Expanding Fiscal Policy
I. The economy has entered a phase of active destocking, which is the most pessimistic stage in the short economic cycle.
The short economic cycle can be sequentially divided into four stages based on changes in demand and inventory: passive destocking, active restocking, passive restocking, and active destocking. This division is quite awkward to say or hear. Just as nature has seasons, so does the economy. If we compare it to the four seasons of spring, summer, autumn, and winter, it becomes much easier to remember and understand. Passive destocking signifies recovery, akin to spring; active restocking signifies prosperity, akin to summer; passive restocking signifies desolation, akin to autumn; active destocking signifies recession, akin to winter. When the economy enters a phase of active destocking, it typically means that economic demand is falling, businesses become pessimistic about the future, actively reduce their inventory, and the economy enters a "winter." Active destocking, or "winter," is the most pessimistic stage in the short economic cycle.
Currently, China's short economic cycle has entered a phase of active destocking. Both the year-on-year inventory of industrial enterprises and the year-on-year finished products of industrial enterprises reached their peaks in July this year and then declined.
Although, as the poet Shelley said, "If winter comes, can spring be far behind?", after enduring the winter, the warm spring will arrive. However, the biting cold of winter still makes people shrink and find it hard to bear the silence. When winter comes, people always try to add some firewood to drive away the cold. The same is true when facing the economic winter. Looking back at the United States' historical interest rate reduction cycles, they all began after the economy entered a phase of active destocking. Even in this atypical short economic cycle of the U.S. economy, the Federal Reserve also started to cut interest rates after the peak of inventory growth, that is, after entering a phase of active destocking.
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To cope with the decline in demand and the contraction of inventory investment growth, and to dispel the chill of the economy, China's macroeconomic regulatory authorities have started a package of incremental counter-cyclical policies since September. However, the market has different views on the future. For example, think tanks within the system signal that one should trust the determination of the higher-ups, but some investment analysts believe that several press conferences lack new ideas and have not found any particularly impressive or market-exceeding measures.
Why is there such a huge cognitive difference? I think it is because the economy has encountered a situation that is significantly different from the past. In fact, since entering 2022, China's short economic cycle has obviously weakened, with the amplitude of the cycle far lower than any time since the subprime crisis.
Governor Zhou Xiaochuan once said: How to counter-cyclical regulation? First, you must determine whether the problem in the economic system is a cyclical issue. Sometimes it is a cyclical issue, and sometimes it is not. Counter-cyclical policies are mainly used to smooth cyclical fluctuations.
There are several important non-cyclical reasons for the severe weakening of cyclical fluctuations since 2022, such as the scar effect of the pandemic leading to low consumer confidence, and insufficient entrepreneur confidence and unstable expectations leading to untimely and small economic structural adjustments.
These non-cyclical reasons, combined with the cyclical reasons of the economy itself, have led to overcapacity and even overproduction in some industries. Overproduction is an important reason for the severe weakening of the economic cycle since 2022. (Note: Many scholars believe that the current economic problems have both cyclical and structural reasons. We believe that economic cycle fluctuations are a process of continuous economic structural changes, a process of the elimination and destruction of old structures and the creation and formation of new structures. Different scales of economic cycles, such as Kondratiev long waves and Juglar medium cycles, correspond to different types of structural change processes, so cyclical factors are structural factors. Of course, structural factors are not necessarily cyclical factors, such as the scar effect and unstable expectations of private entrepreneurs mentioned earlier. To better distinguish, such factors can actually be classified as non-cyclical factors.)
At present, the driving force of China's economic growth is transitioning from the old momentum represented by real estate and infrastructure to the new momentum represented by high-end manufacturing and the digital economy. In the process of the transition from old to new momentum, China's manufacturing industry, as a capacity production department, has not been able to adapt to the structural changes of the capacity consumption department in time due to the aforementioned reasons, resulting in overproduction issues that have suppressed the cyclical fluctuations of the economy.Manufacturing represents production capacity, while infrastructure, exports, real estate, and consumption represent the consumption of production capacity. Therefore, the production surplus, which is the difference between the growth rate of manufacturing investment and the combined growth rate of exports, real estate, and infrastructure, to some extent, reflects the degree of overproduction in the economy. Before 2022, the production surplus was highly coordinated with the short-term economic cycle represented by the manufacturing PMI new orders, fluctuating around 0, with each cycle spanning 3-4 years. Thus, the cyclical accumulation phase of production surplus was in line with public expectations, and the market reaction was relatively calm. However, since entering 2022, the production surplus has remained in a positive range, indicating a continuous accumulation of production surplus, which is the so-called "overproduction" problem worsening, and the non-cyclical accumulation phase of production surplus has exceeded market expectations. As a result, we have seen that the manufacturing PMI order index, which reflects demand, has been below 50% for most of the time, and the short-term economic cycle has been severely suppressed.
It is not a major issue for the economy to enter an active destocking phase; it is just a part of market structural adjustment, similar to the natural change of seasons, where autumn gives way to winter, and then winter gives way to spring. However, when combined with a series of non-cyclical factors, the prolonged overproduction over a long period complicates the issue.
II. Macroeconomic policy needs to take effect, and increasing "fiscal expansion" is key.
In the face of the current economic situation, how should we respond?
Because the economy has shown significant differences from past cycles, macroeconomic regulatory policies may need to be intensified, both to cushion the downward pressure brought by cyclical factors and to withstand the pressure brought by non-cyclical factors in the short term.
