The case for a clean stimulus in the time of insecurity

The world faces a major medical emergency. COVID-19 infection rates are rapidly rising and thousands have already died. Societies are becoming disrupted both from the health impacts and the action taken to contain it. Businesses around the world are suffering from a simultaneous hit to supply and demand and the economic consequences are deep. The OECD has revised down its forecast for economic growth in 2020 to 1.5% from 2.9% projected in November. More downward revisions can be expected.

The economic response must focus on supporting people in these difficult times. Amongst the gloom, however, there is an opportunity to look beyond the crisis and support a green economic transition as part of the macroeconomic response to the corona virus. With a global recession likely in the first half of 2020, governments can utilise unmet investor demand for sustainable assets to underpin a pro-climate stimulus. Such an approach can support income and jobs today and in the years after the worst effects of the virus have abated.

The recent coronavirus epidemic constitutes a global demand and supply shock. Supply is constrained as workers stay home and trade and distribution lines are disrupted. Demand is undermined because fear and panic reduce consumer spending and cause negative wealth effects from downward asset price adjustments. The two can reinforce each other quickly as revenues are curtailed and credit and liquidity dries up, so early action is required.

The limitations of monetary policy?

Monetary policy is of limited effectiveness as interest rates in the developed world are close to the zero bound. Conventional monetary policy doesn't work when the economy is stuck in such a liquidity trap (experiments with negative rates have been tried, but ultimately money can make a better return under the mattress). The near-absence of inflation have allowed central banks to drop policy rates to boost economic activity.

But there is another reason behind this prolonged episode of record low rates. Interest rates are the price which clears the market for saving and investment. Low risk-free interest rates signal a surplus of desired saving chasing too little desired investment. The markets are searching for growth to the point where they are willing to lend to governments and get nothing in return.

Table 1. Unhappy returns: real yield curve rates

March 9^th 2020

Table 1 shows that futures markets expect real risk-free rates to remain below zero for decades to come. The bond market isn't just pricing in a recession as a result of the coronavirus, it also expects the policy rates to be near zero for the long term marking a prolonged era of 'secular stagnation' where productivity growth and inflation remain subdued and interests stay on the floor. Deleveraging, ageing populations, inequality, corporate short-termism and growing monopoly power and the build-up of FX reserves are among the reasons cited for driving a trend towards greater desired saving and lower productivity. Greater precautionary saving in the event of a global pandemic and recession is likely to exacerbate the downward pressure in rates.

The green opportunity

This presents an opportunity to stimulate the economy by putting capital to good use in financing a necessary and cost-effective green transition while stimulating the economy. Major economies are in danger of inducing a classic 'paradox of thrift'. This occurs when saving and cost-cutting is the rational response to economic fear at the level of an individual business (which also sheds labour), bank (which restricts credit) and household (which consumes less). But when everyone retrenches simultaneously, fear of extended recession becomes a self-fulfilling prophecy yielding a vicious circle of low demand and low investment. It requires the government to step in and invest the surplus net saving of an increasingly anxious private sector. It does this by borrowing more in lockstep with the private sector saving more.

Sensible people will rightly worry that public sector debt in most rich countries has accumulated since the financial crash. But in such conditions, debt remains historically affordable. Indeed, tightening public budgets is likely to undermine debt sustainability in the long run.

With interest rates so low, debt servicing costs for most countries are affordable. Indeed nominal GDP in most countries is rising faster than the stock of debt, even when accounting for new borrowing to cover interest payments. Indeed, most rich countries can run primary deficits of the order of 2% of GDP while still keeping debt/GDP unchanged and therefore sustainable.¹

This borrowing be spent on growth boosting public investment in green infrastructure, R&D, skills and education. Once one adds back interest payments, most countries can run sustainable deficits of the order of 4-5% GDP.

If the policy is successful at delivering its aim of a multiplied boost to GDP in the short run, as might be expected in a demand deficient environment facing a liquidity trap, while investment expands productive capacity and generates positive returns in the long run, the debt to GDP dynamics might even improve. This is because of what is known as the fiscal multiplier, whereby each percentage point of GDP of borrowing to spend generates more than a percentage point of additional income.

Authoritative studies from leading economists and the IMF show that fiscal multipliers associated with government spending fluctuate from near zero when the economy is operating close to capacity to about 2.5 during recessions. One leading study shows that government spending in a slump not only generates positive benefits, it also prevents negative hysteresis effects on future supply, whereby capital is scrapped and labour skills are lost as a result of protracted under-utilisation.

Of course, if successful in generating growth this policy would be expected to eventually raise interest rates and debt servicing costs in the long run. But this would be a symptom of success and at that point policymakers can always tighten the fiscal screws as global private sector activity normalises. But that point is not now.

The time is now

But what to invest in? One problem is that a quick fiscal boost requires investment in shovel ready schemes to be effective. Often, public investment that invests in long term growth is hard to implement on short notice. This means urgent action is required.

During the 2009 global financial crisis, governments embarked on a variety of green stimulus programmes amounting to 16.3% of the total public finance boost². This time around governments can be more ambitious as available options are cheaper and more shovel ready. These investments include efficiency retrofits of homes, zero carbon new homes, renewable energy and connected demand response mechanisms, public transport and electric vehicles. It will also require retooling and reskilling those whose livelihoods are threatened by the shift away from carbon intensive production.
 

But time is of the essence. The International Energy Agency (IEA) recently warned that although the coronavirus epidemic is helping cut global carbon emissions this year, the outbreak threatens to undermine investment in clean energy. Bloomberg New Energy Finance cautions that 2020 could mark the first fall in global solar power capacity since the 1980s, following cuts in Chinese production.

Noting that 70% of the world's clean energy investments are policy-driven, Fatih Birol, IEA's executive director, warned “We have an important window of opportunity. Major economies around the world are preparing stimulus packages. A well designed stimulus package could offer economic benefits and facilitate a turnover of energy capital which have huge benefits for the clean energy transition."

There is much uncertainty about the economic outlook, but if governments act fast and grasp the opportunity, the foundations can be laid for an irreversible shift to a sustainable economy through a coordinated green stimulus.

¹ the standard equation for debt dynamics is given as:
Change in d = -p + (r — g)*d(-1)
Where d = debt/GDP, p is the primary fiscal balance (public borrowing after interest payments), r is the rate of interest and g the rate of nominal GDP growth. This basically says that, all else equal, if an economy grows faster than the rate of interest charged on its stock of debt, its debt to GDP ratio will fall. This is because the numerator (debt) grows more slowly than the denominator (GDP). In most countries g is approximately 4% and r is around 2% suggesting countries can run primary deficits of the order of 2% of GDP while keeping debt/GDP unchanged.

² Robins, Nick, Robert Clover, and D Saravanan (2010), Delivering the green stimulus, HSBC Global Research, New York, 9 March