The fight against sluggish global economic growth has been expensive, protracted, and unexpectedly vexing, leaving central bankers in developed economies with a laundry list of shared frustrations. Meager economic growth, flagging wages, and low inflation persist, in spite of bankers’ monetary stimuli, and threaten to quash upward mobility for young job seekers and midcareer employees in even the richest countries.
There’s a poster child for what countries do not want to become: Japan. The former economic powerhouse has been stuck in low-growth purgatory since 1991. And yet, as much as they’d like to avoid it, some countries have been sliding in that direction.
Many big economies are stagnating, and economists are running out of options to fix them. The conventional monetary policy for encouraging spending has been to drop short-term interest rates. But with rates already near, at, or below zero, that method is all but exhausted. Some economists have also started to empirically and theoretically question the power of forward guidance, in which central banks publicize plans for future interest-rate policies, at the zero lower bound.
To create the rising prices that fuel higher wages and economic growth, central banks must convince consumers and companies to spend more money. But controversial asset-buying programs that brought down long-term interest rates have not also produced sustained price increases as hoped, and they have inflated central-bank balance sheets. In the United States and Europe, those figures recently stood between 24 and 36 percent of GDP, according to WSJ Pro Central Banking. Japan’s central-bank balance sheet was a whopping 90 percent of GDP, and prices are still going down.
The situation has confounded many economists, who predicted rampant inflation by now.
Tax becomes an incentive to spend
After a German sales tax was enacted, people’s willingness to spend remained comparable to the time before the tax was announced.
Japan’s economy illustrates the ravages of low inflation. In the nearly 25 years since the country’s stock and real-estate prices collapsed, Japan’s economy has barely grown. Corporate Japan is hoarding cash estimated at 50 percent of the country’s GDP. Pay hikes are running at about 2 percent a year, even though low unemployment has created a tight job market. Japanese stock prices today are roughly where they were in the year 2000. Despite record-low borrowing rates (some mortgage rates are below 1 percent), Japanese consumers aren’t buying. Deflation, or falling prices, has given them good reason to hold off on purchases. The near-zero interest rate paid to savers also makes accumulating funds for retirement difficult.
Although Japan has been fighting it the longest, this cycle of low inflation and low growth repeats itself throughout the developed world today. Even the stronger economies such as the US and the UK have seen prices hold fairly steady in recent years.
The situation has confounded many economists, who predicted in recent years that the US would be experiencing rampant inflation by now. In hopes of promoting investment, many central banks, including in the US and Europe, bought massive amounts of financial assets in the years following the Great Recession. Because the programs required central banks to create new assets for the purchases—the banks essentially made money out of nothing—mainstream economists warned that high inflation would follow. But the critics were wrong. Not only did the money-printing schemes fail to inflate prices appreciably, parts of the eurozone are now flirting with deflation.
Meanwhile, GDP growth across Europe was well below 2 percent last year. In the US, the Fed forecasts GDP growth of about 2 percent in 2016, with lower growth in the following two years.
Buy now, or pay later
The idea that the threat of a sales-tax hike might stimulate stagnant economies has been around for some 25 years. But before the researchers homed in on the German VAT increase, economists had not documented such an effect in real life.
University of Michigan’s Matthew D. Shapiro first made the case, in 1991, for using a tax increase to get consumers to spend. Harvard University’s Martin Feldstein proposed in 2002 that recession-plagued Japan announce plans for quarterly VAT increases, along with simultaneous income-tax reductions, to entice households to spend money ahead of the cost increases. (Both sales taxes and VATs are consumption taxes: a sales tax applies to goods, while a VAT generally applies to both goods and services.)
A decade later, another group of economists—Isabel Correia and Pedro Teles, both of Banco de Portugal and Universidade Católica Portuguesa, Harvard’s Emmanuel Farhi, and Federal Reserve Bank of Minneapolis’s Juan Pablo Nicolini—demonstrated theoretically that the tax policy Feldstein described could stimulate economic activity when interest rates were at or near zero, which is the zero lower bound that limits central bankers’ options for providing growth through conventional monetary policy.
