When are fiscal policy changes needed to boost the economy?

When the economy is struggling, it’s usually central banks that will step in to give it a little nudge through a shift in monetary policy. But when that’s not enough, governments can step in with fiscal policy changes.

“Historically, monetary policy always had an immediate effect, even though it might take time to trickle down to everybody,” said Paul Shelestowsky, a senior wealth advisor with Meridian.

“It was very much a signal that the central banks were trying to react.”

When oil prices fell sharply in 2015, for instance, the Bank of Canada made a surprise rate cut to help offset the hit on that sector, so those companies would have to spend less money servicing their debt.

“It helps a lot of businesses stay profitable, become profitable, reinvest back in their company,” said Shelestowsky.

“(They) can also hire people back or do R&D. A lot of times it (just) helps them keep their head above water.”

But sometimes, monetary policy seems to have less of an effect, with a weaker correlation between the rate cut and its impact on the market.

That was the case in March 2020, when the ongoing threat of a pandemic resulting from the coronavirus shut down entire countries, imposed quarantines and disrupted market activity amid fears of supply chain disruptions and slowing economic activity.

Central banks acted to try to offset threats of an economic downturn by cutting already low interest rates, but markets still tumbled to their worst level since the 2008 financial crisis when a drop in oil prices compounded the growing panic over coronavirus and falling stock prices.

“(When) interest rates are already so low, pushing them further down is like pushing a string – it doesn’t do too much,” said Kevin Milligan, a professor of economics at the University of British Columbia.

“Even if they thought monetary policy was very effective (at that time, changes happen) in the future.”

In Canada, concerns about spending and the economy led the federal government to announce a $1-billion package that included $500 million for the health care system, research funding and waiving the one-week waiting period for employment insurance to help workers and businesses affected by the virus. Italy and the U.K. also announced stimulus measures.

Those types of measures fall within the two arms of fiscal policy that can be used to try to boost economic activity: tax cuts and spending.

Spending typically relates to infrastructure or jobs, and takes the longest time to really trickle down into the economy, while tax cuts can have a more immediate effect.

In the U.S., when President Donald Trump floated the idea of payroll tax cuts in response to the virus, markets responded favourably.

“When you saw Trump talk about a payroll tax cut, that puts money into the hands of the citizens right away. If your take home pay is $1,000 and now it’s $1,200, you’ve got $200 to spend,” Shelestowsky said.

Fiscal policy hasn’t historically been used for emergency purposes, however, because tax cuts and spending lead to higher deficits down the road.

While big government spending packages in response to a crisis are rare, Milligan says in an unprecedented situation like the threat of global coronavirus pandemic, the use of fiscal policy to boost confidence and spending is within the boundaries of what governments are meant to do.

“It tells us that there important short-run risks for the economy,” he said.

“(If) people are going to sit on their wallets, spending will dry up. By the government stepping in and saying, ‘We’re going to make sure the economy continues to run smoothly,’ that’s an important signal to send to people, that … (they) don’t have to worry about their paycheck in the future: the government is going to make sure that the economy continues to flow.”

To Shelestowsky, however, it’s important to balance that wish to keep the economy on an even keel and reassure consumers and investors with the need to avoid creating long-term changes (or ballooning deficits) for a temporary problem.

“(Market downturns like this one) … are fear-based. It’s not being driven by where the companies are right now, it’s really driven by people being worried about where the coronavirus is going to drive companies (that are) fundamentally sound today three to six months from now,” he said.

“If the number of cases starts to stabilize … they will have sold off for a fear that never fundamentally materialized.”

9 months ago