Investors have clearly become more optimistic about the likely pace of global growth in recent months. Much of that optimism has been spurred by expectations of more growth-friendly policy settings in the United States. Little noticed, however, in our view, is the global trend toward easier fiscal policy and the role defence spending in Europe might play.
Looser fiscal policy on the horizon
Looser fiscal policy is on the horizon. The underlying primary balance for the Organisation for Economic Co-operation and Development (OECD) area as a whole – a good approximation for the aggregate fiscal stance – is estimated to have already eased by 0.2 per cent of gross domestic product (GDP) in 2016. That’s admittedly a small relaxation of fiscal policy but it follows several years, from 2010 to 2015, when fiscal austerity had typically been the norm.
The OECD is also assuming that fiscal policy becomes much looser in the period ahead and specifically by a further 1.5 per cent of GDP from 2017 to 2018.
Although the economic situation, particularly in several European countries, might not necessarily lend themselves to increase fiscal spending, we believe politicians’ views on the scope for fiscal policy to boost demand are changing.
The global trend towards looser fiscal but tighter (or less accommodative) monetary policy
Defence is the best offence
Implications of a likely looser fiscal policy and tighter monetary policy stance for some asset classes are far reaching. More importantly, we believe the shift towards tighter
monetary policy and easier fiscal policy will lend itself to increase defence spending in Europe.
Following the election of President Trump there is now growing pressure on a number of NATO member states including European member states to boost their defence spending. NATO guidelines specifically suggest that defence expenditure should account for at least two per cent of the member state’s GDP. However, amongst eurozone countries there are only three that comply with the NATO threshold. Moreover, our calculations suggest that in order for those eurozone NATO members to meet a two per cent defence spending target their combined spending needs to be increased by 0.5 per cent of eurozone GDP. That amounts to around EUR51bn. At first glance – and if it were implemented in isolation – this is a sizeable potential fiscal stimulus.
There is little academic research on what the fiscal multiplier on increased military expenditure in Europe would be. Assuming a fiscal multiplier of around one on increased aggregate government consumption in the Eurozone, a fiscal boost worth 0.5 per cent of GDP that is driven by increased defence spending, would, in other words, boost GDP by around 0.5 per cent relative to a baseline after one year. It would incidentally also raise consumer prices by around 0.5 per cent after one year.
The shift is global
Whilst the focus has been on the US increasing its defence spending, we believe there is plenty of scope for defence spending to increase on the other side of the Atlantic.
A global shift toward easier fiscal policy settings is already underway and Europe is likely to make an important contribution to this trend even if their ability to do so is constrained by fiscal legacy positions and budgetary rules.Read more