Thursday, March 18, 2010


Talk to Graduate School of Government, University of Sydney
March 18, 2010

Before I get on to talking about the policy response to the GFC I want to go back to first principles and remind you that while, as public servants, you take government policy activity for granted - it’s what you’re employed to do - the appropriate role of government (whether, and under what circumstances, governments should intervene in markets) is perhaps the most contentious topic in politics and economics. The political philosophy of libertarianism - which gives primacy to individual liberty and carries a presumption against the need for government intervention - is overrepresented in the political debate in Australia and particularly the US. While by no means all economists are libertarians, most have a big streak of it in them because the dominant model of conventional, ‘neo-classical’ economics is built on the assumptions that people always act rationally and that markets are self-righting.

The ground rules for intervention

While the public is always urging governments to intervene to correct problems, real or perceived, and politicians are almost always keen to leap in, economists have a two-stage test before they accept such a need: 1) a significant instance of ‘market failure’ has to be demonstrated and 2) the ability of government intervention to correct the market failure - or at least do more good than harm - has to be demonstrated.

Market failure arises where:

a) there is insufficient competition within the market to produce the outcomes the model promises, or

b) there are ‘externalities’ (that is, where the actions of the participants in a market transaction have consequences for third parties [eg the wider community] whether those consequences are negative [eg generation of pollution] or positive [eg my education -or my invention of some improved technology - benefits other people]), or

c) where the goods or services being exchanged display the qualities of ‘public goods’. The two key qualities are that they a non-rivalrous (my consumption of the good doesn’t reduce the quantity of it available to others eg knowledge, use of the internet) and non-excludable (no one can be effectively excluded from using the good eg free-to-air television). The standard egs of public goods are lighthouses and defence spending, but there are other, less perfect examples. The free market will produce less of a public good than is in the best interests of the community because it’s so hard for private firms to make sufficient profit from producing it. This is why governments often end up producing those goods and services which have partial or complete public goods characteristics.

Other classes of market failure arise because of transaction costs, agency problems, or information asymmetry.
But there is also such a thing as government failure - where government intervention in the market makes things worse rather than better, or when the modest benefits don’t justify the considerable costs (eg the home insulation scheme?). There is a political/economic theory known as ‘public choice’ which holds, among other things, that politicians and bureaucrats always act in their own interest rather than the public’s interest, and that, whatever their original motivations, all government regulation of industry ends up being captured by the industry and turned to the industry’s advantage in, say, reducing competition within the industry (to the incumbents’ advantage), increasing protection or in persuading the government to subsidise industry costs.

Where I do stand in this debate? I believe market failure is common and that governments should usually act to correct it. But I also believe in govt failure and some degree of truth in the public choice critique. Governments and their bureaucrats do sometimes act in their own interests rather than the public’s and some regulation is captured and perverted by those being regulated. So I believe in intervention, but I also believe that getting intervention right, minimising unintended consequences and doing more good than harm is a tricky business, requiring a lot of careful thought, trial and error, experimentation, learning from experience and project evaluation. This is why I’m pleased to see you studying Policy in Practice and interested in discussing the choice of appropriate policy instruments.

Now let’s turn to the GFC. But before we do, let me just say this: one reason I was moved to remind you of the libertarian, free market, laissez faire view of the world is that it’s been very much in evidence in the debate about the causes and cures of the GFC, particularly in the US. It seems blatantly obvious to most people (including, I think, most economists) that the GFC is a case of massive market failure, but there have been plenty of libertarian-leaning economists in the US (and some here) willing to argue the crisis was really the product of government failure - government intervention gone wrong - and argue that the proposed regulatory response to correct the problem was unnecessary or even counterproductive. This, of course, is a line of argument that powerful interests in the financial markets are happy to hear and willing to sponsor.

I could talk about the GFC from a global perspective, but I’m going to concentrate on the Australian perspective - which, of course, is very different from that of the North Atlantic economies in the eye of the storm. (You can draw me out on the more global view in question time.)

The policy response to the crisis can be divided into two strands: 1) the macroeconomic response - the policy actions necessary to restore stability to the real economy, to lessen the recession and hasten the recovery and 2) the regulatory response - the policy actions necessary to correct the regulatory failures that permitted the crisis to occur and reduce the likelihood of a similar crisis recurring. I’m going to devote most time to discussing the choice of instruments in the macroeconomic response, but I will briefly discuss the prudential regulation response. (Again, you can draw me out in questions.)

