In the USA, Lawrence Summers tells us that the case for a fiscal stimulus is stronger than at any time in my professional lifetime. And most people other than a few crazy republicans agree with him. Paul Krugman and Greg Mankiw both add their voice: counter-cyclical measures are needed immediately. The same applies to the UK and Europe.
So why is the Australian Political Left and so much of the popular media still so debt-allergic? Why do our fiscal authorities refuse to respond to the imminent threat of a recession? And why are they so reluctant to finance new infrastructure investment at a time when new private investment has a very high risk premium? And why do we fail to recognize that monetary policy faces a breakdown in trust, irrespective of the lending rate?
Is fiscal policy effective?
Fiscal expansion can be effective in stimulating activity if the income effects outweigh the crowding out effects. Crowding out occurs through various channels:
– physical crowding out, which stems from demand pressure on productive resources; this only applies when the economy is operating close to full employment; it does not apply to the expected outlook over the next few months;
– direct interest rate responses by the central bank; this assumes a non-accommodating monetary policy, which now seems unrealistic;
– financial/crowding out, which occurs through indirect effects on financial markets and business confidence;
– exchange rate movements (with secondary effects on net exports); and
– some forward looking consumption smoothing by private agents (Ricardian equivalence effects where people are smart enough to recognize that higher deficit spending will lead to higher taxes later on ).
Extreme monetarists play up these leaks, especially the last three. But such extreme circumstances are unsupported by the evidence.
A recent US academic review of the empirical literature on how best to craft fiscal stimulus (authored by Elmendorf and Furman, January 10 and available in Greg Mankiws blog) concluded that, provided a discretionary fiscal stimulus is seen as temporary, it would boost economic activity more quickly than monetary policy and would usefully supplement and reinforce any monetary stimulus.
How to overcome implantation lags?
Well used, fiscal policy can clearly be effective as a contra-cyclical tool. But its biggest stumbling block is implementation lags, especially in periods when governments do not control the Senate.
To overcome the reluctance to increase tax rates in boom times, an independent body could be given the power (a la Gruen) to make small upward or downward adjustments to tax rates without the need for Parliamentary approval.
But another rewarding idea would be to have a number of sensible ready to go infrastructure projects for quick implementation. The advantages of such a proposal are potentially large.
First, spending increases on infrastructure projects produce a more effective contra-cyclical demand effect per dollar than tax changes – because it initially raises aggregate demand in the economy dollar for dollar, whereas a share of the tax cut is saved.
Secondly, the benefit-cost ratio on any new infrastructure project is much more favourable if it is started at a time when there is a lot of spare capacity in the engineering and construction industry and if it were sensibly cut off soon as soon as private building finance becomes more readily available (which point to the need to target low-gestation infrastructure).
Thirdly, investment spending has much bigger spin-offs for the economy in the long term than increased transfers and consumer spending e.g. it offers an opportunity to rectify the past neglect of social and environmental investment such as in education, health, public transport, low-cost housing, urban roads, rivers and water.
But governments need to be institutionally prepared. For investments to be well timed and productive there needs to be prior federal state coordination and a national audit to determine priorities. This is currently being done through coordinate federal-sate bodies such as COAG or the new Infrastructure Australia body.
The rules of the game
So why is Australia so different from the rest of the world in its stance on fiscal debt?
It cannot be simply the rules of the game. These clearly define the fiscal target as being “to maintain budget balance, on average, over the course of the economic cycle”. Formally, this gives governments scope to run budget deficits or surpluses depending on the economic circumstances. Nor have our rules changed much relative to the Hawke and Keating period.
Yet our fiscal advisers seem to make a distinction between automatic stabilizers and discretionary spending the former is tolerated (subject to some attempt to cushion its effects) but the latter is not.
I think the reasons must lie in
1. Costellos constant harangues against government debt, forcing new state governments to avoid incurring new net fiscal borrowing;
2. The fiscal conservatism of people like Carr and Rudd;
3. The political objections of the far right, who always prefer a tax cut;
4. Ongoing fears of the risk of a debt downgrading (which makes little or no sense);
5. And a degree of reluctance to run fiscal surpluses in the face of our stubbornly large current account deficit (which is illogical as private borrowing to fund infrastructure has exactly the same effect on the current account deficit).
Can you think of other reasons?