Fiscal stimulus Part 2

There have been three important developments since my last posting a statement by Federal Reserve chairman Bernanke; a policy preview by President Bush; and a comment by RBA Governor, Glenn Stevens. In this posting I also explore policy options for Australia if the worst case scenario were to arise.

1. Bernanke

Bernankes statement yesterday throws light on three aspects of the debate we have been having on the idea of a fiscal stimulus.

1. A fiscal stimulus could usefully complement monetary policy because fiscal and monetary stimulus together may provide broader support for the economy than monetary policy actions alone

2. Money should be put in the hands of low and middle income households that would spend it in the near term. Tax credits for business investment (presumably of temporary duration) might also make sense, according to Bernanke.

3. Any new spending measures should not be offset by higher taxes as that would be counterproductive.

Not surprisingly, I concur with all three propositions.

2. Bush

President Bush has indicated he favors broad-based tax relief rather than spending projects. In putting this view, he may be potentially in conflict with Bernanke and most US economists who favour a flat tax rebate and spending programs targeted at low income households. Bush is also likely to clash with the Democrats, who have expressed a preference for tax rebates, targeted spending and assistance to low-income families.

3. Stevens

The Governor of the RBA, in an overnight speech in London, has confirmed that he is still concerned about the outlook for inflation and warned implicitly of an unwelcome shift in the unemployment/inflation trade-off (requiring us to either scale down our inflation or unemployment aspirations). He added that, while Australia faced some external threats (slower growth in China and a loss of business confidence), there is no evidence so far of any significant impact, although it may be too soon to see it yet.

This speech is being taken by markets as increasing the likelihood of an interest rate rise in February. I hope not. Australia is at a different phase of the business cycle from the USA. But I believe the probability is high that we will start to slow down during the course of 2008/9. A mild slow down will be a blessing in disguise as it would relieve inflationary pressures and skill shortages. But what if it went beyond that and threatened to generate excessively high unemployment? This is the contingency I addressed in my earlier posting. If it occurs, I hope Stevens will be making similar noises to Bernanke in a year or so (about the need for fiscal policy to back up monetary policy), giving Swan the moral authority to dump his zero government borrowing commitment. This fiscal stance has always been a silly one even as a medium term goal (on average over the cycle) and could now soon become a cyclical liability.

If Stevens took this bold Bernanke stance, it would mean (on his analysis) living with 3 to 3.5% inflation (even in a core sense) for a short time rather than accepting a kick up in unemployment to 5% plus.

4. What would be the optimal fiscal stimulus for Australia?

If one accepts that, in the event of a severe slow down, a fiscal stimulus might usefully complement monetary policy, the question is: what form should it take in Australia?

Ideally the stimulus trigger should
(a) be amenable to quick implementation and fairly quick withdrawal when economic conditions change;
(b) help those hardest hit by the slow down (both on equity grounds and because it will produce the biggest demand effect per dollar); and
(c) as far as possible, yield sustained economic and social benefits over and above short-term stabilization.

This suggests such measures as temporary tax credits or rebates, a temporary increase in unemployment benefits or a temporary investment tax credit (withdrawn when unemployment falls back to a desired level).

I also believe that an economic slow down would offer an opportunity to rectify the past neglect of social and environmental investment such as in education, health, public infrastructure, low-cost housing, urban roads, rivers and water. The Rudd Government has a little time to plan ahead and if COAG does its homework well, they could find many small short-gestation social infrastructure projects with high benefit cost ratios which could be put immediately into action when (if) the crisis hits in a year or so. Such investment would provide the strongest short term demand stimulus and the best long term economic and social returns.

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17 Responses to Fiscal stimulus Part 2

  1. I think I agree with all you’ve said, though shouldn’t we try to walk and chew gum by using the occasion to improve our fiscal institutions as we go? We could for instance commit to temporary tax relief which the government would flag would be withdrawn on some independent advice. (You could take it from the Reserve Bank if you don’t want the hassle of thinking about who else would have appropriate standing).

    Also, I’d go a bit sotto voce on the equity angle. Always nice to get more money to those at the bottom of the heap – especially temporarily where it has least impact on incentives where we have a problem with EMTRs etc. And I guess those at the bottom of the labour market are harder hit in a downturn. This is illustrated in the greater variability of those on low incomes at the bottom in the graph I posted a while back.