Still, economists struggled to prove that consumers changed their spending plans when faced with impending inflation. Two separate studies from 2015 report conflicting conclusions. A study led by University of Notre Dame’s Rüdiger Bachmann finds no statistically significant association between households’ inflation expectations and their readiness to spend on durable goods such as appliances, lawn equipment, and other household investments expected to last for a few years, such as cars and houses. A study led by the New York Fed’s Richard K. Crump, using data from the Federal Reserve Bank of New York’s Survey of Consumer Expectations, finds a significant positive association between inflation expectations and spending growth expectations.
Evidence in Germany
D’Acunto and his team exploit a natural experiment that closely resembles the theoretical situation explored by Correia and her colleagues, who had supposed that a government, at a time of flat nominal interest rates, would announce in advance increases in consumption taxes. And something like that did happen in 2005, when Germany unexpectedly announced a 3-percentage-point increase in VAT in 2007. Germany acted for political rather than economic reasons; the move was required to bring the German deficit in line with EU rules governing debt-to-GDP ratios. To comply with the requirements of the 1992 Maastricht Treaty, which ultimately created the European Union, the increase became effective in January 2007. The European Central Bank explicitly stated it would not adjust interest rates to counter the inflationary effects of the tax.
The VAT-increase announcement immediately increased German expectations of inflation, but it did not change inflation expectations in similar households in the UK, France, and Sweden, according to analysis of monthly household surveys conducted by the European Commission. By November 2006, German households, compared to the control group, were 34 percent more willing to buy durable goods. By 2007, the announcement had increased consumer price inflation in Germany.
While sales or VAT taxes generally apply equally, they have a greater effect on the poor, who spend a larger percentage of their disposable income on consumer goods.
The Bank of Japan announced this past September that as the economy approaches the central bank’s long-term target of 2 percent inflation, it will overshoot that inflation target rather than cut back on inflationary practices. It will keep making massive purchases of bonds, exchange-traded funds, and Japanese REITs (real-estate investment trusts) until the country’s observed consumer price index consistently grows more than 2 percent.
Central banks worldwide have spent the better part of a decade trying to spark inflation through low interest rates and boosting the money supply. The US Federal Reserve and many other central banks have paired asset-purchasing programs with reassurances that they would not allow inflation to rise above a set rate, typically around 2 percent. Japan, which has been in or barely out of recession since the early 1990s, has also used this approach.
But a study by Chicago Booth’s Kinda Hachem and Jing Cynthia Wu—first circulated in August 2012 and brought to the mainstream in a May 2016 column by Narayana Kocherlakota, former president of the Minneapolis Fed—finds that strict inflation limits handicap efforts to sustain a healthy rate of inflation. The researchers provide evidence that expansionary monetary policy would be more effective if central banks allowed inflation rates to rise and remain above targets for a period of time before taking steps to ease rates down to desired levels. This is exactly the overshooting strategy Japan is now pursuing.
Hachem and Wu find that overshooting counteracts downward pressure on inflation.
When companies have a variety of inflation expectations, the ones that expect low inflation or even deflation don’t want to be caught spending more money today than they take in tomorrow. As a result, they pull back on production, which creates a drag on the economy and puts downward pressure on inflation.
To counteract this, a central bank needs to capitalize on the inflation expectations of other companies and essentially galvanize those that expect inflation to be high, the research suggests. Companies that expect high inflation will continue producing their goods or services, and they’ll set high prices. To give these companies extra encouragement, central banks should make a series of aggressive announcements, the researchers suggest. Hachem and Wu’s model prescribes that a central bank should announce short-term inflation targets that are higher than the desired long-term inflation goal. Those targets will encourage some companies to set higher prices for their goods or services, which will lead to inflation.
