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).