Impending Economic Slow-Down: Need to Revisit Contra-Cyclical Fiscal Policy

It is now widely expected that the world economy will slow down in 2008 and could start to affect Australias own economic vitality in 2008/9. A mild economic slow down in Australia would not be a bad thing. It would help relieve the skills shortages, dampen wage-price pressures and lessen the risks of further rises in official interest rates. But a more severe slow down could start to seriously threaten jobs. If that happened, the first line of defense would normally be monetary policy (a lowering of overnight loan rates between banks).

But monetary policy could run up against two constraints this time around. First, the Reserve Bank might well be reluctant to switch gears at a time of still high underlying inflation for fear that it might damage its hard-won financial market credibility and fuel an unwelcome sharp decline in the Australian dollar and a renewal of the housing price bubble. Secondly, even if the Bank acted to vigorously reduce interest rates, this might not have the necessary stimulative power because if there is a recession the cause will not be the high cost of money or the incapacity of banks to lend but an unwillingness of institutions to lend to each other or to less secure clients because of the lack of trust in capital markets and intense risk aversion.

If this is the scenario which unfolds, it will be essential for governments to consider changes to tax and spending policies.

Unfortunately contra-cyclical fiscal policy has fallen into disfavour right across the world. The Rudd Government has staked its reputation on fiscal conservatism so it may be as reluctant as the RBA to provide a substantial economic stimulus. The Government may allow the automatic fiscal stabilizers to work, even if it meant running down its budget surplus, but it may not want to inject a discretionary fiscal stimulus and risk a large budget deficit, even if only temporary. That reluctance could prove a fatal mistake. The Rudd Government might find itself with another 1991 situation and for what? A discretionary fiscal stimulus would be perfectly consistent with its promise to run surpluses on average over the course of the economic cycle; there would be no breach of promise if it borrowed for a year or two.

Hopefully reason will prevail. If discretionary fiscal policies are considered, what would be the best options? In a recent letter to the AFR (pblished yesterday) I expressed the following view.

If the slowing of activity in the private sector goes too far and starts to seriously threaten jobs, it will surely be a never-to-be-missed opportunity for governments to start fixing our long-neglected public infrastructure. Who doubts the need for more investment in public education (especially early education), health, low-cost housing, public transport, our river and water systems, our roads and ports and so on? But governments need to be prepared. Governments, through COAG, must get their national infrastructure priorities sorted out quickly and start putting a few viable potential projects on the table.

The cynics will laugh. Here is the old Keynesian warrior at it again, they will say. Doesnt the old coot realize that economics has moved on and that governments are more likely to stuff the economy further because of untimely intervention?

I acknowledge this risk but it is surely avoidable. I draw attention to a recent review of the empirical literature on how best to craft fiscal stimulus (authored by (by Elmendorf and Furman, January 10, and available in Greg Mankiws blog). It concludes that, provided the intervention is timely (which means having plans on the drawing board ready to go) and well targeted at demand and employment and provided the stimulus is seen as temporary, discretionary fiscal stimulus would boost economic activity more quickly than monetary policy and would usefully supplement and reinforce any monetary stimulus (when the impact of policy instruments is not known, policy makers should use all the instruments available)

Subject to timeliness and design problems, this same paper unsurprisingly concludes that, relative to tax cuts, an increase in federal purchases has the largest effect because it initially raises aggregate demand in the economy dollar for dollar, whereas only a small share of the tax cut is assumed to be spent and rest saved.

The big challenge with infrastructure spending is that projects with sound benefit-cost ratios have to be ready to implement quickly and they should be capable of being cut off or slowed down when the economy recovers. Surely there must be such projects around? If not, the focus could be on shorter term oriented investment in human capital such as education and health. If all else fails, Rudd could consider temporary (withdrawable) tax credits targeted at lower income households.

I am not able to express any judgment about the optimal forms of fiscal stimulus (I have been out of Treasury for donkey years). But of one thing I am certain: Rudd needs to clarify his fiscal stance quickly to make it clear that fiscal deficits are not always bad and may well be needed again sometime during his term (first or second).

