Ergas argument against fiscal policy

Thank you, Rafe, for sending me the October 8 article by Ergas. There is also a new article in todays Australia — http://www.theaustralian.news.com.au/story/0,,24730487-7583,00.html?from=public_rss

I was originally looking for hard evidence – that Kevin Rudd is alleged to have refused support for a major transport project in NSW on the ground that it did not run through any marginal electorates. I see no evidence. The charge has been repeatedly denied by all Labour sides of the fence. Ergas himself argues that that even were that (SMH) report incorrect (which he does not repeat in todays column), there are other strong reasons against a fiscal stimulus.

Ergas clearly has bigger fish to fry. He refers to the failure of the PMs criteria for project selection, which reads more like a bad haiki.

He has no objection to automatic stabilizers but he opposes the use of discretionary spending as a form of short term stimulus.

Ergas argument can be challenged in two stages.

First, is discretionary spending necessary? And secondly, what else can the Government do with the infrastructure money?

On the first question, we must agree to disagree. I find the arguments of Paul Krugman, the Secretary of the Treasury, the Governor of the RBA and most Australian economists all very convincing (on the merits of discretionary spending).

What of the second question – what else should the Government do with the moneys?

1. Private sector infrastructure investment is not readily available at present, except at exorbitant (irrational) prices. The reason is that the financial system is not functioning well at present, because of the failure to regulate the shadow banking system. The banks are alone and very distrusting of other non-bank borrowers.

2. The Government has set up the Infrastructure Council. It has been at work for nearly a full year. Surely, they can deliver some useful items by now ones which might meet the stringent tests (such as rigorous cost-benefit testing of all projects, full disclosure etc) presented by the ALP.

3. You can ofcourse give all the money away by way of a tax reduction, as Ergas notes today. In todays circumstances, a good deal of this money would be wasted (saved) and so prove quite ineffective as a source of short term stimulus. If we want to go down that road, why not give the unemployment recipients a generous increase in the much neglected Newspoll? This can be easily rolled back once the recovery starts.I doubt that the incentives to work and save and the vulnerability to rent-seeking have any bearing on the current problems.

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conrad
conrad
12 years ago

If you’re worried about people saving tax cuts given to them (which I find unlikely, unless we see a massive change in behavior), you could just target poorer groups. Why not raise the tax free threshold as much as possible? I’d find it especially difficult to imagine that those on the bottom of the pile are going to start saving any great amount of money, especially if things like rent, food, and so on keeping on going up.

Rafe Champion
12 years ago

What about burying the idea that saved money is “wasted”? Unless it is literally put under the mattress it is put somewhere to earn interest while someone else spends or invests it.

NPOV
NPOV
12 years ago

True Rafe, but at the moment banks are tending to hoard cash in order to deleverage. At some point though, as I proposed on another thread, this should make them more ready to lend, which can only be a good thing.

Henry Ergas
Henry Ergas
12 years ago

hi Fred,

With respect to whether infrastructure funds will be spent wisely, surely the key question is whether there will be sufficient transparency to allow spending decisions to be properly evaluated by the public?

In particular, I see no reason at all why the Government would refuse as it is doing to commit to full disclosure (1) of the cost-benefit studies undertaken and (2) of PPP contracts entered into. I was critical of the previous Federal government, and of the States, for not doing so, and I frankly do not see on what basis the failure to disclose this information could be justified. The Government (echoing the Labor states) has argued that PPPs are commercial contracts that are required to be confidential, but this is rot: for example, the United States is one of several jurisdictions which provide for their full disclosure.

As regards, the question of discretionary fiscal policy, I thought I had stated my position relatively clearly in the article in The Australian. That position can be summarised as follows:

(1) Whether discretionary fiscal policy is especially effective is the subject of extensive argument in the academic literature. I am no expert in macroeconomics, but my understanding of that literature is that the evidence is very mixed indeed. As John Taylor, whose work I greatly respect, has put it in recent pieces, there is especially little evidence that would back simple Keynesian views of how the economy responds to fiscal stimuli (what in my OECD days we used to disparagingly refer to as hydraulic Keynesianism). I am consequently surprised and disappointed at how readily those views (which I thought had died in the 1980s) seem to have returned to the fore. It is as if we had learnt nothing from the experience subsequent to the oil shocks.
(2) Be that as it may, the problem that surely emerged with great force from experience in the 1970s and 1980s is that discretionary increases in outlays are almost invariably associated with marked reductions in the quality of public expenditure. This is for simple political economy reasons, which then make those bad expenditure decisions extremely difficult to reverse. The Rudd government has already engaged a number of spending decisions that are extremely poor quality in economic terms, though perhaps highly popular; if it continues down this path, the prospects seem dire.
(3) If a discretionary stimulus is desired, it would therefore be more sensible to act through broad-based tax reductions, especially if these could be used to correct distortions at the bottom and the top end of the tax structure. Additionally, if you accept the permanent income model, making those tax changes permanent would be more effective in stimulating consumption, as well as in improving incentives.

All the best, Henry

Michael Kalecki
Michael Kalecki
12 years ago

What people such as Krugman and Summers have been arguing is that given the impotence of monetary policy then it is entirely sensible for countries such as the USA to use discretionary spending to attempt to boost the economy.

This did not happen in either the 1970s or 1980s.
what Henry is what Taylor recently argued permanent tax cuts which would entail permanent increases in the structural deficit.

quite ironic. This would not happen with increase in infrastructure.

Henry turns out to be more left wing than Fred on budget deficits

Henry Ergas
Henry Ergas
12 years ago

Monetary policy played a far-reaching role in the 1970s and 1980s, just as it did in Japan in the 1990s.

As regards the overall fiscal stance, the point is that if (and it is a real ‘if’) a discretionary fiscal response is desired, then one way of effecting it is through a tax reform that is not revenue neutral in the short run, but would be revenue neutral at higher levels of activity. Such a reform would be obviously preferable to wasting tax-payer money on foolish infrastructure projects, as the current government seems intent on doing.

Michael Kalecki
Michael Kalecki
12 years ago

No Government has been able to cut taxes which are revenue neutral when economic growth is more ‘normal’.
Such supply side arguments were shown to be false by the Reagan years for example.
If you wish for tax reform to be permanent then it has to be put with expenditure cuts otherwise you merely increase the structural deficit which amongst things leads to crowding out with higher economic activity.

Some infrastructure projects are wasteful . The Alice Springs to Darwin railway being an obvious one. Others are not such as dual carriage way on the eastern coast.

Moreover infrastructure costs are finite unlike tax cuts

JC
JC
12 years ago

What people such as Krugman and Summers have been arguing is that given the impotence of monetary policy then it is entirely sensible for countries such as the USA to use discretionary spending to attempt to boost the economy.

Ummm Have they argued that homer? Please show us where Krugman/Summers argued that monetary policy is impotent. In actual point of fact Krugman was strongly arguing for the kitchen sink be thrown at the Japanese disaster in the 90’s. Krugman was one of the first to support quantitative easing. Now you’re telling us that monetary policy is impotent?

So, Homer would you be advising the RBA not to lower rates today?

(Henry, Michael K is Homer. He says very amusing things. I have a laundry list of them)

Michael Kalecki
Michael Kalecki
12 years ago

We are talking about the USA today.

for Krugman just go to his blog and ook it up. For Summers go to Brad De Long’ blog and look it up.

always on topic JC.

Good to see

JC
JC
12 years ago

Homer

Please link to where Krugman and Summers have said monetary policy is impotent. I hope you’re not confusing a medical ailment here with economics. You’ve done that before.

Michael Kalecki
Michael Kalecki
12 years ago

I told you where it is.
Don’t be lazy.

RBA is the Central Bank here not the USA.
I would cut rates by 2-3% and get it over with.

Henry Ergas
Henry Ergas
12 years ago

Hi Fred

There are really two issues: whether a discretionary fiscal stimulus is desirable; and if so, its form and extent.

With respect to the first, there is, in my view, a significant disconnect between the academic literature (which is admittedly quite diverse) and the policy rhetoric, with the former being far more cautious as to the effectiveness and desirability of discretionary fiscal policy. Some of the arguments rely on variants of Ricardian equivalence, but I would not have thought that was the dominant strand of argument.

With respect to the second, it may be that society would be better off with enhanced public investment in a range of areas: but that depends on whether the projects that are selected have benefits that exceed their costs. It is surely difficult to believe that this applies to the governments car plan, to take but one example. Given that, it is, in my view, preferable to operate on the tax front, perhaps using the scope to reform the tax structure so as to move it towards flatter rates of tax, eliminating distortions at the bottom and the top of the taxable income distribution.

