Crisis brought a twinkle to the eyes of expansionary policy buffs in 2009. Wide-open fiscal wallets had market-watchers hailing the return of Keynesianism as new, exciting public projects were announced around the globe. Plunging borrowing costs added considerably to the festivities. But the party ended abruptly in mid-2010 when rapid economic slowing led to greater scrutiny of the effectiveness of the new programs, and their impact on the stability of fiscal and monetary systems.
Worry about fiscal soundness prompted a policy reversal that pre-empted true recovery. Near-collapse of fiscal finances on the periphery of the European Union ushered in restrictions so draconian that the resulting economic weakness has made fiscal targets elusive -- threatening a vicious spiral of ever-greater cutbacks. Meanwhile, monetary policy could hardly be more stimulative, and significant tightening over the medium term is a well-accepted given.
Quite contrary to original intentions, 'policy drag' has now become prominent among a number of factors weighing on current sentiment. References to protracted sluggish growth, referred to frequently as the 'new normal', are usually quickly twinned with the need for a lengthy period of policy tightening. These are often accompanied by gloomy fiscal projections extending well beyond the medium term, and established rules-of-thumb on the restrictive effects of higher interest rates.
Behind the scary headlines and gloomy looks of policymakers, the results of recent actions are already beginning to beat expectations. Higher US growth and an about-face in its beleaguered housing market have boosted fiscal finances and led to positive revisions to projections. States that a few years ago were virtually bankrupt are now struggling to manage surpluses. Growth always has this effect. In contrast, expectations have remained static in Japan. Europe, however, has yet to turn the corner. Will it fall victim to a vicious spiral that negates the policy success elsewhere?
Not so fast. Dividend payments from Europe's courageous tightening may not be long off. According to both the IMF and OECD, additional fiscal restrictions as a share of GDP will in 2014 be a fraction of the 2011-2013 average if current plans are maintained, a dynamic that will likely produce not only higher-than-expected economic growth, but also fiscal performance. At the same time, central banks are generally highlighting the need to maintain monetary stimulus until the economy improves.
Analysts generally agree that fiscal and monetary policy in the largest economies is about right. A recent Consensus Economics survey shows that the only deviations are in the US, Italy and the Netherlands, where analysts feel fiscal policy is too restrictive, and in Germany, where 65 per cent of analysts believe that monetary policy is too loose. Most respondents also believe that current policies will be maintained. The exception is again in the US, where tightening monetary policy is expected, and looser fiscal policy is seen as necessary. France and Italy also believe that fiscal policy should be more stimulative, while Japanese analysts think that fiscal policy should, and will, be more restrictive.
The bottom line? Fiscal policy is already a drag on growth, and will be, but perhaps not for as long as many now believe, given the speed with which fiscal dynamics can flip around. Monetary policy is generally expected to tighten, but in a way that does not undermine, but rather lend support to nascent economic growth. Suffice it to say that in the coming months, getting the mix of policy right will require a significant amount of surgical precision. For analysts, correctly gauging the impact of policy movements will be more important than usual to the accuracy of near-term economic forecasts.