Economic stimulus: everything you need to know

What is economic stimulus?

Economic stimulus is when a government introduces policies that try to stimulate the economy and prompt a response from the private sector. It is usually introduced when an economy is in trouble and aims to either reverse or prevent a recession.

The economy is made up of many different parts and an event in one area often has a knock-on effect. For example, when a country enters a recession then unemployment rises, which means there are less people working and spending money, which reduces demand, which prompts more companies to lay off workers, and so on. The point of economic stimulus is to directly intervene and prop up the temporary reduction in demand, which in turn creates employment, going on, this time, to create positive knock-on effects across the economy to allow it to recover.

Fiscal stimulus vs monetary stimulus

The two predominant ways of introducing economic stimulus is through fiscal policy and monetary policy.

Monetary policy is the most widely used form of stimulus. This refers to policies that are carried out by central banks, like lowering interest rates or through quantitative easing (QE), which typically aim to improve the availability of credit so people and businesses can borrow money at better rates to encourage them to spend more and save less.

Fiscal policy, on the other hand, is introduced by governments and therefore exposed to politics. This can include the likes of tax cuts, which gives people and businesses more money to spend, or increased government spending, which can help prop up a slack in demand from the private sector to boost jobs and investment.

There are pros and cons to both monetary and fiscal stimulus, and each are constrained by their own limitations. More often than not, central banks and governments will try to keep their ambitions for the economy aligned as this is more effective than countering each other’s actions out, but they do occasionally go against one another. For example, a central bank could cut interest rates to encourage people to borrow more money, but that could be futile if the government decides to raise taxes and cut public spending.

Fiscal stimulus

Governments have the opportunity to be creative with fiscal stimulus, arguably more so than central banks. Still, the favourite policies to introduce as the economy ebbs and flows are tax cuts and higher government spending. Increasing people’s disposable income incentivises people to spend more to increase demand in the economy, while higher public spending can create jobs and other benefits.

It can target specific industries that are in need, or those that it wants to help grow at a faster rate. This could be a tax cut for tech start-ups to encourage the country’s industry to bloom, or increased investment in infrastructure like roads and housing.

Importantly, fiscal stimulus relies on the government increasing public debt. It is the opposite of austerity, which is when governments curtail public spending and raise taxes in order to reduce public debt. However, it does not always need to involve money. Scrapping regulations to make it easier and cheaper for an industry to do business can also be regarded as an attempt to stimulate a specific part of the economy.

The aim of the stimulus is to get economic growth to outpace the rise in debt so the deficit is eventually closed. This is called the multiplier effect. Any stimulus with a multiplier above 1 can be regarded as successful. For example, if a government borrows an additional £1 billion to inject into the economy and that causes gross domestic product (GDP) to rise by £2 billion, then the stimulus would have experienced a multiplier effect of 2. However, it is important to note that poorly-executed stimulus can experience a negative multiplier effect if it causes job losses or reduces consumer spending, resulting in a multiplier of below 1.

Fiscal stimulus will lead to a higher debt-to-GDP ratio in the short term but, if it is successful, should help reduce this further down the line as the policies start to take effect. The debate over the impact of fiscal stimulus is over the reliance on using debt and achieving a substantial multiplier. Gauging the direct impact of individual policies can be difficult and some argue that an acceptable multiplier can never be achieved as the government is simply spending money that would have, under ordinary circumstances, be paid by consumers, all at the expense of the public purse.

Monetary stimulus

The world has become used to monetary stimulus since the last financial crash in 2008-2009. Central banks had the responsibility of reviving the economy and they started off by slashing interest rates so it was cheaper for people and businesses to borrow money in the hope they would then spend more. Lower interest rates also reduces the incentive for people to save their money and encourages them to either spend it or invest it.

Interest rates can only go so low, and today we are even seeing a handful of countries with negative rates - which effectively means they are paying people to borrow money. This means central banks have had to use other forms of stimulus to keep the global economy going over the past decade.

The primary tool has been QE. This is when a central bank prints additional money and uses it to buy debt in the form of bonds from commercial banks, pension funds and other financial institutions, which then have more money to lend to consumers and businesses, which can then spend more and invest.

Ultimately, monetary stimulus is about managing the supply of money or credit in the markets to ensure it is running smoothly, keeping employment steady, prices stable (via inflation), and growth ticking along.

But criticisms of these forms of monetary stimulus have been growing over the years, and have accelerated since the coronavirus came around. Central banks from around the world have spent trillions on QE and interest rates are at record lows but the economy is need in rescue, leaving many to think that central banks have little wiggle room to see their economies through the current crisis.

This has heightened discussion about more unconventional forms of monetary stimulus, such as the use of helicopter money or even more radical ideas like an introduction of universal basic income – both of which would have to be run hand-in-hand with the government’s fiscal policies. One drawback of a government and a central bank aligning their stimulus packages is that it raises questions about the independence of the latter as it becomes exposed to be doing the former’s bidding.

How to trade economic stimulus

The impact of any economic stimulus depends on the finer details but fiscal and monetary policy can both have a significant influence over the economy, and therefore the markets.

Read more about what stimulus efforts are being introduced to battle the coronavirus crisis

The best opportunities lie in the forex market as currencies always move to adjust for any changes in monetary policy and can also react to fiscal policy. Cutting interest rates often leads to the country’s currency depreciating as people move their cash to other currencies that can offer better saving rates. QE tends to do the same as it increases the amount of money in circulation and dilutes the value of all the existing money, much in the same way a company dilutes its investors when it issues new shares in the business. On the other hand, fiscal stimulus tends to provide a boost as demand for assets denominated in that currency will increase.

There are also opportunities in indices and stocks, particularly when it comes to fiscal stimulus. If the government provides support to a specific part of the economy, like housing, then this should translate to (all else being equal) higher share prices for housebuilders. Similarly, if an economic stimulus package results in a weaker currency, then this will provide a boost to stocks that export or earn their income in another, stronger currency, whilst importers will suffer because they will have reduced buying power.

This can then go on to have indirect effects on other markets such as commodities, presenting further opportunities for traders. This is especially true with US economic stimulus because most of the world’s resources are priced in dollars – so any fluctuation in the strength of the greenback directly effects the value of everything from oil to soybeans.

Economic stimulus not only stimulates the economy but the markets too. The challenge is taking all the separate parts of any package and analysing the finer details so you can successfully trade any stimulus that is introduced or, for investors, prepare your portfolio accordingly.