    Blog_CBO_Income_Inequality_2007

    But then those with the lowest income are already on benefits so their income doesn’t fall during recession. But they’d be good candidates for a temporary boost in income as they’d spend most of it. And there’s another group doing it tough in a recession – all those poor suckers in the top 1% who take a substantial proportion of their substantial income from profits in the market either directly as capital owners or indirectly in their bonuses. I don’t guess you want to hand them any cash.

  2. observa says:

    ‘Money should be put in the hands of low and middle income households that would spend it in the near term.’
    Isn’t that exactly what the finacial intermediaries did with all the money created by central bankers with all those sub-prime loans? They spent it alright and now how’re we/they all doing? Priceless how these Keynesian drug addicts never understand a simple truth. There’s never a shortage of demand, just a shortage of real savings and investment to satiate the craving beast, as every parent knows.

  3. Jc says:

    This suggests such measures as temporary tax credits or rebates, a temporary increase in unemployment benefits or a temporary investment tax credit (withdrawn when unemployment falls back to a desired level).

    Temporary measures don’t work, if these guys are correct, Fred.

    One dissenter was economist Milton Friedman. His research had led him to conclude that consumer spending was less a function of liquidity than something he called “permanent income.” Friedman observed that when workers lost their jobs, they didn’t immediately cut back on spending. They borrowed or drew down savings to maintain spending, in the expectation of finding a new job shortly. Conversely, consumers didn’t immediately spend windfalls. They kept spending on an even keel until they achieved a promotion at work, or other increase in their long-term income expectations.

    Thus Friedman predicted that the $100 to $200 checks disbursed by the Treasury Department in the spring of 1975 would have a minimal impact on spending, because they did not alter peoples’ permanent income. Most likely, people would save the money or pay down debt, which is the same thing. Very little of the rebate would cause consumers to buy things they wouldn’t otherwise have bought in the near term.

    Subsequent studies by MIT economists Franco Modigliani and Charles Steindel, and Alan Blinder of Princeton, showed that Friedman’s prediction was correct. The 1975 rebate had very little impact on spending and much less than a permanent tax cut — which would change peoples’ concept of their permanent income — of similar magnitude.

    http://online.wsj.com/article/SB120070786488902199.html?mod=opinion_main_commentaries

  4. Jacques Chester says:

    With word of cheques being posted to every American, two things spring to mind.

    1: that episode of Futurama where President Nixon’s Head does the same.
    2: I’m glad I have Apple shares. The iPhone is going to sell even more crazily.

  5. Kevin Cox says:

    Isn’t the problem one of creating more money than we needed through asset bubbles, spending on wars and other non income generating expenditure and now we somehow have to soak it up. The amount of money can be diminished through inflation or it could be removed by delaying spending or it could be spent on investments in the future – a form of delayed consumption.

    So encouraging business investment is good. Spending on new housing is good. Spending on infrastructure is good and even better if it is renewable energy infrastructure. Delaying spending by putting more into health insurance or more into superannuation is good. Spending on education and training is good.

    Generating money to spend on the stock market is bad, leveraged buyouts are bad, buying harbourside mansions with loans is bad. In other words generating money to spend on non productive assets is best reduced.

    If the above is true then isn’t this what we should be doing all the time? That is, we have policies that encourage money creation for future wealth creation investments rather than money creation for investments based on returns from asset value inflation.

  6. Kevin Cox says:

    One thing I forgot to mention was that we can address the equity issue by channeling more of our community expenditure (taxes) on future wealth creation through the poorest rather than as we do at the moment by favouring the wealthiest.

  7. Fred Argy says:

    JC your point is a good one. It raises one of the obvious risks of contra-cyclical tax cuts – although I think the risk is lower in situations where people’s permanent incomes have already been hit by recession and where governments offer tax rebates targeted at low income households rather than to across-the-board proportional tax cuts.

    But accepting the gist of your argument, where should it lead governments if they were looking for a quick fiscal stimulus? Answer: direct government spending e.g. on low-gestation social investment or on higher unemployment benefits. If the logistics could be sorted out, that would suit me fine.

  8. Tom N. says:

    AN ASIDE: SLOW-DOWNS & EQUITY

    Fred,

    I found your recent posts interesting and tend to agree with your general argument, but wish to draw your attention (again) to what seems to me to be lazy thinking (or at least simplified drafting) in relation to equity issues. Specifically, I would ask you to reflect on your statement that:

    Ideally the stimulus “trigger” should … (b) help those hardest hit by the slow down (both on equity grounds and …

    What, I challenge you, is inequitable about the fact that a slowdown hits some folks harder than others? Presumably, many of the hardest hit from the slowdown also benefitted disproportionately from the preceding expansion, or at least hoped to. Consider, for instance, a low-medium income family that purchased a home, partly in the hope of pocketing capital gains consequent upon house price inflation. In a slowdown, they might face the prospect of losing their home (and at least some of the investment they made in it). But why are their losses particularly inequitable, remembering that there would be others in society on similar incomes who did not take the risk of purchasing their own home?

