More spending, more growth? Don’t be so sure
Can you believe it's been five years since the Covid-19 pandemic kicked off? Those cringey TikTok dances and depressing Zoom ‘socials’ may seem like a distant past. But the seismic economic shifts? I suspect they’re still etched firmly into the memory of the world’s central bankers. Above all, the pandemic period reminded us just how powerful governments can be in driving economic growth, in a way that monetary policymakers can frankly only dream of. Just think of those US stimulus checks, or more recently, the vast quantities of cash European governments spent shielding households from higher gas prices. Interest rates are still so high in no small part because of those bold policies. But here’s the thing: maybe fiscal stimulus is losing its bite. As Europe mulls over more defence spending, or Washington touts multi-trillion dollar tax cuts, I can't help thinking that the impact on economic growth might not be nearly as game-changing this time around.
Take Europe and its ambitions to boost NATO spending. Carsten has a nice explainer on how the continent might pay for it, and two of his statistics really stand out. One, if – a big if – NATO spending expands from 2% of GDP to 4%, it would cost Europe EUR 340bn extra per year. And two, since Russia’s invasion of Ukraine, 80% of European defence procurement was sourced outside the EU. European leaders are waking up to the fact that they need their own domestic supply chain. But that’s a multi-year exercise and the reality is any immediate spending increases are going to be largely spent beyond Europe’s borders. In short, that extra spending probably won’t give the European economy the shot in the arm it so dearly needs – or at least not over the sort of time horizon the European Central Bank is interested in. And if extra defence spending means austerity elsewhere, we could actually see the opposite.
Chart of the week: NATO defence spending (% of GDP)
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For now, nothing has formally changed. And until it does, Carsten makes the point that the ECB can only act on official government policy. He’s still expecting the ECB to take the deposit rate down to 2% and probably below. The more immediate headache for the ECB is the bond markets. Debt issuance looks set to rise, regardless of how the European Commission decides to relax the rules surrounding the Stability and Growth pact. In the absence of pan-European borrowing, the risk is that sovereign debt concerns bubble back to the surface, which our Rates Strategy team warns could morph into wider spreads between member states. In an extreme scenario, as Carsten writes, we know the playbook: increased asset purchases from the ECB. All of this bears some resemblance to what’s happening over in Washington.
US President Donald Trump has this week endorsed a budget blueprint touted by the House of Representatives, which if passed, would unlock $4.5 trillion extra in tax cuts over the next decade. That’s a big number, but speaking to our US expert James Knightley, it’s one that could be entirely eaten up by the cost of extending Trump’s 2017 tax cuts beyond this year. And remember, that extension would make no actual difference to household income. If the Republicans want to create new tax cuts on top – exempting tips and overtime from income tax, to give two prominent examples – more funding is going to be needed.
That could be a challenge. Under Washington’s complicated system of budget reconciliation, any new fiscal stimulus would need to be deficit-neutral over a 10-year period. In practice, big savings or extra revenue will be needed to offset the extension or even expansion of tax cuts. James K is sceptical of the government’s ability to save the proposed $1.5 trillion, not least because of much of its is slated to come from the politically-sensitive Medicaid. For added context, even if every Federal worker were fired, James calculates the Treasury would barely save $230 billion per year in salary costs. And of course, that would leave nobody to run the government!
Even if cuts on the scale proposed are achieved, the hit to economic growth could be noticeable. That arithmetic and the need for extra money is one of the central reasons our team thinks sizeable tariffs are coming in the spring. And tariffs which aren’t offset by meaningful tax cuts or a large dividend from deregulation could challenge the narrative of US exceptionalism as we go into 2026. That’s partly why we think the Federal Reserve will still cut rates twice more in the second half of this year.
The bottom line is this: If 2020 showed us how government spending really matters, then 2025 will prove that how it's spent matters even more.