Monday, November 24, 2008


Comview conference, Melbourne
November 24, 2008

Economic developments have come thick and fast during the Rudd Government’s first year in office and, as a result, the policy mix and the stance of policy arms have changed significantly. Since you’ve just heard from Chris Caton on the economy’s current performance and outlook, I’ll focus on describing the changing policy response to those developments.

But first, a little political context. When the Rudd Government came to power last November, two perceptions dominated its approach to matters economic. First, it believed - no doubt on the basis of its market research - it had a serious credibility problem with voters on the question of economic management, thanks to Peter Costello’s success over the previous 11 years in characterising it as the bad manager who left him to inherit a $10 billion ‘budget black hole’ and a mountain of federal government debt. In the process of scoring these political points, Mr Costello managed to roll back decades of Keynesian thinking, convincing many in the public and in political circles that budget deficits and debt were an unarguable sign of economic irresponsibility, whereas budget surpluses and the elimination of government debt were the ultimate proof of exemplary economic management. As a result of this, Labor believed it had no choice but to embrace the Howard Government’s policy mix and fiscal rhetoric without demur.

Second, well before it won the November 2007 election, Labor knew it would be taking over after the economy had been expanding for a record 16 years, but with the economy approaching full capacity, inflation pressure building and the Reserve Bank stepping ever-harder on the monetary policy brakes. Federal office usually changes hands immediately after an incumbent government has presided over a recession, but this time the change-over was occurring before any recession. So Labor knew the chances of a recession during its first term were high, and that if it was to survive such a disaster it would have to start from the very beginning implanting in the electorate’s mind the belief that every adverse economic development was the fault of its predecessors’ mismanagement.

When federal government changes hands once a decade or so, standard practice is for the incoming government to find an excuse to make its first budget a really tough one, in which spending programs are cut hard. The econocrats encourage their new masters to do this, knowing it’s their best chance of ever persuading governments to have a spring cleaning because all unpleasantness can be blamed on their predecessors. This practice is also motivated by a desire to cut out their predecessors’ pet programs to make room for their own pet programs.

As you remember, so concerned was the Reserve about the build up of inflation pressure - which was pushing the underlying inflation rate well above the 2 to 3 per cent target range - that it increased the official rate in August 2007, shortly before the start of the election campaign, and then did so again right in the middle of the campaign. From the moment it took office the Rudd Government would have realised that the Reserve was intent on raising rates further, as indeed it did in February and March 2008. Wayne Swan thus began by emphasising the severity of the inflation problem the new Government had inherited from the Liberals. We were given the clear impression Labor’s first budget would be very tough, with sweeping cuts in spending used to produce the largest budget surplus possible given Labor’s commitment to matching the three years of tax cuts the Liberals had promised in the election campaign.

The object was to change the policy mix, with fiscal policy tightened so it took more of the burden of restraining demand and thus reduce the need for ever tighter monetary policy. As it turned out, however, the budget was not a tough one. Spending was not cut hard and the main way Labor attempted to cover the cost of its election promises was with a few tax increases (on alcopops, luxury cars and oil condensate). Why the sudden change of heart? Because Mr Swan’s private discussions with American and European leaders during his trip to the IMF convinced him the problems arising from the subprime crisis were far from over and that the world economy was heading into recession. This was not the time to add a tightening in fiscal policy to already tight monetary policy. So, in the end, the policy mix wasn’t changed at that time.

The Rudd Government’s first year has thus been one in which a preoccupation with the need to reduce inflation by using policy to slow the economy has been replaced by a preoccupation with the need to prevent the economy being pulled down into the global recession by dramatic reversals in the stances of both fiscal policy and monetary policy. Let’s examine the two policy arms in turn, concluding with a summary statement of the changed mix of those policies.

Monetary policy

Objective and instruments: The Rudd Government made no change to the objective of monetary policy, which is to be the primary instrument for achieving internal balance - that is, low inflation, low unemployment and a stable rate of economic growth. It accepted the RBA’s inflation target - to hold the inflation rate between 2 and 3 per cent on average over the cycle - and affirmed that the RBA would be allowed to conduct monetary policy independently of the elected government. The new Government agreed to some minor changes to the RBA’s institutional arrangements eg decisions of the monthly meetings of the RBA’s board are now announced at 2.30 on the afternoon of the meeting, rather than at 9.30 the following morning.

The RBA has made some small changes to the way it conducts its open market operations in response to the financial crisis. Most textbooks say market operations are conducted by means of the outright purchase and sale of CGS but, for many years, the main means has been by ‘repurchase agreements’, known as ‘repos’. Under a repurchase agreement the RBA agrees to buy (or occasionally, sell) eligible securities with a simultaneous undertaking by the seller to reverse the transaction at an agreed price and date in the future. This means a repo is essentially a secured loan. A bank that wants to borrow exchange settlement funds (‘cash’) from the RBA hands over an eligible security worth more than the loan, agreeing to repay the debt by buying the security back, with interest, on an agreed date anything from a week to a year later.

Since the subprime crisis began in August 2007, the RBA (like many other central banks) has been steadily widening the range of highly rated securities it is willing to accept for repo agreements. As well as accepting all types of government securities, it is now willing to accept bank bills and certificates of deposit.

