It Is Too Early to Withdraw Fiscal Stimulus?

Authors: Uri Dadush, Vera Eidelman
Originally published by the Carnegie Endowment for International Peace

The withdrawal of fiscal stimulus is set to depress demand in advanced countries by some 1 percent of GDP in 2011 and inventory accumulation is also expected to slow sharply. Meanwhile, emerging markets are tightening policy and unlikely to contribute to the net exports of advanced countries. Maintaining advanced country growth in the 2010 range will hinge, therefore, on their private final demand. But with unemployment still high and household net worth and consumer confidence weak, consumers in advanced countries are unlikely to accelerate spending. Though corporate profits are rising, capacity utilization remains low, and the outlook for private investment is uncertain. For these reasons, large countries that can afford to limit stimulus withdrawal should do so.

Waning fiscal stimulus

With most advanced countries pledging to cut their deficits in half by 2013, higher taxes and lower government spending—which accounts for about one-fifth of GDP in the European Union, the United States, and Japan—are set to drag on advanced country GDP growth in 2011. Though it is easy to exaggerate the effect of stimulus or retrenchment on growth, 1 percent of GDP is a reasonable estimate of the likely decrease in demand. While a double dip recession in industrial countries remains very unlikely, the possibility of a sharp slowdown in growth and persistent high unemployment is real.

Already, government spending did not contribute to Euro area GDP growth in the first quarter of 2010 and subtracted 0.3 percentage points from U.S. GDP growth in the same period, though it contributed 0.9 percentage points in the second quarter.

In contrast, with inflation subdued and a debt crisis still simmering in Europe, monetary policy is not likely to change significantly. Indeed, central bankers across most advanced economies have signaled their intent to resume various quantitative measures if needed. Increased risk aversion and cash hoarding could limit the effectiveness of monetary policy, however. Furthermore, relying exclusively on monetary policy could create more problems down the road as carry trades¹ proliferate and reabsorbing liquidity becomes even harder.

Will emerging markets help?

Despite rapid growth in emerging markets, net exports barely contributed to GDP growth in the OECD countries from 2000 to 2008, on average. In 2009, net exports added significantly to OECD demand.

Going forward, emerging markets—projected to grow by more than 6 percent in 2011—are the most likely source for increased external demand. But much of their growth is likely to come from exports—especially to other emerging markets—and many of them are also withdrawing fiscal stimulus and tightening monetary policy to avoid overheating and appreciating exchange rates. As a result, it is unclear whether they will stimulate demand for advanced countries.

Emerging markets accounted for 25 to 50 percent of advanced country export growth in recent years, but advanced countries consistently imported more from emerging markets than they exported there. China—which accounted for about one-quarter of emerging market demand for advanced country goods—is already seeing a moderation of growth on the back of stimulus withdrawal.

On the other hand, exchange rates across emerging markets are appreciating, making imports from advanced countries more affordable.

Nonetheless, net exports are not expected to contribute to total OECD country growth in 2011, according to OECD estimates. IMF projections paint a similar picture, as exports of goods and services from emerging and developing countries are expected to grow faster than their imports in 2011. The most recent U.S. GDP report is in line with these indications: net trade subtracted 2.8 percentage points from growth in the second quarter, compared to an average net contribution of 1.2 percentage points in 2009.

Private demand to the rescue?

With net exports unlikely to spur GDP growth in advanced countries, private consumption and investment must compensate for the 1 percent drag on GDP growth next year if government stimulus support stops and 2010 growth rates are to be maintained.

Private consumption

Private consumption in advanced countries, which accounts for the majority of their GDP—70 percent in the United States and nearly 60 percent in Japan and the European Union—increased at an annualized rate of 1.6 percent in the last quarter of 2009 and the first quarter of 2010. But can it grow more quickly? The answer largely depends on unemployment, household net worth, and consumer confidence.

A drop in unemployment is not likely to sufficiently boost consumption in 2011. The OECD unemployment rate reached 8.7 percent—a post-war record—in April, compared to the pre-crisis 10-year average of 6.5 percent. Both the OECD and the IMF expect unemployment to remain at or above 8 percent through 2011 in advanced countries. Compared to 2010 rates, unemployment in 2011 is expected to fall by only 0.9 percentage points in the United States and 0.2 percentage points in Japan, while it remains the same in Europe. Labor hoarding—the practice of decreasing employees’ hours rather than firing them, which was common in Japan and the Euro area during the recession—may make unemployment an even longer-term problem there.

