The latest OECD’s Economic Outlook (EO) contains several surprises. First, it argues for a rethink of the current fiscal policy stance. Secondly, it forecasts an acceleration of the recovery in the OECD because of a major fiscal stimulus in the US. Last but not least, the OECD tackles the Euro Area’s Stability Pact and proposes rather fundamental changes in its rules.
A fiscal stimulus to escape the low growth trap
For at least the past year, the OECD has been pointing to the fact that monetary policy is overburdened and that a fiscal policy response is needed to break the vicious circle of gloomy expectations and get the global economy out of its low growth trap. With sovereign interest rates at historic lows, the fiscal space to accelerate growth robustly exists.
The latest EO (see the chapter “Using the fiscal levers to escape the low growth trap”) reiterates this thinking but backs it up with even more numbers and simulations. It estimates that if OECD economies were to undertake a ‘productivity enhancing’ fiscal expansion of 0.5% of GDP, the output gain in the first year would be 0.4-0.7%. Business investment would not be crowded out but instead be lifted by a median of 0.7%. Moreover, if such expansionary fiscal policy were to be shared amongst the large advanced economies, the additional output gain after one year would be 0.2%.
The OECD also estimates that a fiscal expansion of 0.5% of GDP could be maintained on average for three to four years without raising the debt-to-GDP ratio in the medium term. In the case of the UK and Ireland, this fiscal expansion could even be run over a period of up to seven years.
The table below summarizes the concrete fiscal policy recommendations. Germany and the UK should shift to an ‘expansionary’ fiscal stance whereas the US, France and a number of small European economies should go for a ‘mildly expansionary’ stance.
Growth forecasts revised upwards
The next surprise is that, in its central forecast, the OECD is banking on a global recovery to gather steam. Average OECD growth is forecast to intensify from a mediocre 1.7% (2016) to a slightly more robust rate of 2.3% in 2018. This OECD average is almost exclusively driven by the US where the think tank is assuming growth to double from 1.5% now to 3% in 2018. with the Trump fiscal stimulus responsible. Public consumption and public investment in the US would each increase by 0.25% of GDP in 2018 and personal income taxes and corporate taxes would be cut by 0.5% and 0.75% of GDP respectively. Such a tax stimulus is projected to prop up US GDP by almost 1 percentage point (pp) in 2018 with spill-overs of 0.15 to 0.3 pp in China, the Euro Area and Canada (see graph below).
Source: OECD Economic Outlook 100 database and OECD calculations
A ‘golden rule’ for net public investment
A third surprise is that the OECD continues to question the current rules of the Stability Pact (S&GP). Arguing that “existing fiscal rules could limit the recourse to fiscal policy in about half the countries considered” (see text box in chapter 2), the OECD calls for public investment to be treated more flexibly. While recognizing that some adjustments taking public investment into account already exist within the S&GP, the OECD adds that such adjustments are “marginal”.
It proposes expanding the current ‘investment clause’ significantly. Excluding public investment from the deficit criterion should be enacted for all investment categories, not just for projects that are co-financed by the EU. This should be done on a permanent basis and also for countries that are in the Pact’s corrective arm rather than being limited to very special circumstances. In other words, and the OECD is openly saying so, this is a move to a ‘golden rule’ on public investment.
Moreover, delving a bit deeper into the EO reveals that the OECD is taking this even further. Indeed, its euro area chapter adds the proposal for the ECB’s quantitative easing policy to condition its buying operations of national sovereign bonds to public investment. This can be taken as implying that the introduction of a ‘golden rule’ on public investment is to be backed up by the ECB providing member states with a reliable source of finance to cover their public investment efforts (as opposed to funding these on volatile financial markets). It may also provide a new avenue of thinking on how the ECB can make its QE policy more effective by directing the billions of money printed into tangible investment and support for the real economy instead of ending up, as is often the case right now, sitting in the balance sheet of corporations (see here).
A mixed bag
Finally, perhaps the biggest surprise is how the OECD treat the US and the euro area in rather different ways.
Indeed, apart from the fact that it is rather rash for it to simulate (or maybe second guess) the effect of the incoming US administration’s plans, the policy modelled by the OECD is almost exclusively one to cut taxes. This stands in stark contrast with the basic OECD recommendation which is to use public investment (as opposed to tax cuts which can simply boost savings) to directly inject new demand into the economy. The consequence is that the effectiveness of the US 1.75pp fiscal stimulus becomes much reduced, delivering only 1pp of extra GDP. If instead the stimulus had been targeted on public investment, we estimate (using the OECD’s implicit multiplier of 1.4) that US GDP would have been boosted by 2.45 pp of GDP. .
Even this extra1pp GDP is not so certain as “Trumponomics” may very well boil down to cutting taxes on the top incomes and corporate profits (see here). To assume that this will “boost demand significantly’ is exaggerated as the propensity to save is a lot higher for top income earners. The OECD’s estimate of 1pp extra GDP may therefore be overestimated.
For the euro area, on the other hand, the OECD “sticks to its guns” and continues to advance the case for a public investment stimulus, both in terms of relaxing the fiscal rules on public investment but also by linking the public investment stimulus to the finance provided by the ECB’s QE operations. This rather resembles calls by progressive economists and trade unions to have ‘QE for public investment’.
The latter by the way allows linking up with another phenomenon deeply buried inside the EO’s statistics. Behind the euro area average hides the fact that the ‘demand deficit’ of individual member states still differs a great deal. Whereas core members seem to be operating at (or even above) a level of GDP that is in line with their productive capacity, other members are going in the opposite situation. High and persistent negative output gaps in Italy, France, and Spain (see graph) are pointing to the fact that these economies continue to suffer from serious deficits in aggregate demand. New fiscal rules on public investment together with a monetary window at the ECB to finance additional public and productive investment could go a long way to mending the euro by all members and in particular those economies most severely hit by the euro crisis would finally get out of their low growth trap.