Open market operations involve the RBA using its market operations to manipulate the supply of exchange settlement funds so as to ensure the demand for funds equals the supply of funds at the target cash interest rate it has nominated. Every bank is required to end each day with a balance on its exchange settlement account with the RBA of zero or more (ie not be in overdraft). Because the interest rate the RBA pays on ES balances is a little less than the cash rate, banks usually prefer to lend any surplus ES funds to those other banks that expect to be short of funds at the end of the day, with the interest rate on the loan being the (full) cash rate.

However, because the global credit crisis has left banks in Australia and other developed economies reluctant to lend to each other (for fear that they may not be repaid, or fear that no other bank will be willing to lend to them should they need funds in future) the RBA and other central banks have had to use repos to lend much more to banks than would normally be the case. That is, the banks have been hoarding cash. The media sometimes refer to this process as ‘flooding the market with liquidity’. There are three things to note. First, the funds are lent to the banks against security for short periods at normal interest rates. So the banks aren’t receiving any subsidy. Second, the increase in ES funds does not involve any change in the stance of monetary policy. Indeed, the central banks’ willingness to lend the system all the extra funds it needs because some banks are hoarding their funds actually prevents the cash rate from shooting up way above the central bank’s target rate. Third, the process doesn’t involve adding to the money supply and isn’t inflationary. As the banks calm down and start trusting each other again, the surplus ES funds will be withdrawn from the system.

Stance of policy: When the Rudd Government was elected in November 2007 the RBA was busy resisting the build-up of inflation pressure and the cash rate stood at 6.75 per cent, which was ‘tight’ or ‘restrictive’ - that is, it should actively discourage households and firms from borrowing and spending. By March 2008, the cash rate had been raised twice more, to 7.25 per cent, which is quite restrictive.

By September 2008, however, the RBA judged that the economy was slowing rapidly - at that stage, partly because of the negative effects of the global slowdown, but mainly because domestic interest rates had been so high for so long. The RBA also judged that insufficient growth and thus higher unemployment was becoming a bigger risk than excessive inflation pressure. So the RBA began easing policy, lowering the cash rate by a cautious 0.25 percentage points. Not long after, the financial markets’ adverse reaction to the US authorities’ decision to allow the Lehman Bros investment bank to fail caused the credit crunch to worsen into the full-blown global financial crisis, in which various US and European banks and other financial institutions had to be bailed out and propped up by governments. These were frightening events for consumers and businesses around the developed world and many governments had to issue explicit guarantees of bank deposits to prevent runs. In this dramatically worsened environment - in which the risk of a local recession cast out all fears about continuing high inflation - the RBA cut the cash rate by a surprising 1 percentage point in October and a further 0.75 percentage point in early November.

This combined cut of 2 percentage points in just two months - early September to early November - reduced the cash rate to 5.25 per cent. Thus the stance of monetary policy has quickly been returned to ‘neutral’ - neither expansionary nor contractionary. Any further cuts will take the stance from neutral to ‘expansionary’ or ‘accommodating’. And the RBA has left little doubt it is prepared to cut further, either in the hope of avoiding a recession or ensuring one is as short and shallow as possible. The lowest the nominal cash rate has got in the past was 4.25 per cent in the first half of 2002. It won’t be surprising to see the rate get down to that next year, if not lower.

Credit crunch: In the aftermath of the subprime debacle many US and European banks and merchant banks became reluctant to continue lending. The market for mortgage-backed securities froze up. The very best credit risks (eg our Big Four banks) could borrow only at much higher rates, while lesser financial institutions (eg our non-bank mortgage originators) could not borrow at all. Economic theory says that in a free market banks are always willing to lend, although their degree of enthusiasm or reluctance - including their assessment of the degree of risk involved - will be reflected in the size of the prices (interest rates) they charge.

We know, however, that at times of stress, the theory doesn’t hold: banks become unwilling to lend regardless of the price they could charge. In such circumstances, banks are rationing credit on a basis other than price. This is the meaning of the term ‘credit crunch’.

Our banks borrow heavily from abroad. As you probably know, almost all of Australia’s net foreign debt has been borrowed by our banks. The banks have been able to roll over their short-term foreign loans, but only at significantly higher interest rates. The banks have passed these higher borrowing costs on to business borrowers in full, and early this year they sought to pass them on to customers with mortgages, and then to avoid passing cuts in the cash rate on in full. The politicians berated the banks for their greediness, but the RBA Governor has defended them, arguing that higher rates are preferable to the alternative: the banks refusing to lend because lending has become unprofitable.

The point to note is that the RBA has made it clear it will take full account of the banks’ ‘unofficial’ rate rises in the judgements it makes about by how much the official cash rate needs to rise or fall. In the end, what it cares about are the interest rates that affect the behaviour of households and businesses, which are the rates households and businesses actually pay. It will adjust the cash rate to whatever extent is necessary to get actual borrowing rates to where it judges they need to be.