    Even if you focus purely on the unemployment effects of a slowdown, it is not clear to me that there are strong reasons as to why a slowdown – and the consequent increase in unemployment associated with it – means that any particular unemployed person warrants more consideration from the public purse on equity grounds than an equivalent person did before the slowdown. Presumably, we already set unemployent benefits and other support measures at some level to reflect our equity judgments. Do you really believe that the equitableness of such measures depends in any significant way on the number of people receiving them?

    Tom

  9. Tom N. says:

    PS: I just noticed that my concerns overlap with some of Nick Gruen’s earlier comments. Shorry for the duplication.

    Tom

  10. Bring Back CL's blog says:

    Fred,

    The problem in the US is firstly the liquidity premuim and secondly and related to fear of recession pushing up corporate spreads.

    The Fed should cur rates drastically so Banks will lend to the corporate sector. At present the 2 year swap is lower than the 3 month libor rate!

    then they have to find a solution to the counterparty risk problem.

    One deals with monetary policy the other is associated with it.

    I see no reason for the US budget to further deteroriate now.

    The Fed has been very slow at the wheel. It needs to act

  11. Jc says:

    I agree with most of what Homer says.

    But I would add a litle more about the Fed. Bernanke seems frozen and the Fed is making a lot of mistakes.

    3 weeks ago Fedsters were telling the market that they were concerned with inflation and indicated that were going to be slower on the easing.

    Stock market begins to crumble.

    Late last week Bernanke tells the market that he is in agreement with the suppourt package and that they will ease as the economy is clearly weakening. So he’s telegraphed an easing bias yet he’s done nothing about it and seems to prefer to wait until the next fed meeting rather than ease immediately. Moreover he’s changed his view over the space of a few weeks…. 180 degrees!

    Stock market goes down again.

    In other words the guy is behaving like a total clown.

    I’m less concerned than I have been for the US. The large banks that needed recapitalization did so and a good part of the writedowns have been made.

    So the Fed needs to act quickly to ensure contagion doesn’t spread to the rest of the credit market. They need to ease quickly.

    The thing they don’t want is the next most important asset class after real estate (the stock market) doesn’t tank.

  12. observa says:

    Piffle! Throwing more money at a solvency crisis can’t achieve the same outcome as throwing it at a liquidity crisis. As of today our stock market has retreated 20% from its high and is in freefall with the world’s bourses. Housing is next and for us with the most expensive housing in the western world, that’s about to get really ugly. My kids haven’t experienced a global recession in their adult lives and they’re about to get a doozy now. The Rudd govt is on the right track vacuuming up all the funny money created over a decade to get back to real savings and investment over the next 3-5 years of painful unwinding of the malinvestments caused by central bankers funding of a giant global, pyramid scheme. Pain, pain and more pain for long term gain is the only answer now and never again should we roll the printing presses. We’re also about to see how well those unions can protect incomes and the jobs of their members in a falling market now. Watch for Accord MarkII as the bankrupt Keynesians go ducking for cover, to hide from the obvious. The Rudd govt will be tearing up AWAs and unfair dismissals, just about the time firms are reviewing their order books and wondering whether to hoard labour and ride it out. The threat of scrapping unfair dismissals will be all the signal they need.

  13. observa says:

    Oh and blame Labor of course.

  14. Jc says:

    Why not obby, I always do. :-)

    You make a good point though that i have been making for a while (which is why it’s such a good point).

    The new kids could tighten the labor market right at the exact wrong time.

  15. Jc says:

    Obby

    there good value in that stock market trash can at the moment. Stop wasting time and have a hunt around to find a coupla bargains.

  16. observa says:

    Yeah, the mums and dads and margin calls are bailing fast. I noticed Commsec shut down for an hour this morning due to unprecedented overload. I like PrimeAg (code PAG) now at a close of $1.66. They listed late last year (150mill shares at $2.00) with the aim to buy well watered ag property. Sound management and they just signed up for properties that now have 3 years guaranteed water from the Emerald dam with food prices heading blue sky as a result of these GW nutters sticking the world’s food supply in our tanks. Buy now with a minimum 3yr time frame in mind. I reckon they’re right where the future lies.

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