The two main instruments available for macro management - the short-term stabilisation of demand as the economy moves through the business cycle - are fiscal policy (the manipulation of govt spending and taxation to influence the strength of demand) and monetary policy (the manipulation of interest rates to influence demand). Under the Keynesian influence, fiscal policy was the dominant instrument used in the post-war period, but from the mid-1970s the dominance switched to monetary policy. I want to start by explaining why fiscal policy fell out of favour with policy-makers - why they changed their view on which policy instrument was more appropriate for use in the day-to-day management of aggregate demand - and then explain why, contrary to that established view that fiscal policy was passé, it has been given a major role in the macro response to the GFC, both here and around the world.

Why fiscal policy fell out of favour with policy-makers

There has never been any denial that the budget’s automatic stabilisers should and do play an important counter-cyclical role. Rather, the query has been over discretionary policy. At least since the time of the Fraser government, monetary policy has been the primary instrument used for the short-term management of demand, with fiscal policy playing a back-up role at best. There was a great concern that policy adjustments needed to be more timely, to ensure their effects on economic activity were counter-cyclical rather than pro-cyclical. Policy-makers identified three causes of delay, and concluded that monetary policy was better than fiscal policy on two out of the three.

First, the recognition lag - the time it takes policy makers to realise that a policy adjustment is needed. This is caused mainly by delays in the publication of economic indicators and, on the face of it, you would expect it to apply equally to both policy arms. However, monetary policy has sought to reduce the lag by adopting a forward-looking or pre-emptive approach where policy adjustments are based on forecasts of inflation, with actual indicators used mainly to update the forecasts. Particularly because of the next point, this is easier to do with monetary policy than fiscal policy.

Second, the implementation lag - the time it takes to actually change the policy setting after it has been decided that it should be changed. Here, monetary policy wins hands down; it’s significantly more flexible. The stance of monetary policy is reviewed at every monthly meeting of the Reserve Bank board and could be changed even more frequently if necessary. Changes are easily implemented the following morning after the decision has been made. Policy can be changed in small or large, frequent or infrequent steps, without any implication that earlier decisions were wrong. By contrast, fiscal policy is usually adjusted only in May each year and though mini-budgets are possible, for them to come too soon after a budget, or for there to be too many of them, could attract criticism over short-sightedness. More significantly, there are delays while cabinet decides the particular tax or spending changes to make, while the legislative authority is passed through parliament, and while the administrative arrangements needed to put decisions into effect are put in place.

Third, the transmission lag - the time it takes for the implemented measure to affect economic activity. Here, fiscal policy wins. Government spending affects economic activity as soon as the money leaves the government’s coffers, while tax cuts or cash bonuses (transfer payments) affect activity as soon as the recipient chooses to spend the money. By contrast, Reserve Bank research shows that a sustained change in interest rates of 1 percentage point causes a change of 0.33 percentage points in real GDP in the first year, with a further 0.33 points in the second year and a further 0.17 points in the third, giving a total effect after three years of 0.83 percentage points.

But despite this advantage on the transmission lag, fiscal policy lost out because of its poor performance on the recognition and implementation lags.

Why fiscal policy is back in favour

It was always easy to predict that fiscal policy would come back into fashion just as soon as the economy dipped into recession. The politician who could resist the temptation to use the budget to stimulate the economy during recession has yet to be born.

But there were two other, more economic arguments favouring greater reliance on fiscal policy which arose from the particular nature of the global financial crisis. First, the synchronized nature of the global recession - because all developed economies were hit at the same time by the same developments in global capital markets - gave fiscal policy a comparative advantage. When a single country goes into recession, easing monetary policy can help stimulate the economy also by lowering its exchange rate, thus making its export and import-competing industries more price competitive. But that can’t happen when all the country’s trading partners go into recession and ease monetary policy at the same time, because there’s no one to depreciate against.

When a single country goes into recession, easing fiscal policy has the disadvantage that some proportion of the stimulus leaks overseas in the form of higher imports. But in a synchronized recession, when all countries ease fiscal policy at the same time their leakages cancel each other out. Each country suffers a leakage from imports, but also enjoys an injection from exports.

Second, the fact that this global recession had its origin in a crisis on the financial side of the economy was another factor counting in favour of fiscal policy. When you’ve got an impaired banking system, lower interest rates may not be passed through to households and businesses and, even if they are, the banks may be unwilling to lend. Further, if you’ve got an impaired banking system, the official interest rate will probably soon be close to zero, leaving no further room for conventional monetary easing, although ‘quantitative easing’ remains open. Countries in this situation are caught in the legendary Keynesian ‘liquidity trap’ - a classic justification for favouring fiscal policy over monetary policy.

