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.
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.
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.
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.