Finally, I am very puzzled as to why you dont support my call for full transparency of cost-benefit evaluations and of government infrastructure contracts. It is a pity the previous government did not do enough in this respect; it is surely even more important now that we have this very large-scale infrastructure fund. Why shouldnt taxpayers have access to the bases on which decisions spending are taken that involve many hundreds of millions of dollars of public money? Why should I not be able to know what the effective rate of return allowed PPP proponents is and how risks are distributed as between the public and the private sector? Such disclosure should, in my view, be a prerequisite for receiving any support for the Building Australia Fund.

Of course, it would be desirable to see that level of transparency more widely. For example, most studies I have seen (admittedly largely for Europe) suggest that the benefit/cost ratio associated with reducing queues for elective surgery, when they are at levels similar to ours, is very low indeed. Yet the current government is making this a priority: dont taxpayers have a right to see what studies or analysis this is based on?

In short:

(1) You cannot simply assume discretionary fiscal policy is desirable;
(2) Even if it is, given the risk of poor spending decisions, there is a case for focussing on broad-based tax cuts; and
(3) At the same time, we should be doing more to improve the quality of spending, including through far greater transparency.

All the best, Henry

Ingolf
12 years ago

Both of you have quite possibly already seen this recent post from Greg Mankiw where he poses the following question:

The Keynesian model has some clear, practical insights about how to think about fiscal policy during economic downturns. But are those insights true?

I am so far from truly knowledgeable in this area but the conclusions of the two studies cited both apparently contradict standard Keynesian theory. One of them also supports Henry’s view that a deficit financed tax cut is much more effective than deficit financed spending.

Anyway, FWIW.

Henry Ergas
Henry Ergas
12 years ago

Hi Fred

I am not sure I quite understand your response. Are you saying that there should not be full transparency also for PPPs? Why not?

As regards my criticisms of the previous government, it did not relate to the PPPs which the previous government was very cautious about (and rightly so). Rather, it related to the limited disclose made in AusLink I felt there was scope to go further, and I believe the current leadership of the Opposition agrees.

The obstacle to full transparency is consequently the Government. Given that, would you be happy to add your voice to calls for complete disclosure of the information relevant to decisions that involve literally billions of taxpayer dollars, in some instances (notably PPPs) being used to underwrite contracts with private firms?

All the best, Henry

Tel_
Tel_
12 years ago

The obstacle to full transparency is consequently the Government. Given that, would you be happy to add your voice to calls for complete disclosure of the information relevant to decisions that involve literally billions of taxpayer dollars, in some instances (notably PPPs) being used to underwrite contracts with private firms?

It should be outright illegal for any government to sign a contract in secret and commit taxpayer money under undisclosed terms.

As for the World Youth Day cost blowout from $20 million, to $120 million — how can that even happen? Why did it take so long to figure out what was spent? This is precisely why government must be constrained by a strictly balanced budget, because once they get an inkling that they can skip on accountability, so it will go.

Michael Kalecki
Michael Kalecki
12 years ago

We have just been through a once in a lifetime increase in commodity prices.

Yet we couldn’t increase our volumes!

A little bit of factfinding brings one to the realisation concerning the lack of infrastructure.
( Bomber was rabbiting on about this in the 2001 election but was ignored!)

The benefits of a dual carriage way from Brisbane to Melbourne has been known since John Cox wrote about this in the 70s and 80s.

One thing Governments do is put off capital spending to get surpluses. This means there a large number of project that need to be completed.

It is a bit silly that they are competing for resources during a commodity boom.

Makes sense if the worst economic downturn since the Depression is coming up.

Certainly better than Henry advocating tax cuts which miraculously are affordable as economic conditions get better.

Henry is a fan of crowding out

JC
JC
12 years ago

We have just been through a once in a lifetime increase in commodity prices.

Yet we couldnt increase our volumes!

Homer, if volumes had increased we wouldn’t have seen prices go up :-)

Michael Kalecki
Michael Kalecki
12 years ago

JC,

you are mixing world supply with Our Supply.

guess what producers do when prices go up?

Michael Kalecki
Michael Kalecki
12 years ago

you are confusing a change in the quantity demanded with a change in demand.

We did have a change in demand