDP with lower growth rates and higher living costs.
Taxation is potentially easier to change, and it has been a tad more volatile over the deades. 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.” Corporations have been better off in the US and some other countries, which is good because lower tax burden means more free disposable income to hire & pay salaries.
Lower taxes would enhance productivity and spending within the economy – but governments worldwide seem to always oppose tax cuts. Just look at how much difficulty President Trump is having with his tax reform! And the final bill will most likely not look anything like his initial plan.
Lower taxes, lower (and more efficient) government spending and reasonable debt issuance are the key to a sustainable macro environment for any country. But this recipe just hasn’t been applied. Traders around the world, and Market Wizards, have known this for decades. And now you too are equipped with this information – use it wisely!
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.