En Nº de Parte:, we discussed the fiscal response to COVID-19 and why governments use fiscal stimulus during an economic crisis, while also analyzing the change in global debt levels as a result of the additional spending. The metaphorical argument we made was that similar to the theme of Metallica’s “Black Album,” past decisions will affect future outcomes and it’s worth trying to determine how.
This brings us to Part 2. We’ll explore whether the additive government spending resulted in the desired economic goals, as well as the correlation between fiscal policy and economic growth with the potential for political violence in various markets.
What Were the Actual Economic Effects of Fiscal Stimulus in 2020?
Did the additive debt accomplish the goals policy makers sought? Debt has benefits, and downsides, as we noted earlier. In the end, did the numbers add up?
One way to answer this question is by comparing the magnitude of a nation’s fiscal deficit to its economic growth. Under normal circumstances, if a country is running a deficit equal to 5% of GDP but its real economic growth is just 1%, then something is not adding up. Referencing back to the GDP formula highlighted earlier, government spending is just one part of overall economic growth. Yet if government spending alone is 5% but growth is far below it, then it implies that either exports, investments, or consumption are well below where they should be. But we’d hope at a minimum that fiscal spending helps grow the economy by a similar magnitude, although this is not always the case.
There is research that indicates fiscal deficits crowd out private investments in select markets and distort labor markets and wage conditions. For example, government spending could boost wages for those doing work for and with the government, thereby raising private sector wages, even though productivity does not grow in tandem, thus becoming a net drain on the economy. Also, the increase in debt absorbs savings, which could otherwise go to more productive use such as capital expenditure.
Under a normal scenario, we may have opted to compare one year’s fiscal deficit to its GDP growth. But given the circumstances, we instead opted to compare the change in fiscal deficits from 2019 to 2020, to the change in GDP from 2020 to 2021. And there’s a reason why we did this.
We know that most countries run fiscal deficits in normal times. But given the COVID-19 shock, we were more interested to know the change in deficits that occurred as some countries increased their spending by a significant magnitude. And consequentially, we wanted to observe the change in deficits to the change in economic growth. By doing so, we are discounting the deficit to growth ratio in “normal times” and instead measuring the impact of the increased spending. Also, we recognize that there is likely a lag between when the spending occurs and when it affects growth, hence why we are looking at the change in deficits from 2019 to 2020, relative to the change in growth from 2020 to 2021 (plus, given that 2020 was a recession year, we can truly pick up the impact of spending using this as the base year).
We also looked at an estimated fiscal multiplier of the 100 largest economies to examine changes in economic growth in relation to an increase in spending.
The takeaway is countries like Ghana, Oman, Serbia, and Ireland did not experience an improvement in growth that coincided with the increase in deficits they induced. U.S., Canada, Israel, Finland, Nigeria and Vietnam’s change in growth was largely in line with the change in spending, and then India, Mexico, Malaysia, Philippines, and Peru saw significant (positive) swings in growth that were multiples of the additional spending they incurred.
Egypt, meanwhile, decreased its deficits, but also saw a drop in growth – one of the few countries to experience this in 2021. While Senegal, Pakistan, Taiwan and Bangladesh either kept their deficits flat, or decreased them, but managed to squeeze out a positive swing in growth. To be clear, this does not imply that these countries experienced strong economic performance or stability, but that they had a net positive change in their growth trajectory – i.e., an improvement in 2021 relative to 2020.
The answer to the question of “did it meet the goals” depends on which country. Of the 100 largest economies:
- One had inconclusive data
- One experienced a negative fiscal multiplier
- 52 had a multiplier at or below 1x
- 27 had a multiplier between 1x and 2x
- 19 had a multiplier above 2x
In other words, for only 19% of the sample set, the fiscal spending resulted in a significant economic swing and another 27% experienced some improvement, but nothing substantial. But, from our perspective, 52% did not experience any significant benefits. Although, one could argue the spending may have prevented an otherwise deeper economic recession, which is a fair point.
Added Debt and Waning Growth Could Lead to Instances of Political Violence
As a second order effect, we’re interested to know if the deficits and fiscal decisions that took place in 2020 could induce wider societal issues such as political violence. A few years back, we argued that the then Chilean riots stemmed from the government enacting fiscal restraint at a time when the economy had not fully healed, at least not for all segments of society (the government raised metro fares). As a result, fiscal prudence, or austerity, caused, and can cause, political violence.
We extended that argument to say that there is a negative correlation between fiscal policy and political violence. The more governments spend, and the more they induce fiscal deficits, the lower the likelihood of political violence because that form of spending often provides various benefits that could quell uprisings. This includes social safety nets, subsidies and increased capital expenditures that create jobs, as well as other forms of government spending. However, the challenge is that as deficits grow and compound, aggregate debt levels rise to a point where it becomes increasingly challenging for a country to continue to spend. At that point, they approach a potential default on their debt, or they drastically curtail spending including social benefits and subsidies, which then raises the likelihood of political violence.
We’ve seen instances where proposals for austerity have led to political backlash, and violence (e.g., Chile). But absent austerity, some of these countries may face default, at which point the consequential economic shock and forced halt to spending could also lead to political violence, such as Venezuela. Thus, the negative correlation eventually becomes a fully positive one if spending is not controlled over the long-term.
Granted, we did see instances of violence during 2020 and 2021 despite high levels of spending, but these were more closely tied to lockdowns, government-imposed restrictions, and existing inequities in society versus outright spending decisions. For our analysis, we are more interested to understand the relationship between fiscal policy and potential political violence.
Of course, this is our theory. But to visualize it, we took the above graph and formalized it into an actual “fiscal multiplier” (our CCER version of a fiscal multiplier) by simply dividing the change in spending by the subsequent change in GDP growth and plotted it against debt to GDP. Per our theory, countries with low fiscal multipliers and high debt levels are subject to heightened prospects of political violence because their current spending is not delivering on growth, and they are also facing rising debt levels that may need them to bring down spending, thereby further constricting the already weak growth. To be clear, we are not saying political violence is a given, but rather the potential for it is elevated.
There are of course varying levels of probability within this grouping too. For example, U.S. and UK have higher thresholds for when debt becomes unsustainable given that both are reserve currencies and havens for investor capital. Therefore, they can spend more for longer than Sri Lanka before they are either cut off from financial markets or are forced to make hard fiscal choices. Some countries are omitted from this graph like Japan, which has a debt to GDP of 250%, to ensure others can be easily viewed.
The global response to 2020, which included fiscal stimulus, was very much warranted. And as we saw above, in most cases it did help improve the economic trajectories of the affected countries. With that said, it’s often hard to pull back on the fiscal levers because countries get used to the additive spending (this is one of the challenges with the politics of policy making). However, liquidity is not unlimited. The prospects of facing a default will force countries to make tough decisions with respect to fiscal consolidation. The more severe the crisis, the more aggressive their austerity measures could become. Plus, we could also argue that absent fiscal reforms, there is an erosion to fiscal buffers that otherwise help countries buttress against future health and economic crisis. And we’ve seen the aggressive austerity plans in the past that have resulted in violence. Which is why we go back to our argument that fiscal policy is inversely correlated to political violence, until a pending default is on the horizon, in which case, the relationship becomes positive correlated.
And therefore, the actions of 2020 made sense and were the textbook response to an economic shock. The economic benefits, however, were mixed. But more importantly, we should watch the horizon for the longer-term implications of those decisions, whether that be heightened potential for default in select markets, or heightened probability of political violence.
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