That last argument doesn’t apply to Australia, of course, but all of these arguments explain why the circumstances of this global recession prompted even the ultra-orthodox International Monetary Fund to urge its members to respond to the downturn with fiscal policy.

A further, local factor is that, this time, worries about the recognition and implementation lags were countered by the peculiar nature of this crisis. We were able to see the shock coming, and start acting to counter it, well before it actually reached us across the Pacific (apart from the instantaneous effect on business and consumer confidence as Australians watched the crisis unfolding on TV every night).

Before we move on, I should warn you that fiscal policy has not replaced monetary policy as the dominant instrument of macro management. And Dr David Gruen of our Treasury has noted that the special circumstances that made fiscal policy such a necessary and major element in the response to the GFC aren’t likely to be present in future recessions.

The regulatory response to the GFC

As you know, in the heat of the crisis, in October 2008, the Rudd government responded by producing two new policy instruments: the government guarantee of all small deposits in banks and other deposit-taking institutions. This was in response to a lot of people moving their money to banks they perceived to be bigger and safer, thus causing significant problems for some of our smaller banks. An unwanted side effect of the guarantee was to prompt other people to move their savings out of unguaranteed non-bank trusts (such as mortgage trusts) requiring those trusts to freeze withdrawals for a time. Second, the government guaranteed the bank’s large deposits and wholesale funding, in return for a variable fee. This was necessary to ensure they could continue to obtain the considerable overseas funds they needed to continue operating, in the face of a world where most other developed countries’ government had guaranteed their banks. Because this latter guarantee was quite expensive for the banks, they stopped using it as soon as they could, and now it will be removed at the end of this month. It tended to advantage the bigger banks over the smaller ones. As yet, nothing has been done to regularise the guarantee of small deposits, which the government should really be charging for, thereby reducing the competitive advantage accorded to the guaranteed sector.

Looking at the regulatory response more broadly, I won’t discuss the regulatory failures that permitted the crisis to occur - particularly as there weren’t any great failures in the regulation of our banks - but go straight to discussing the improvements in regulatory instruments being worked up at the international level by two bodies associated with the Bank for International Settlements in Switzerland (the central bankers’ club): the Basel Committee on Banking Supervision and the Financial Stability Board. As part of the G20’s renovation of these bodies, Australia has a seat on both.

They are working on proposals to tighten up the international standards on the adequacy of the capital banks are required to hold - that is the limits on the extent to which banks may increase their gearing - including by closing loopholes in the capital adequacy standard and by introducing a supplementary leverage ratio. They are also working up proposals to require banks to improve their liquidity - their ability to pay their debts as they fall due - by holding greater highly liquid assets (such as government bonds, which can really be sold on the market) sufficient to tide them over for, say 20 days, if their short-term funding was suddenly cut off (as it was during the crisis).

This is all fine and much needed internationally, but the Australian banks - and the Australian authorities, especially APRA and the Reserve Bank - are concerned that the rules may be more onerous here than is justified by the good performance of our banks. These rules will increase the cost of ‘intermediation’ - which is what banks do, act as an intermediary between savers and investors, lenders and borrowers. Raising the cost of intermediation would mean widening the gap between the average interest rate the banks pay to borrow funds and the average interest rate the banks charge their borrowers. This increased cost would be passed on to the banks’ customers, particularly their borrowers. These higher interest rates to borrowers would act to dampen economic growth. That is, there is a price to be paid for making banking safer and less exposed to crises. A particular worry of the Australian banks and our authorities is that, as the liquidity requirement now stands, it would require our banks to hold more government bonds than are actually on issue.

Once the new capital and liquidity standards have been agreed on internationally, it will be up to the national authorities in each country (APRA in our case) to adapt them to local conditions and apply them locally. In theory, this means we don’t have to comply with any requirement that doesn’t suit us. In practice, however, we will be under considerable pressure from other countries to comply with the higher standards. Our banks need to borrow from overseas and want to operate in other countries, and their reputations would suffer if a perception arose that they were being inadequately regulated at home.

At present, our authorities are working on the two committees to ensure the final requirements are sufficiently flexible to accommodate the Australian case. To the extent that they fail, APRA will have to walk a fine line to modify the new standards in a way that doesn’t damage Australia’s reputation.