Monetary and Fiscal Stimulus has Failed – What Next?

Jonathan Rochford

Narrow Road Capital

In 2014 Larry Summers called the current malaise “secular stagnation”. The secular part implies that the change is not cyclical but has become entrenched. The stagnation part means that there is little or no growth. This year the mainstream business news (i.e. Bloomberg not just Zero Hedge) has started regularly publishing articles questioning whether orthodox economic policy has any answers left. Orthodox economists and central bankers are openly saying that monetary policy has reached its limits and the answers must be found elsewhere.

Whilst there might be a consensus that monetary policy isn’t working, there isn’t a consensus on whether fiscal policy is the solution. At one end of the spectrum, Paul Krugman argues that bigger government deficits are the answer. At the other end there’s a growing group who think that orthodox economics continues to ignore debt and hence hasn’t correctly diagnosed the problem. If the diagnosis is wrong the remedy is almost certainly wrong as well.

Much of orthodox economics doesn’t mention debt or include it in its models. Whilst it’s been a while since I finished an undergraduate economics degree I can’t recall coming across debt research in those studies. It’s not that economists never study debt, it’s that the work by Irving Fisher (1930’s) and Hyman Minsky (1950’s-1980’s) gets ignored. There’s never been a Nobel prize awarded for work on debt so far, perhaps Reinhardt and Rogoff might get that honour if sovereign debt defaults spike.

Like many, it is as a result of the financial crisis and being part of debt markets that I’ve come to understand how important debt is in the functioning of an economy. Incorporating debt into economic analysis is a light bulb moment. Easy and cheap debt creates overcapacity in economies. Examples include property and infrastructure in China, the recent energy boom and the pre-crisis housing boom in the US. Over-capacity is typically cleaned out in a recession, but the ongoing global wave of bailouts hasn’t allowed this natural process to occur. Minsky observed that stability creates instability. By trying to avoid recessions we make the likelihood and severity of future recessions worse. The inevitable can be postponed but not avoided.


How Debt and Interest Rates Impact an Economy

It is often said that debt is a mechanism for bringing consumption forward, producing a quick stimulus in an economy. However, the interest and principal payments required become a long term drag on spending in the future. When reviewing monetary policy in this light, the failure to stimulate economies becomes easier to understand. Businesses see the overcapacity and reduce investment in growing their output. Cheaper borrowing rates don’t incentivise capacity building, rather it encourages borrowing for stock buy-backs, mergers and acquisitions. Supply stays the same, it’s just the ownership that changes hands with asset prices higher.

For consumers with savings, lower interest rates reduce their income, so they respond by cutting spending or moving to riskier investments. As with businesses, the switch to riskier investments primarily results in bidding up prices for existing assets, rather than investing in new businesses that build new capacity. For consumers with debt their repayments rarely change, rather the lower interest rates see their debt repaid faster. Over the long term this has impact, but in the short and medium term there is no additional discretionary cashflow in the household budget. For those looking to borrow for housing, their savings build slower and their future repayments when they buy a property will be higher as house prices are higher. For consumers as a whole, lower interest rates are likely to lead to lower consumer spending.

The hoped for wealth effect from inflated asset prices hasn’t arrived. Consumers aren’t spending more and businesses don’t need to expand so demand for labour has been slow to recover. Employment to population ratios remain well below pre-crisis levels indicating there is plenty of slack in labour. Real disposable incomes are barely growing or negative. Consumers see their economic situation as worse, regardless of an increase in the value of their house. Low interest rates are seen as marking an economic emergency, rather than being a greenlight to spend money.


Why Fiscal Policy Doesn’t Help

The question then turns to whether fiscal policy is the answer. Here the logic is much simpler. By increasing debt now future generations are burdened with higher repayments. Some argue that governments should use current low interest rates to spend on infrastructure and thus increase productivity and growth. In theory that sounds logical. In reality, it’s about allowing currently excessive levels of stimulatory spending to continue with investment then funded by debt. If a government has $100 of income it should spend $80 on stimulatory spending and $20 on investment rather than $100 on stimulatory spending and borrowing $20 for investment. Even better would be to spend $70 on stimulatory spending, $25 on investment and $5 on reducing debt levels.