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24 Responses to Impending Economic Slow-Down: Need to Revisit Contra-Cyclical Fiscal Policy

  1. derrida derider says:

    Mmm. Yes, there’s a time for fiscal stimulus – it’s just that we haven’t had such a time for a very long while. I think opinions will change if they need to.

    The one thing that gives me pause is that you’re describing a period of stagflation rather than recession. This has some of the same ultimate causes as the stagflation of the 70s – sharp rises in the real prices of commodities (especially oil), overly optimistic judgement by policymakers of the underlying rate of productivity growth, and massive currency misalignments due to sustained war-driven fiscal deficits in the reserve currency’s home. Keynesian policy proved notably ineffective in those circumstances.

    If it happens, it won’t be a good time to be in government.

  2. Fred,

    As you know, like Bernie Fraser, I reckon it’s good to use whatever instruments one can cobble together in the circumstances to lean against the wind of the trade cycle, whichever way it’s blowing.

    That’s why I want to improve the institutional architecture of fiscal policy as we’ve done with monetary policy. As I’ve thought all along, given the pop macro-economics that passes for fiscal conservatism these days, there was a fair chance we’d need those institutions (like an independent body providing public advice to the Govt on fiscal policy) at times such as those you argue threaten us now which require greater fiscal expansion.

    All that having been said, I can’t see how you’ve made the case for fiscal rather than monetary policy easing – at least not with points about anti-inflation cred. If anti-inflation cred is at stake, then why would fiscal expansion be less inflationary than monetary expansion. And to the extent that fiscal expansion stimulates inflation the RBA will presumably take it upon itself to undo this with interest rate rises.

  3. Fred Argy says:

    DD and Nicholas, you both raise a similar and very pertinent concern: will a fiscal stimulus work when inflation is already high and the Bank is determined to give inflation priority? The answer is no, it won’t. And I am not suggesting for a moment that the next Budget should be stimulatory.

    But if my worst-case scenario comes about sometime in 2008 or 2009, unemployment could be rising appreciably. In this environment, the underlying inflation OUTLOOK might well be starting to subside, even though it will not yet be showing up in the CPI figures. In this situation the RBA may be prepared to cautiously reduce interest rates. But, because our Bank likes to dribble out changes (unlike the Federal Reserve which seems prepared to savagely cut despite high inflation), and because of doubts about the effectiveness of monetary policy in a financial crisis situation, the RBA might actually welcome some support from fiscal policy. The two instruments would then be in synchrony and reinforce each other. A rigid “no deficit” stance would be very silly in those circumstances and I hope Rudd prepares the ground for it in his rhetoric.

  4. James Farrell says:

    The Elmendorf and Furman paper that Fred mentions (when will you learn use links, Fred?) certainly backs up Nicholas’s comment. Two of the three reasons they give for preferring monetary to fiscal stimulus are related to the political complications besetting the latter. The same applies to the third, too, really. If the terms of reference of Nicholas’s Fiscal Board included long-run portfolio decisions, costly debt traps could in principle be avoided as well.

    It’s interesting that the paper doesn’t mention the current account and national saving as a factor in fiscal policy; whereas her it’s still the main variable officially guiding our own fiscal policy, as embodied in the ‘Medium-term fiscal outlook’ in the budget documents, the Intergenerational Reports, and so on,

  5. I didn’t ‘clinch’ the point that was actually most exercising me in my last comment – it’s this. I reckon that one of the reasons the ALP would have avoided building greater independence into fiscal policy in its pre-election platform is the same reason the Howard Govt didn’t want to do it. It had never had it so good – and an independent agency opining publicly about fiscal policy would have been a pain in the electoral arse because it is likely to have wanted the punch bowl taken away.

    But things change – and now it’s more likely that some independent fiscal agency even of an advisory nature would actually help the Govt run responsible fiscal policy if a downturn eventuated. One thing that’s been evident for years at the state level is how cringing the ALP is when the word ‘deficit’ is mentioned. In more and more states PPPs and privatisations have been run on the absurd grounds that they lower debt (but pushing it off the books in the former case and by selling assets and usually reducing govt net worth in the latter case). It’s been evident given this that if you want to return to a bit of simple budgetary commonsense – including budgetary commonsense – one needs to develop the institutions that can hold governments’ hands at times when their opponents are feeling like taking a free kick.