Lower income expectations and reduced household net worth may also hold back consumption. Studies have shown that those who enter the workforce during a recession earn less over their lifetimes, and those who re-enter the workforce may see their incomes set on a permanently lower trajectory. In the United States, household net worth is recovering but remains 15 percent below its 2006 peak. In addition, with household balance sheets in the United States and the Euro area still overleveraged, consumers may save more rather than spend money. The OECD expects saving rates in 2011 to be 0.2 percentage points higher in the United States and 0.8 percentage points higher in Japan than they are now.

Consumer confidence paints a similarly negative picture for consumption. In the United States, the Conference Board’s Expectations Index declined sharply from 72.7 in June to 66.6 in July, while in Germany, the ZEW Indicator of Economic Sentiment dropped by 7.5 points to 21.2 in July 2010, far below the historical average of 27.4.

Investment

Private investment—historically the most volatile part of demand and critical in both recessions and recoveries—grew at an annualized rate of 28.8 percent during the second quarter in the United States and 4.7 percent in Japan in the first quarter of 2010, while it fell in the Euro area in the first quarter. Its ability to surpass those rates will depend in part on capacity utilization² and corporate profits, and will likely be hindered by slowing inventory accumulation.

Though rebuilding inventory after it was aggressively sold off during the crisis boosted growth in recent quarters—contributing more than 1.75 percentage points to growth in the OECD countries each quarter from the third quarter of 2009 through the first quarter of 2010—its contribution is likely to fade. This slowdown is part of industrial production’s broader return to normal growth rates following the post-crisis rebound. In the United States, the inventory-to-sales ratio was 1.24 in May, slightly above the 15-year pre-crisis trend.

This is particularly problematic in Europe, where private investment did not contribute to GDP growth except for the increase in inventory; in the United States and Japan, an increase in inventory accounted for one-third and one-half of private investment’s contribution in the second quarter and first quarter, respectively.

Low capacity utilization will also tend to delay business investment. In the United States, capacity utilization in the manufacturing sector rose from February through May and held steady at 74.1 in June, but remains well below the long-term average of 80.6 percent.

Rising corporate profits are significant good news, and the main indicator suggesting that private investment could pick up in the coming months. In the United States, corporate profits—up 34 percent (y/y) in the first quarter—and increased business borrowing—which rose by 25 percent (m/m) in June, according to the Equipment Leasing and Finance Association—are supporting the recovery in investment. In Japan and the EU, however, corporate profits are rising, but private investment rates have yet to pick up.

Policy

With prospects for an increase in private consumption and business investment uncertain, and with inventory accumulation likely to wane, private demand’s ability to fully compensate for decreased government spending is questionable. For this reason, the United States, Germany, France, and potentially the UK and Japan (though not Italy)—which are still able to borrow at record-low rates—should avoid a large-scale withdrawal of fiscal stimulus. The latest evidence suggests that caution is also warranted in China.

The decision by Germany—whose domestic demand is projected to fall this year—to withdraw fiscal stimulus is particularly unfortunate. The withdrawal will place even greater competitive and deflationary pressure on its neighbors in the European periphery who are most threatened by a sovereign debt crisis.

With critical elections looming, the prospects for fiscal policy in the United States are especially murky, contributing to the prevailing economic uncertainty. With the Bush-era tax cuts (worth more than 2 percent of GDP) and the fiscal stimulus (also estimated at about 2 percent of GDP in 2010) set to expire at the end of the year, U.S. demand could technically fall by several percentage points of GDP. While this is unlikely, the White House and Congress—currently locked in a fight over the direction of fiscal policy and its incidence across income classes—need to provide clarity soon or all will suffer.

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¹The practice of borrowing money at a low interest rate—often a low-yielding currency—in order to invest in a higher-return asset—often a high-yielding currency. This tends to shift capital from low-yield economies to high-yield ones.

²The extent to which productive capacity is being used to generate goods and services.