So if further stimulation by monetary and fiscal policies are not the answer what is? The actions required are all about prioritising reform and productivity, with two levers available for governments to pull. Firstly, government spending and taxation needs to switch from temporary relief to long term growth measures. Secondly, businesses must be given greater scope to compete and reduce their costs.


What Does Reform of Government Spending and Taxation Look Like?

It’s tough to have a discussion on government spending without bringing in the “fairness” discussion. What everyone agrees on is having a job is far better than being on welfare for the individual and the economy. Where the controversy begins is the minimum living standard that a job seeking unemployed person is entitled to. If welfare is curtailed, working people pay less in taxes and spend more (creating more demand for goods and services), and unemployed people are given more incentive to seek work. One example in Australia is that our fruit pickers are often seasonal workers from Pacific Islands and backpackers on a working holiday. Yet the highest levels of youth unemployment are in rural and regional areas. Clearly, something is wrong and an adjustment in incentives is needed.

Sometimes the pressure comes from entitlement at the other end of the scale. Based on 2012 numbers from the ABS, the average Australian fulltime doctor earns just under $150,000 per year. Continuing the freeze on bulk billing rebates will slightly reduce the pay of general practitioners. Doctors aren’t happy, but when the rest of the population is seeing a decrease in the number of hours worked isn’t it reasonable to say no to billions of dollars of additional spending that goes straight to the highest income earners? Perhaps we could open up the specialist colleges for more trainees so that specialists feel some pressure to reduce their fees, in the same way that the rate of bulk billing has increased as the number of GPs has increased.

On the taxation side reforms that promote greater employment need to be prioritised. This means reducing income tax rates so that the treatment of employment income and investment income is equalised. Payroll taxes should be eliminated; why would we want to tax businesses for creating jobs? This can be paid for by removing loopholes (including for trust income), cracking down on the black economy, land taxes and a higher and broader GST.


What Does Productivity Reform Look Like?

Reducing regulation to allow greater competition can be difficult to sell. Many people get a small win while a vocal few suffer larger losses. The taxi replacement service Uber is perhaps the most famous example. It’s often been said that taxis are the best advertisement for Uber. The service is often poor and the costs are higher than they should be. Primarily as a result of not needing to earn $30,000 - $50,000 per year to cover the investment in a taxi licence Uber can offer lower fares. The rating system means bad drivers and bad customers can be weeded out of the system, thus making it more efficient for all.

Research from overseas has found that whilst Uber has taken market share away from taxis the overall size of the market has grown. Consumers are responding by demanding more of the same service when the price has reduced. Uber isn’t perfect, there are legitimate concerns about Uber skirting tax obligations and minimum wage levels, but having monopoly controls on taxi services was far worse. The benefits flowed to licence owners with consumers and non-owner drivers worse off. If similar reforms were applied across an economy the benefits would be substantial. The Harper review of competition policy and the Productivity Commission’s 2012 list of recommended reforms are the obvious starting point.



The failure of most economists to consider the impact of debt on economies means they are blindsided by the negative impacts of excessive monetary and fiscal stimulus. Excessive debt has created many bubbles in the past, failing to let those bubbles deflate only increases the likelihood and severity of future recessions. The answer is not lower interest rates, more money printing or larger deficits but reform that promotes better government spending, taxation and a more productive economy.


Written by Jonathan Rochford for Narrow Road Capital on May 30, 2016. Comments and criticisms are welcomed and can be sent to

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Jonathan Rochford
Portfolio Manager
Narrow Road Capital

Narrow Road Capital is a credit manager with a track record of higher returns and lower fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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