The global economy’s voyage seems similar to Star Trek’s Starship Enterprise. The iconic show, which celebrated its 50th anniversary this month, details the mission of the starship’s crew: to boldly go where no man has gone before.
Global policymakers have been charting a similarly bold course in trying to steer the economy back from the global financial crisis. Much of the responsibility thus far has fallen on central banks, which cut interest rates and purchased financial assets in the hope that injecting more money into the economy would help boost growth. Unfortunately, the results have been mixed, at best.
Now it may be time to explore a new frontier: fiscal policy. There are signs governments may be preparing to ramp up spending or cut taxes to help drive growth in a way monetary stimulus didn’t. Here, we’ll take a closer look at how these two types of stimulus work their way through the economy.
Monetary and fiscal policies
Monetary policy is another name for the actions central banks take to influence the amount of money flowing around an economy. When economic growth slows, a central bank can increase the money supply by lowering interest rates. The idea is that lower rates might encourage consumers and businesses to borrow and spend more, thereby boosting economic activity. After all, lower interest rates make it cheaper to borrow and less attractive to leave money in savings.
Fiscal policy is generally the preserve of governments, which can help the economy by increasing spending or lowering taxes. The idea here is that the government can help create jobs by spending on new infrastructure projects, such as building bridges or dams. If more people are working, spending should also rise, which should help drive growth. Cutting taxes leaves consumers with bigger paychecks and businesses with larger profits, which could also help spur spending.
Boldly going where no bank has gone before
Coming out of the financial crisis, many governments didn’t provide much fiscal help to jumpstart their economies. Ballooning national deficits led many countries, particularly in Europe, to opt for austerity. One concern was that a prolonged recession would leave governments without the tax revenues necessary to pay for increased spending.
With austerity weighing on growth, central banks stepped in and brought their monetary tools to bear. Some of their responses were as imaginative as a Star Trek episode. Once they’d cut interest rates to basically nothing, central banks in Europe, Japan and the U.S. started buying government bonds in an attempt to inject even more money into the economy. In Europe, the European Central Bank has even been buying corporate bonds. And the Bank of Japan has even bought stocks.
One result of this campaign hasn’t been particularly satisfying. All that extra demand for bonds has pushed yields on trillions of dollars in government debt into negative territory. (So far, the U.S. has avoided this situation.) That means investors who buy such bonds today and hold them to maturity would find themselves paying for the privilege to do so. In some cases, yields on some corporate bonds have turned negative, meaning a business is actually getting paid to borrow.
Is fiscal policy the next frontier?
Even with all these efforts, the economy is still stuck in low gear, and some central banks have suggested it is time for governments to do their share. There are signs the message is getting through:
- In the U.S., both Hillary Clinton and Donald Trump have said they support an increase in government spending, particularly on infrastructure.
- China has increased its fiscal deficit to a multi-year high.
- A pledge to spend more on infrastructure appeared to help Canada’s new prime minister win his election.
- In the U.K., the government decided to abandon its target for a balanced budget after the country’s decision to leave the European Union. Abandoning that target means the U.K. is open to increasing government spending, reducing taxes or both.
- Even in Germany, which has been a strong proponent of European countries pursuing austerity policies, the finance minister has proposed an income tax cut for 2017.
In isolation, one country deciding to loosen the purse strings may not help the global economy much. A multi-front effort by several countries could be more effective. How the world’s big economies approach this issue is a key issue to watch in 2017.
Don’t time investments with the economy
While a big fiscal push could help the economy, we don’t suggest you try and time your investments around it. Markets often begin to anticipate economic growth before it happens, so if you wait for clear signs of a global economic recovery before you invest, you could miss out on some gains. Timing the market is nearly impossible. It’s time in the market that counts. As Mr. Spock might say: Invest long term and prosper.
What you can do next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.