Fiscal policy

Objective and instruments: The objective of fiscal policy has been expressed in the ‘medium-term fiscal strategy’. Under the Howard government this was ‘to maintain budget balance, on average, over the course of the economic cycle’. In other words, if you add up all the deficits in the bad years and all the surpluses in the good years they should total roughly zero. The Rudd Government’s medium-term fiscal strategy is only a little different: ‘maintaining a budget surplus, on average, over the medium-term’. The difference is more apparent than real, reflecting only Labor desire to appear more Liberal than the Liberals on economic management.

In principle, the role of fiscal policy was to act as a back-up to the main instrument used to achieve internal balance, monetary policy. In practice, and while the economy was booming, the budget surplus overflowing and monetary policy struggling to prevent an inflation breakout, the Howard government put fiscal policy into neutral. Rather than assisting monetary policy by allowing the budget’s automatic stabilisers to produce an ever-greater surplus, it chose to hold the planned budget surplus steady at 1 per cent of GDP. It increased spending and cut income tax as necessary to reduce the planned surplus to 1 per cent of GDP. Thus, contrary to the Howard government’s claims, fiscal policy did nothing to ease the burden being carried by monetary policy in restraining demand, thereby requiring interest rates to be higher than otherwise.

Stance of policy: When the Rudd Government came to power it decided to raise the budget surplus target from 1 per cent to 1.5 per cent, and also that any upward revision of tax collections would be ‘banked’ (added to the surplus) rather than used to increase the already-promised tax cuts. It thus budgeted for a surplus of 1.8 per cent of GDP in 2008-09, only a little higher than the 1.5 per cent expected in 2007-08. Judged the strict Keynesian way, the stance of policy adopted in the 2008 budget was expansionary because the cost of the increased spending and tax cuts promised in the election campaign greatly outweighed the value of the spending cuts and tax increases (on alcopops, luxury cars and petrol condensate) announced in the budget. Judged the way the RBA does, however - that is, simply comparing the expected budget balances for last year and this year - the increase was too small to register. That is, under the Rudd Government the stance of fiscal policy remained neutral.

All that changed, however, when the global financial crisis reached its height in mid-October 2008. The Rudd Government announced a discretionary fiscal stimulus - grandly titled the Economic Security Strategy - involving one-off cash payments to pensioners, families with children, and first-home buyers - worth $10.4 billion in 2008-09, with most of that money paid out in mid-December.

When the mid-year budget review was published a few weeks later, it became clear that the rapid slowing in the economy had caused the budget’s automatic stabilisers to change direction. Whereas formerly the stabilisers had been trying to use a higher budget surplus to hold the booming economy back, now they were producing a lower budget surplus to bolster a slowing economy. The originally expected budget surplus of $21.7 billion (1.8 per cent of GDP) is now expected to be only $5.4 billion (0.4 per cent), reduced by lower-than expected tax collections of $4.9 billion and the $10.4 billion stimulus package (plus $1 billion in odds and ends).

Two things are clear from this. First, no matter how you measure it, the stance of fiscal policy is now clearly expansionary. Second, as could long have been predicted, the turn in the business cycle has prompted the Government to shift to an overtly Keynesian approach to fiscal policy. It has stated that it will ‘allow the automatic stabilisers to support economic stability’ - that is, to operate unhindered - and it has acted to add discretionary fiscal stimulus on the top. Both points are, of course, consistent with the medium-term fiscal strategy, which represents a policy of what I call ‘symmetrical Keynesianism’.

The stimulus package was carefully designed and represents state-of-the-art Keynesian policy in that it follows Dr Ken Henry’s advice to ‘go early, go hard and go households’. The Government has initiated this stimulus very much earlier than was done in previous recessions. ‘Go hard’ means spend a lot, and $10.4 billion represents almost 1 per cent of GDP, which certainly qualifies. ‘Go households’ means direct the stimulus to those people who are most likely to spend it immediately, rather than spending on capital works (which take months or years to organise) or job-creation schemes. Note, too, that the one-off or temporary nature of the payments means the package will make no lasting addition to government spending.

Most macro econocrats have in their minds the rough rule of thumb that fiscal stimulus has a multiplier of 1 - that is, it adds to GDP, but that’s all. In this case, however, the mid-year review states explicitly that the stimulus of almost 1 per cent of GDP is expected to cause real GDP to be between 0.5 and 1 per cent higher than otherwise, and cause employment to be ‘up to’ 75,000 higher than otherwise. Why a multiplier of less than 1? Because of leakages to saving and imports.

The Government has made it clear it will be accelerating its capital works program funded (in part, at least) from the three nation-building funds it established in the 2008 budget. It has also expressed its willingness to apply further fiscal stimulus if necessary. Despite its reluctance to say so before it has to, there is no reason to doubt its willingness to allow the budget to drop into deficit.

The new policy mix

The rapid slowing in the economy has caused significant changes in the stances of both macro policy arms and in the mix of policies. Over the Rudd Government’s first year, the stance of monetary policy has moved from quite restrictive to neutral, with little doubt that it is on its way to expansionary. The stance of fiscal policy has moved from neutral to expansionary. The effect on the mix is that now both arms are pulling in the same direction, with fiscal policy now actively assisting monetary policy in the pursuit of internal balance.