HomeManaging the Fiscal Deficit – The Biggest Challenge in the Years Ahead

Managing the Fiscal Deficit – The Biggest Challenge in the Years Ahead

Fiscal policy has long been viewed as a means to an end for stimulating economic activity in troubled times or to avoid the economy overheating. 

In simple terms, fiscal policy refers to how a government collects and dispatches financial resources.

Just like households and businesses, governments have expenses and revenues. For example, taxes are revenues, while infrastructure projects are an example of expenses. When a government has more expenses than revenues, it turns to financial markets and borrows the difference – just like households and companies do when loading debt.

Record Stimulus Measures to Fight the Pandemic

At the time of writing this article, the President of the United States has signed the coronavirus bill into law. Among other things, it delivers $600 to each individual in another round of direct stimulus. Talks are that the amount will rise to $2,000, and we should not be surprised to see that coming.

After all, governments around the world have injected over $10 trillion in fiscal packages designed to support households and businesses during the pandemic. A study run by McKinsey&Company shows that among the G20 countries, the fiscal measures adopted during the COVID-19 pandemic so far exceed three times the ones taken during the 2008-2009 financial crisis.

During normal economic times, such measures will seem unacceptable. The only problem is that these are not normal economic times, and, like Jerome Powell, the Fed’s Chair mentioned several times this past year, this is not the time to worry about the side effects of too much fiscal stimulus. In other words, let’s get out of the health crisis, and then we will see how to deal with the mess.

The problem with the rise in the fiscal deficits around the world is how to manage them after the health crisis is behind us? Most countries run a fiscal deficit that just becomes bigger and bigger. Servicing the debt means more costs and sacrifices in the future.

Remember, from the start of the article, that taxes are one of the main tools of governments to raise income. To service the 2020-2023 global fiscal deficits, it is estimated that governments will do one of two things – either raising the taxes by 50% or reducing public spending by 25%.

Or a government may easily inflate its way out of the problem. However, this works only if the new debt was issued in the local currency. For instance, the United States issued debt in U.S. dollars, and by letting inflation run away about the 2% target, it will have an easier time servicing the USD-denominated debt. On the FX dashboard, this will trigger bearish USD trends.

Yet, the answer is not that simple. Because the U.S. dollar is the world’s reserve currency, many countries in the world issued debt not in their local currency but in USD. But even if the USD is debased, other currencies will appreciate against it.

Which ones though – as everyone wants a lower currency?

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