However, the central bank will eventually want all companies, not just some, to share the view that inflation will rise at a target rate. It will take time for people to align their expectations with central-bank forecasts, but they’ll do so when they see the bank has a track record of achieving its forecasts. Hachem and Wu demonstrate that once higher inflation has taken hold, the central bank can build this track record by gradually lowering its inflation target toward 2 percent. It can’t act too quickly here: if it does, some companies could be spooked and again cut back on production.
On top of that, consumption taxes are regressive. While sales or VAT taxes generally apply equally, they have a greater effect on the poor, who spend a larger percentage of their disposable income on consumer goods. Adding to the controversy, taxing authorities decide what is or is not considered a necessary item exempt from taxation. Advocates in the US and the UK have protested taxation of feminine sanitary products, for example. “That’s a totally valid point,” says Weber about the taxes’ regressive nature, but he says a tax could be implemented in a budget-neutral way, for example, by pairing a sales tax with income-tax cuts and monetary transfers to the unemployed.
And he already has an endgame in mind: ultimately, if the policy were to work as intended, consumers would start buying more goods. The central bank would escape the zero lower bound. Then unconventional fiscal policy would pass the baton back to conventional monetary policy.
The global economic backdrop is making it possible for such a suggestion to enter the discussion. Some central banks are toying with stimulus plans that would have been considered wildly unorthodox for developed economies a decade ago. The European Central Bank, as well as its counterparts in Switzerland and Japan, has experimented with negative interest rates. In Denmark, homeowners are getting paid interest on their mortgages, according to Gemma Tetlow writing in the Financial Times, which also reports that some banks in Ireland, Denmark, and Switzerland have been charging companies to hold cash.
So far, the Fed governors have seemed averse to straying too far from the stimulus tools already in use. At an annual summit of leading central bankers in Jackson Hole, Wyoming, in 2016, Fed Chair Janet Yellen indicated that rate changes and, when needed, asset purchases remain the tools of choice for managing US economic growth. She did not mention negative interest rates or taxes.
But if the US won’t experiment with an unorthodox tool, perhaps another country will. Japan is a special case, says Weber, but the researchers have been presenting their findings at central banks including the Deutsche Bundesbank, the European Central Bank, Banca d’Italia, Banque de France, and the Reserve Bank of Australia. Weber thinks that the most-likely candidates for trying out sales-tax hikes for stimulus purposes are long-suffering countries, especially those whose high debt levels make debt-financed fiscal stimulus difficult.
“A country where you might see it implemented is Italy,” Weber says. “Italy’s GDP has been barely growing in real terms for the past three decades,” and its debt-to-GDP ratio is high, he says. “They need a budget-neutral (stimulus) policy.” Weber presented the evidence for unconventional fiscal policy in 2015 at the Banca d’Italia, to good reception.
- Rudiger Bachmann, Tim O. Berg, and Eric R. Sims, “Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence,” American Economic Journal: Economic Policy, February 2015.
- Isabel Correia, Emmanuel Farhi, Juan Pablo Nicolini, and Pedro Teles, “Unconventional Fiscal Policy at the Zero Lower Bound,” American Economic Review, June 2013.
- Richard K. Crump, Stefano Eusepi, Andrea Tambalotti, and Giorgio Topa, “Subjective Intertemporal Substitution,” Federal Bank of New York staff reports, July 2015.
- Francesco D’Acunto, Daniel Hoang, and Michael Weber, “The Effect of Unconventional Fiscal Policy on Consumption Expenditure,” Working paper, August 2016.
- Martin Feldstein, “The Role for Discretionary Fiscal Policy in a Low Interest Rate Environment,” Technical report, National Bureau of Economic Research, 2002.
- Alistair McKay, Emi Nakamura, and Jon Steinsson, “The Power of Forward Guidance Revisited,” American Economic Review, forthcoming.
- Matthew D. Shapiro, “Economic Stimulant: Sales Tax,” New York Times Op-Ed, December 16, 1991.
- Kinda Hachem and Jing Cynthia Wu, “Inflation Announcements and Social Dynamics,” Working paper, September 2016.
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