Treating An Ailing Economy – Part 2: Fiscal Policy

In part 1 of this series, I explained about monetary policy and how it helps with cushioning the impact of a recession.

In this post, I would like to go into detail about fiscal policy which is the policy of adjusting government spending and taxation, a common tool of the government to regulate the economy.

Monetary policy, on the other hand, is a tool used by central banks, which are independent from the government, to control the money supply and interest rates in the economy.

Let me illustrate the difference between monetary policy and fiscal policy with a story below

Uncle Fed And Uncle Sam

You are in a rut. You have lost your job and having huge amounts of student loans. You still need to put food on the table for you family and you may not be able to make the next month’s rent payment.

Your uncle Fed comes along and offers to help you out of your situation by giving you a cheap line of credit. You can take up as much as you need to meet your expenses, find a new job or start a new business to get yourself out of your situation.

That is basically what monetary policy aims to do – stimulate the economy by providing businesses cheap access to cash via low interest loans.

Then your uncle Sam comes along and offers help too.

Instead of offering loans, your uncle Sam directly gives you some cash, tops up your unemployment benefits, offers you a job, does business with you and he might even offer you a contract to work with him on his mega projects.

This is the difference between fiscal policy and monetary policy. In fiscal policy, the government actually spends money, create jobs, provide grants and lending programs.

Gross Domestic Product

Before understanding fiscal policy, we need to understand the role of the government in the economy.

The Gross Domestic Product (GDP) is the total economic output of a country. It contains four components, namely: consumer spending, business investments, government spending and net exports.

The formula goes like this: Y = C + I + G + NX

Where

  • Y = GDP
  • C = Consumer Spending
  • I = Business Investments
  • G = Government Spending
  • NX = Exports – Imports

In this recent crisis, the pandemic has affected the following:

  • decrease in consumer spending – people are spending less especially on discretionary items
  • decrease in business investments – businesses are cutting down operations due to lockdowns, lack of demand etc etc…
  • decrease in net exports – factories are closed, manufacturing less and exporting less

As a direct consequence, GDP will contract. In such situation, the government, which is a main component of the GDP equation, can play a part in lessening the contracting by increasing governement spending and reducing tax rates.

Increasing government spending can directly create demand and create jobs. Reducing tax rates indirectly boost the economy because it indirectly increases the disposal income of consumers and businesses allowing them to spend more.

Fiscal Policy Response To COVID-19

Since the onset of the pandemic, governments around the world had since launched various fiscal policy responses to soften the economic impact of COVID-19.

Unlike conventional fiscal policy measures, the recent flurry of policy responses from governments around the world are more focused on sustaining businesses and keeping the economy running rather than boosting the economy.

The amount of each package is also larger because the present situation is more dire and akin to the past financial crisis.

It is not feasible to cover all policy responses so I would just go through some common ones.

Cash Payouts To Individuals

In the 2 Trillion coronavirus stimulus bill passed by US congress, there is a $1200 cash payout (the amount may vary based on individual income) to all American individuals and additional $500 for each child under 17.

Hong Kong also provided a HK$10,000 handout to all permanent residents.

As for Singapore, we still get some cash handouts of S$300 (amount may vary based on individual income) and additional S$100 per child which seems pretty meagre compared to the previous two countries.

And since then, the Singapore government had realized the initial stimulus was not sufficient and had just recently released a second stimulus package, tripling the handouts from the initial S$300 to S$900 (amount may vary based on individual income).

By giving individuals cash directly, the aim of governments is to help affected individuals cope with income loss and encourage spending to boost the economy.

Cash payouts, also referred as helicopter money, are not common. It is clear this is a desperate measure for desperate times.

Grants And Loans To Affected Businesses, Funding for Hospitals and Others

For the US stimulus bill, the aviation industry is given a $32 billion grant with conditions and restrictions – companies receiving grants are not allowed to do the following: pay cuts, furloughs, stock buybacks and even limits executive compensation. These are some of the lessons learnt from the 2009 bailouts.

Similarly in Singapore, the government has also announced a S$350 million support scheme for the aviation industry including wage support scheme, rent relief and various rebates. All these measures are to sustain jobs in industries heavily impacted by this health crisis. Singapore Airlines also receive a bailout of S$15 billion indirectly from the government, from Temasek Holdings, a private company owned by the government of Singapore.

The governments around the world also increased funding for hospitals which are in the frontline of combating COVID-19.

The list goes on. Unemployment benefits, student loan deferment, tax deferment, tax relief

The idea is that the government is aiming to boost spending and support individuals or businesses affected by the health crisis.

Advantages Of Fiscal Policy

The main advantage of fiscal policy is that the policies can be more specific and targeted.

In monetary policy, the money supply and interest rates are a blunt tool to boost or support a falling economy. Whereas in fiscal policy, the policy makers can specify the conditions of distribution and target specific groups or individuals.

This is seen from the cash handouts and the grants to the heavily affected industries.

Also, fiscal policy has many more tools at their disposal. It can range from launching policies to encourage certain industries, tax relief, grants, loans, schemes, waivers and even direct cash handouts. The government also can boost funding to a particular public sector, namely the health sector, to directly respond to the health crisis.

The impact of fiscal policy is also faster because fiscal policy is more targeted, i.e. immediate grants to affected businesses. Whereas monetary policy is slower and has a time lag for the interest rates impact to trickle down to the intended businesses.

The main drawbacks are that fiscal policies are more complicated to enact and are therefore slower than monetary policy responses. Fiscal policy is also more complicated because of the politics involved.

Double Edged Sword?

The other main drawback of fiscal policy is funding. Governments are not able to print money like the central banks. The main source of revenue is from taxes.

In stimulus spending, the government increases spending and reduces taxes. With the reduction of revenue from taxes, the funding for stimulus spending often comes from debt mainly via issuing government bonds.

This is how fiscal policy often go hand in hand with monetary policy. For example, the central banks raise capital for the government by buying government bonds via QE.

However, debt must be paid off sometime in the future and large stimulus spending might just be passing on the debt for future generations. Hence, this is not usually the first response of the governments, especially governments with huge deficits in their budget.

Even for rich countries, like Singapore, part of the stimulus spending comes from dipping in the country’s reserves which it had saved up over the years. So in other words, this is not free money and it will cost the future generations something.

In Conclusion

The economic impact of COVID-19 is unprecedented that governments all over the world are responding with various stimulus packages.

Additional Reading: The IMF has a compilation of the policy responses of all country to COVID-19

Due to the COVID-19 crisis, the stimulus packages are more focused on survival rather than boosting the economy. There are various support packages for affected industries, waivers and relief to sustain jobs and handouts to individuals and grants to affected companies to help see through this trying period.

We had also seen unprecedented monetary policy that includes corporate bond buyout and unlimited lending programs. Recently, the Fed also launched a new lending facility for foreign central banks to convert treasuries to US dollars.

Fiscal policy is complementary to monetary policy. So when monetary policy goes all out, fiscal policy also matches and goes all out too.

We are in survival mode now.

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Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

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