  6. observa says:

    Do what you like, but I’m in the bunker with the Guru, fingering the 12 gauge and buying more gold.

  7. Jc says:

    Fred:

    Just recently you were against the tax cuts saying that it would be inflationary. Now you’re implying (i think) that we should do away with the tax cuts and build a few bridges.

    If the problem is averting a potential recession in the private sector, why would you want to prevent the tax cuts from alleviating the stress there rather than going for the bridges?

    Japan’s fiscal position remains a mess from all the Keynesian spending that went on during the 90’s and it ended up doing diddly sqwat in terms of kick starting the economy.

    And just how would say spending 10 bill a year messaging the economy with infrastructure (for lord knows what) when we have a GDP at $1 trillion prevent any serious recession. It’s a drop in the bucket.

    Maybe they ought to be accelerating the tax cuts offering bigger depreciation allowances and not tightening up the labor market at the worst possible time.

    Major bank stocks like the NAB have fallen over 20% in the last 2 months, which is a reasonable indicator for our real estate market in some ways. The last thing the new kids wanna be doing is gluing up the labor market and taking us back to the early 90s recession.

  8. observa says:

    The best thing they could do with all that funny money, after sacking the tax eaters on the Reseve Bank Board, is quietly buy gold with it all, then announce Oz is going over completely on to the gold standard. That should kick the reserves along nicely, before the dollar drops like asset prices. Then we’ll see how real those budget surpluses are.

  9. Bring Back CL's blog says:

    Fred,

    We are not in a recession at present and the RBA will be mad keen to avoid one by tipping rates to breaking point amongst debt charged households.

    In a recession we only need automatic stabiisers and the RBA to do their job. It is only in a depression we need fidcal policy to do its job because low interest rates don’t work.

    If the government wants to spend on neccessary infrastrucute it can it just has to cut in other areas

  10. Fred Argy says:

    JC, I was not “implying” that the promised tax cuts be withdrawn in the next budget. That would be silly! All I was saying was that, if a fiscal stimulus were needed in 2009 (and it may not), it would be more effective to do it through government spending rather than tax cuts and it would make more economic sense to select spending programs that have productivity-boosting effects (through investment in human or physical capital) rather than increase transfer payments.

    James, the “political” problems are not nearly as great in Australia as in USA. The bigger problem is the logistic one of quick implementation of sensible investment programs (increases in transfer payments are easier). That’s why I suggested COAG needs to plan its priorities ahead and have some projects ready for action.

    James, I do feel silly not using links. I now know how. You shamed me into it.

    Nicholas, I agree in principle with your ideas for an independent fiscal stabilization authority and always have. But I remain very skeptical that any government, having given up two key instruments of macroeconomic policy, will now resign itself to giving up (admittedly in part only) the fiscal one too.

    There is a ray of hope however. The Rudd Government has promised us more transparency so, if difficult circumstances arise and the Opposition is playing funny games, it has the option to release formal advice it received from Treasury and RBA on the appropriateness of fiscal deficits. If I am right in believing that the RBA will, in some extreme circumstances, welcome fiscal support, such transparency could come in handy to the Government. That could be one foot in the door towards fiscal independence and it could lead to bigger things (e.g. a government admitting at times that it does not have the approval of RBA or Treasury). Even that would be dangerous politics.

  11. observa says:

    I see the analysis of the central bankers’ pyramid schemes has begun in earnest
    http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/13/ccschwartz113.xml

  12. Fred Argy says:

    For two other views on the case for a fiscal stimulus and what form it should take see http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf
    and
    http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf

    Interesting debate also between Greg Mankiw and Jason Furman in:. http://gregmankiw.blogspot.com/2008/01/cbo-on-fiscal-stimulus.html

    Just showing off that I can use the Link mechanism (I think).

  13. Jc says:

    JC, I was not implying that the promised tax cuts be withdrawn in the next budget.

    Fair enough , fred. That was the impression I got, which is obviously wrong. But you would have preferred to see no tax cuts anf more spending, is that correct?

    All I was saying was that, if a fiscal stimulus were needed in 2009 (and it may not), it would be more effective to do it through government spending rather than tax cuts and it would make more economic sense to select spending programs that have productivity-boosting effects (through investment in human or physical capital) rather than increase transfer payments.

