[Lee Jong-woo's Economic Reading] Fiscal Injection or Interest Rate Cut?

Fiscal Injection or Interest Rate Cut?

There is no single policy to overcome a recession. It changes frequently depending on the situation. Before the 1920s, monetary policy was central. Even though the gold standard limited the amount of currency that could be supplied, economic adjustments were made using the money supply rather than fiscal policy. The leadership shifted to fiscal policy during the Great Depression. As private demand declined due to severe economic downturn, the government intervened. In the 1960s, interest rates were again used to control the economy and inflation, and this approach continued until recently. After the 2008 financial crisis, the influence of monetary policy peaked, and the focus has been gradually shifting since then.

There is an economic term called the "liquidity trap." It refers to a situation where monetary easing policies fail to lower interest rates and investment remains sluggish. Economist John Maynard Keynes first used this term to emphasize that strong fiscal policy, in addition to monetary policy, was necessary to escape the Great Depression.

Major countries' benchmark interest rates have fallen to near 0%. Despite large-scale quantitative easing, the economy has not improved much. If this were only recent, one might attribute it to the impact of the novel coronavirus disease (COVID-19), but the role of monetary policy had been significantly weakening for two to three years prior. Generally, the benchmark interest rate acts as the lower bound for market interest rates, and the fact that rates have fallen to a level where they cannot go any lower is considered the reason for the diminished role of monetary policy. This inevitably raises suspicions of a liquidity trap.

Therefore, expanding fiscal spending has been proposed as an alternative. In a low-growth, low-inflation, and low-interest-rate environment, fiscal policy is more effective, so the idea is to keep pumping money until it works. Going beyond traditional fiscal policy, some even suggest combining unlimited quantitative easing by central banks with unlimited government fiscal spending, known as Modern Monetary Theory (MMT).

The biggest concern when using this policy is inflation. When a lot of money is supplied and fiscal spending increases, inflation is inevitable. From the 1970s to the late 1980s, a period of about 20 years, and more broadly over 40 years since the 1960s, the global economy has suffered from inflation. This was caused by a significant increase in demand due to the baby boom and industrialization, while supply did not increase due to the low technological level of emerging countries. In 1980, the U.S. Federal Reserve (Fed) had to raise the benchmark interest rate to 20% to relieve inflationary pressures, causing severe pain. While this is a point to be cautious about, it should also be noted that advanced countries, including the U.S., have not suffered from inflation for decades.

Unlimited money supply is more likely to cause problems in areas other than inflation. The most concerning area is the financial system. If funds flood into asset markets and create bubbles, problems inevitably arise in the credit market. It is also important to consider that the government's power to execute fiscal policy becomes stronger, reducing checks and balances among economic agents.

Despite these constraints, fiscal policy is expected to be strengthened both domestically and internationally in the future. This trend is evident in COVID-19 measures. The U.S. government decided to inject $2.2 trillion to stimulate the economy. This amount is 10.3% of last year's U.S. Gross Domestic Product (GDP) of $21.4 trillion and three times the amount allocated for stabilizing financial markets through purchases of commercial paper (CP) and corporate bonds. Considering that $1.6 trillion was injected in two rounds of stimulus over six months during the financial crisis, it shows how strongly fiscal policy is being implemented this time. In Europe, Italy, France, and Germany have announced large-scale fiscal spending plans. They introduced active fiscal policies anticipating economic contraction due to the spread of the disease.

Our government also decided to provide emergency disaster relief funds to 14 million households in the bottom 70% income bracket. While the main source of funding is cuts in existing expenditure projects, some will be resolved through increased fiscal burden and expanded government bond issuance. This is the second measure following the supplementary budget in mid-March, indicating that our government's response is shifting from monetary policy to fiscal policy.

The reason fiscal policy is being strengthened like this is that there are no other options. Although the Fed rapidly cut interest rates since the second half of last year, it was ineffective. The 1.5 percentage point rate cut in March was so questionable that one might wonder why the rate was lowered at all. Although Fed Chair Jerome Powell says there is still room for Fed policy, considering the current interest rate level, further measures are unlikely. The Fed's recent announcement of unlimited purchases of government and corporate bonds is not purely monetary policy. Since it is based on $450 billion in Treasury bailout funds, it should be seen as a mix of fiscal and monetary policies. Monetary policy in the U.S. has reached its limit.

The limitations of monetary policy are also reasons why fiscal policy has been called upon. Monetary policy can be implemented quickly as it only requires the central bank's decision, but its scope is broad and its effects on specific sectors are weak. On the other hand, fiscal policy can focus on targeted areas in a pinpoint manner, producing strong effects. Therefore, when managing a slowdown in household consumption like now, fiscal policy is more effective.

When the government announced plans to increase fiscal spending, concerns about deficits grew. People said that if spending continues like this, the national treasury would soon be depleted. Our government debt is only about 40% of GDP. This is thanks to the strict adherence to the principle that only the amount collected from the public should be spent since fiscal accounting began, making it difficult to find countries with better fiscal soundness than ours except for a few in Northern Europe.

Currently, the situation is too urgent to discuss the side effects caused by fiscal spending. If we hesitate to use policies for fear of side effects that may occur after a long time, we may have to pay a higher price later. Just as the Great Depression created a new economic philosophy of government intervention, different policies must be used to overcome the current situation. Fiscal policy should be used when necessary and reinforced again over a long period once the situation stabilizes.

This content was produced with the assistance of AI translation services.