Geopolitics & macro policy
History shows that big power geopolitical rivalry shapes fiscal and monetary policy: expect more expansive macro policy
I spent time before Christmas reading through a mountain of 2024 notes from investment banks. There were common themes, such as a slowing global economy as well as ongoing reductions in inflation and interest rates. Geopolitics was also widely thought to be central to the global outlook, with increased global economic fragmentation and the potential for global supply chain disruptions.
But the changed geopolitical environment will have a broader economic impact in 2024 and beyond: intense strategic competition will also shape macro policy.
The common macro policy outlook for 2024 is that there will be some tightening of fiscal policy across advanced economies in response to high debt levels; as well as loosening monetary policy as inflation moves back to target levels. However, the contingency of macro policy on the geopolitical environment is likely to contribute to a more complex path for fiscal outcomes, inflation, and rates.
History rhymes
The historical record over the past several decades shows that the geopolitical regime has a powerful effect over the way in which monetary and fiscal policy are conducted. This is obviously the case in periods of war and their aftermath – high government spending and debt, often with accommodating monetary policy that suppresses yields and finances government deficits.
Beyond this, the geopolitical environment also changes the underlying political consensus around macro policy (and economic policy) in profound ways. In the 1950s, for example, Republican President Eisenhower embedded FDR’s New Deal into the US in the context of the increasingly intense Cold War with the Soviets – increased spending on the military, infrastructure (such as the interstate highway network), as well as welfare spending and support for unions to strengthen the development of the middle class.
Without this external threat it is unlikely that the political support for this bigger government policy consensus would have existed; a more conservative policy approach would have prevailed, with a smaller role for government. This was supported by monetary policy: constraints on interest rates, as well as strong nominal GDP growth, led to reducing debt levels despite higher government spending.
Similarly, the military spending associated with the Cold War and Vietnam War in the 1960s, together with the Great Society programmes, led to expansionary fiscal policy which could not be reconciled with the Bretton Woods exchange rate system: leading to President Nixon’s unilateral decision to exit the system in 1971. The strategic political priorities of the Cold War context overrode economic policy constraints. And the Reagan Administration’s strategic decision to out-spend the Soviet Union on defence in the 1980s, as well as to cut taxes, led to substantial fiscal deficits.
But the ending of the Cold War, as well as the process of intense globalisation, reoriented domestic economic policy. Most obviously, the peace dividend allowed for military spending to reduce. More broadly, the changed geopolitical context – and the Cold War victory – helped to powerfully embed a new neoliberal policy orthodoxy into the mainstream (the ‘Washington Consensus’).
Capitalism was seen as the victor, and the received interpretation was that ‘the era of big government was over’. Government spending was reduced, assets were privatised, and independent fiscal and monetary policy institutions were widely introduced to reduce policy discretion.
A new regime
And now the policy pendulum is swinging again in response to a changed geopolitical environment. Already trade and technology policy are being reshaped by the emerging strategic competition between the US and China, with new approaches to industrial policy (the new Washington Consensus). Geopolitical competition has reinforced public attitudes that had already changed in response to the global financial crisis and the pandemic, with increased demand for government support.
Government support for industrial policy, research and innovation, and supply chain resilience, is increasing – importantly motivated by the era of big power rivalry (see the JPMorgan chart below). And there is increased demand for military spending, in the US and more broadly, with a target of 2% of GDP. This will place upward pressure on government spending (and debt) even in the context of already strained fiscal positions across many advanced economies.
This geopolitical context is likely to lead to more expansionary approach to fiscal policy – reinforced by a busy election year in 2024, and concerns by incumbents about the rise of populist parties. This will push against and delay the fiscal tightening that would be expected in response to an unsustainable fiscal trajectory in multiple advanced economies.
This will be variable. In the US, there is no meaningful political constituency for fiscal consolidation; and only modest market pressure (so far) from bond vigilantes – despite statements of concern. And this will worsen if Mr Trump wins in November.
In Europe, there are more constraints with the new fiscal rules which were agreed just prior to Christmas. But even so, significant demands will be placed on European government balance sheets by a range of strategic priorities: from military spending to strengthening the industrial base. The geopolitical and strategic context will shape the way in which fiscal rules are interpreted, as well as domestic political pressures.
Large economies are more likely to pursue loose fiscal policy than small economies. Small economies tend to be much more fiscally conservative than large economies, in part because their higher levels of exposure to economic shocks. But in general, public debt across advanced economies is likely to continue to increase.
Taken together, significant fiscal stresses are likely to emerge. A UK-style implosion (under Truss/Kwarteng) is unlikely unless there is a weakening of fiscal institutions that gives markets a sense that policy is spiralling out of control. We are not there yet, but pressures are growing - and will strengthen if Mr Trump wins in November.
These fiscal dynamics are also likely to generate higher inflation, as high pressure economies intersect with an increasing array of (geopolitically-driven) supply side constraints such as less efficient global supply chains. Indeed, the historical record shows that periods of global competition tend to be inflationary (‘wartime inflation’).
This will place pressure on monetary and fiscal policy institutions. Just as it will be challenging for many larger governments to adhere to fiscal guidelines in the face of the pressures from strategic competition, pressure will grow on central banks to accommodate some of this fiscal expansion – through maintaining lower interest rates and using their balance sheets to absorb government borrowing.
As fiscal policy becomes less anchored in larger economies, we are more likely to see unconventional approaches to contain borrowing costs such as yield curve control measures (as per Japan).
Implications
The trajectory of macro policy around advanced economies in 2024 and beyond will be shaped by the geopolitical context. Macro policy will be approached as a strategic/political exercise as much as a technical/economic exercise. This will be a significant change from the largely rules-based policy of the past few decades. The historical episodes discussed above provide a flavour of what we might expect.
This is a higher risk approach to macro policy, different to the regime that has prevailed over the past few decades of the post-Cold War period. Geopolitical regime change will also mean a reframing of macro policies and institutions. Macro policy in times of geopolitical rivalry will look different than in periods of peace.
At Landfall Strategy Group, we provide insights and advice to help our clients navigate economic and geopolitical risks and opportunities. Do get in touch if you would like to schedule a briefing/presentation for your team, Board, or clients, on these issues. Contact me at david.skilling@landfallstrategy.com
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