    Fred, my understanding is the big chunks of (productivity) beef arrive when the capital to labor ratio is increased. Graduating additional neurosurgeons or economists for that matter will do little to change that. So if you want to really raise living standards, which is another way of describing productivity increases, you want to raise the capital to labor ratio. You can only do that through private capital expenditure increases. So the best ways to raise productivity/ living standards is through accelerated depreciation allowances and say through further cuts in capital gains taxes (down the zero).

  14. observa says:

    Hold the gold thingy! Eureka! I think the scientists might have found a home for all Fred’s fiscal stimulus
    http://www.news.com.au/adelaidenow/story/0,22606,23068489-2682,00.html?from=public_rss

  15. observa says:

    Mind you if you’re looking for a home yourself, the Guru and I in our bunkers will need fiscally stimulating with nothing but gold, canned food or ammunition
    http://www.atimes.com/atimes/Global_Economy/JA12Dj01.html
    Either that or find your own bunker.

  16. James A says:

    There’s some back on forth on economic stimulus on The Hill, which is a blog featuring a bunch of US congress members from both sides. Found via the Library of Congress blog.

  17. Kevin Cox says:

    I am told that the reason we have inflation is that we have too much money chasing too few goods. If we have inflationary pressures in Australia where has the money come from? Given that Australians borrow $20 billion every month to buy houses this has to be a major factor in increasing the money supply. Given that 90%+ of all housing loans are for existing houses rather than new houses and given that even 10 years ago 50% of housing loans were for new houses it would seem that we are creating a lot of money for no increase in underlying assets.

    Given this, surely one way of reducing inflationary pressures is to change the rules of lending for “old houses” that makes such lending less attractive to lenders. There must be all sorts of ways to do this. Think of a way that has an immediate effect, is easy to administer, and can easily be removed and let the system sort itself out.

    This may result in a drop in existing house prices but as it is 3 years until an election and the restriction old house lending can be removed a year before the next election the political effect may be acceptable.

  18. observa says:

    Unfortunately Kevin, you’re asking a lot of big, uncomfortable questions here all at once. You’re right about too much money chasing too few goods,(there can be supply side reasons too) so much so that the govt is now ‘harvesting’ the stuff.
    http://www.news.com.au/adelaidenow/story/0,22606,23066882-5006368,00.html
    Presumably it’s laying about stuffed in cupboards in govt offices everywhere, by the sounds of things and it’s now a bit of a problem for those who like to spend it all on good social works. Austrian economists(like Gerrry Jackson) would argue “The present surplus is the product of a massive monetary expansion.” largely because “Reserve Bank figures show that from March 1996 to July 2007 currency grew by 101.6 per cent, bank deposits by 177.7 per cent and M1 by 169 per cent.” Basically central bankers around the world funded and fuelled a giant pyramid scheme for over a decade, but once the players work out the game can’t go on forever, it doesn’t and here we all are, albeit there’s a fair bit more unravelling, hair tearing and hand wringing to go.

    As for the price of ‘old’ houses, they’re no different than ‘old’ shares, gold, stamp collections, paintings, factories, shops, antiques, etc, etc, although as you’ve noticed, too much funny money chasing them, coupled with the interaction of the income tax system, can produce funny prices, not to mention some other nasties like skewing real investment and savings and the balance of trade. What should we do about all this? Well that’s one helluva question, but perhaps the size and prolonged fallout from the collapse of this latest pyramid scheme, coupled with some other pressing problems with the whole constitution of our current marketplace, might make us go looking for a complete reappraisal and restructure of same. On that note I did outline one such constitutional marketplace we could have here
    http://johnquiggin.com/index.php/archives/2008/01/08/ergas-v-quiggin-on-risk-and-social-democracy/
    (see comment 19 and subsequent), but as you can see, it will take some real inertia for serious change from the science of muddling through we have inherited. Don’t hold your breath, because lots of people aren’t really interested in socially desirable outcomes, just power and banning plastic shopping bags and the like. Controlling investment in ‘old’ things too by the sounds of it.

  19. Kevin Cox says:

    Observa I don’t think a constitutional marketplace is likely to happen let alone in time to make any difference.