(1) Loose monetary policy is necessary, but it is only releasing the brakes, not stepping on the gas.
When analyzing the policy effects of loose monetary policy, it is necessary to consider the "soft rope" effect of monetary policy. The so-called soft rope effect refers to the fact that monetary policy is like a "soft rope"; contractionary policies can effectively restrain an overheated economy with a single pull; however, when it comes to using expansionary policies to boost the economy, this "soft rope" is not strong enough. The reason is that monetary easing essentially provides ample liquidity to commercial banks and reduces the external financing costs for businesses. However, the financing needs of businesses are mainly influenced by fluctuations in total economic demand. When the economy is downturn, if new markets have not yet formed, businesses will not borrow money to increase leverage or investment, even if interest rates are low, and there is no talk of increasing demand (see "From 'Loose Monetary Policy' to 'Loose Credit': Relying on 'Fiscal Expansion' is Key").
Of course, the soft rope effect of monetary policy does not mean that "loose monetary policy" is unnecessary. In fact, compared to the "soft rope," it might be more appropriate to liken the implementation of monetary policy to stepping on and releasing the brakes: when the economy is overheated, stepping on the brakes with "tight monetary policy" can effectively curb economic overheating; when the economy is downturn, it is necessary to release the brakes, and "loose monetary policy" will lift the restrictions on the demand expansion of economic entities.
Currently, China's short-term economic cycle is in an active destocking phase weakened by non-cyclical factors, and "loose monetary policy" is necessary, which can bring some marginal easing of "credit." However, achieving comprehensive "loose credit" is quite difficult. "Loose monetary policy" only relaxes restrictions, helping to cushion the downward pressure on the economy, slowing the speed and magnitude of the economic downturn. However, it should be noted that loose monetary policy is only releasing the brakes; loose monetary policy is not stepping on the gas. Or more bluntly, loose monetary policy is never stepping on the gas. Borrowing from the two-factor theory in organizational behavior, for stimulating the economy, loose monetary policy is only a hygiene factor, not a motivational factor.
Therefore, for "loose monetary policy" to achieve the expected effect, it requires the cooperation of "fiscal expansion" policy.(2) Intensify "Broad Fiscal" Policy to Alleviate Overcapacity and Overproduction
During the active destocking phase, to increase "effective demand," it is crucial to fully leverage the catalytic role of government public investment. When compounded by persistent overcapacity and overproduction, broad fiscal policy must be intensified, not only to play a counter-cyclical role in smoothing out cyclical fluctuations but also to drive the economic cycle.
Economic growth is a cyclical reproduction process. The economic operation includes four interrelated stages: production, distribution, exchange, and consumption. In this process, these stages are organically linked, allowing for the continuous cycle of social reproduction and the increase of social wealth. If there is an imbalance in the supply and demand structure, it may lead to a situation where total supply exceeds total demand, resulting in overproduction. When enterprises produce goods that no one buys, products accumulate in inventory, funds cannot be recycled, and reproduction becomes difficult to sustain. In severe cases, this can lead to a great depression.
The essence of overcapacity is a mismatch in the supply and demand structure. In the long term, the solution to this problem mainly relies on market mechanisms, which can be addressed through adjustments in the capacity structure. However, it is essential to recognize that in the current situation where overcapacity and even overproduction have become established facts on the supply side, short-term responses are very important and necessary. Otherwise, as Keynes famously said, "In the long run, we are all dead," and the economy comes to a standstill.
The most critical task at hand is to intensify broad fiscal policy to "expand domestic demand" and absorb excess capacity, allowing the economy to operate in a positive cycle.
There are many such examples, such as Roosevelt's mention in his fireside chat on April 14, 1938, of measures to counteract economic downturns and promote economic circulation, including:
1. Providing new jobs to significantly increase the country's purchasing power.
2. Enabling the United States Housing Authority to immediately begin investing about $300 million in supplementary slum clearance construction projects.
3. Quickly initiating public works improvement projects costing about $1 billion in various states, counties, and cities to renew public works programs.
4. Adding an additional $100 million to the federal funding for highway construction projects that I proposed in January of this year.Four is to add an additional $37 million for flood control and reclamation work on the basis of the previously estimated $63 million.
Five is to add $25 million for the construction of the federal government across the country.
Therefore, whether it is stimulating investment or consumption, it is a short-term response to keep production going. "Loose fiscal policy" is to give full play to the leading role of government public investment, by increasing public expenditure, driving investment, stimulating consumption, and forming a positive cycle of demand expansion.
III. Outlook
The current economic short cycle is in the stage of actively reducing inventory, superimposed by non-cyclical factors bringing about overcapacity and even overproduction in some industries. Macro-control policies need to not only smooth the cycle fluctuations but also "expand domestic demand" to absorb overcapacity and let the economy circulate. Therefore, in addition to loose monetary policy, it is necessary to increase loose fiscal policy.
Although macro-control can alleviate the problem of insufficient total economic demand in the short term, to fundamentally solve the problem of supply and demand structure mismatch, it is still necessary to fully stimulate the entrepreneurial spirit of entrepreneurs and promote capacity structure adjustment through market mechanisms. On the one hand, the profit-seeking nature of entrepreneurs will drive enterprises to actively eliminate backward capacity and develop advanced capacity, thereby naturally achieving the adjustment of the economic capacity structure. On the other hand, one of the manifestations of the entrepreneurial spirit is the ability to give full play to imagination and innovation. Entrepreneurs can create new markets and open up demand space through continuous technological innovation and product innovation.