    If the ratio of lending for new dwellings to the lending for existing dwellings increased from 10% to 50% then it is likely to make a substantial drop in the increase in money supply and with it inflationary pressures. The number of new homes built would increase a little but loans for existing homes would drop a lot and with it a reduction in money supply.

    If this is correct then the trick would appear to be how to get this outcome with little impact on productive investment loans. The blunt instrument of a Reserve Bank Rate rise impacts on all investment, the increase in the banks mortgage rates for houses is better but would be even better if it only applied to existing houses.

    We cannot expect the banks (who are the ones making the loans) to work to reduce the loans they make because that is how they make their profits. They are probably happy with the current situation because it has enabled them to weaken or take over other lenders and so reduce long term competition and hence enable them to increase their lending margins and hence profits. They know that it is going to take a brave government to directly work to reduce the price of the family home so their loans for inflated valued houses are “safe”. It would appear we have dysfunctional capital markets that favour casino investments in inflated assets (both property and stock) not productive investments in ways to increase wealth.

    Perhaps the way to tackle the problem is to directly address the fact that it is more profitable to make an individual investment in old capacity than to make an investment in new capacity. If I want a loan to invest in new productive capacity wouldn’t it be better for the economy to have a lower rate than a loan to buy existing productive capacity? In house terms wouldn’t it be better for society as whole to have loans to buy a new house at a lower interest rate than a loan to buy an existing house?

    A problem is that it is normally riskier to build new productive capacity than it is to buy existing capacity and so the interest rates tend to be the other way around.

    Perhaps one way of redressing the balance is to put a surcharge on loans to buy existing capacity and use it to subsidise loans for new capacity? This could be done in the case of houses by requiring lenders to have a lower lending rate for first time usage of a house versus lending to buy a house that has been occupied. This would seem a relatively easy and enforceable strategy and would not impact on existing loans.

  20. observa says:

    There are two main contributors to the problem Kevin. Firstly central bank money creation that kicks off and fuels the pyramid scheme in asset prices and secondly the influence of income tax (marginal tax rates, negative gearing, capital gains treatment and the like)
    As to the former, an increase in money supply, short of matching increases in output, would inevitably raise prices, increase imports, or some combination of both. To the extent that the balance of trade suffers, we’d normally expect currency markets to adjust that or overseas borrowings to increase. Now prices over the past 10 years didn’t rise commensurate with the increase in money supply and neither did our dollar fall. That leaves an increase in debt, presumably to Asian savers, or to the extent that didn’t happen, those same Asians bought into inflated assets with the plasmas, whitegoods, cars and a plethora of manufactures they have forgone the pleasure of over the years. Now, although asset pyramid schemes are dynamic until the new money runs out as it has, our central bank supply was never lost in the process. If I owned a house worth say $350k a few years ago and sold it for say $500k today, the buyer forgos the extra $150k in consumption which is now available to me. For every buyer there’s eventually a seller with his money and that applies in aggregate. So to the extent that new indigenous dollars created are not absorbed by new goods inflation, they were spent overseas. Why didn’t our dollar fall as a result to equilibrate exports and imports? True, Asian savers may have been happy to fund our credit binge for a while, for some return, but even that should have bitten our dollar by now. The answer must lie in the fact that enough of them were happy buying some of our assets at inflated values to prevent that happening. They fed the pyramid scheme with new money and will get burned similarly. That on top of bad lending to Australians(and US sub-primes, etc) to do likewise is a double whammy for them (or via their govt investment corporations) Once bitten, twice shy and they won’t be funding MDC credit binges anymore, particularly if our asset prices drop 20-30% as they should. It could get uglier than that. Goodbye to cheap credit and it’s likely to take 3-5 years of pain to unwind the malinvestments that have grown apace over a decade.
    As for our income tax system and its gross distortions and warped incentives, coupled with environmental impotence, it should go the way of the dinosaurs, rather than continue tinkering at the margins with more muddling incrementalism. Whether the fallout from the impending world recession causes that change in thinking is a moot point, but we need to consider serious alternatives now. We certainly can’t throw anymore funny money at our problems, but rather we need to construct a new marketplace that serves us best in future while banishing the current bankruptcy.

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