Friday, August 24, 2012

THE EVER-EVOLVING POLICY MIX: Keeping up with changing fashions in macro management

Talk to VCTA Teachers Day, Melbourne, Friday, August 24, 2012

One of my self-appointed roles is to help economics teachers keep up to date with changing economic policy and economic thinking. Today I want to give you an update on the policy mix, but I’m going to put it in historical context and so it will also involve a bit of a refresher course. The macro managers change the policy mix in response to the economy’s ever-changing circumstances, but there’s also a fair bit of economic fashion involved.

What we call the policy mix the academic literature calls the ‘assignment of instruments’. On the one hand, the macro managers have various economic policy objectives. On the other, they have various instruments, or tools, available to use to meet those objectives. They have to decide which instruments are best-suited to use to achieve which objectives. This assignment is fairly settled, but does change over time in line with changing circumstances and changing views. The other thing that changes with the economy’s circumstances - and particularly its present position in the business cycle - is the ‘stance’ or setting of the key policy instruments.

I’m going to discuss four objectives: internal balance, external balance, fiscal sustainability and faster growth with greater flexibility. Then I’ll discuss the five instruments we’ve used on and off over the years to achieve those four objectives: monetary policy, fiscal policy, exchange rate policy, incomes policy and micro-economic policy.

Internal balance

Achieving internal balance is the single most important objective of the macro managers. It means achieving ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy at present is travelling at close to full capacity. (Remember that, although we think of full employment as referring primarily to the employment of labour, it also refers to the full employment of all factors of production.)

The other way to think of internal balance is that it involves achieving a fairly stable rate of growth. It’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a reasonably steady or stable rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’ and ‘stabilisation policy’. The greatest swearword in demand management is to call some policy decision ‘pro-cyclical’ - something that will increase the amplitude of the business cycle rather than narrowing it.

External balance

The objective of external balance (or external stability) has had a chequered history. In the years before the dollar was floated in 1983, it would have meant keeping the exchange rate fixed at the rate established under the post-war Bretton Woods system of fixed exchange rates. To be forced to devalue or revalue the exchange rate was regarded as a sign of serious economic mismanagement. To avoid having to devalue, it was necessary to ensure the economy didn’t grow too quickly and suck in too many imports, thus incurring a deficit on the current account greater than the net capital inflow on the capital account and thus running down the stock of foreign exchange reserves. This could lead to a period of uncertainty, speculation by people paying for imports and receiving money for exports, and a run on the currency while the government agonised over a devaluation. When the economy was growing too quickly and pulling in too many imports it was said the economy had hit the ‘balance-of-payments constraint’, to which the answer was always to use tight fiscal and monetary policies to crunch demand, including demand for imports.

After the exchange rate was allowed to float in 1983 - following another exchange-rate crisis earlier in the year - the RBA withdrew from the forex market and allowed the dollar’s value to be continuously determined by the relative strength of the demand for and supply of Aussie dollars. This meant the deficit on the current account was always exactly offset by the surplus on the capital account. It also meant the disappearance of the balance-of-payments constraint, though it took economists quite a few years to realise how much the rules had changed.

After the float the current account deficit became a lot bigger, with a lot more of it financed by foreign borrowing rather than foreign equity investment, thus causing the foreign debt to rise rapidly. As part of our slowness to understand the full implications of leaving the world of fixed exchange rates, the Hawke-Keating government became very concerned about the high CADs and growing foreign debt. During this period the meaning of ‘external stability’ became achieving a manageable CAD and an acceptable level of foreign debt.

Sometime after the election of the Howard government, however, academic economists led by the ANU’s John Pitchford finally succeeded in convincing Treasury (having much earlier convinced the RBA) that seeking to influence the CAD was not an appropriate objective of macro management. This case was strengthened once the federal budget returned to surplus and the government adopted its ‘medium-term fiscal strategy’ of achieving a balanced budget on average over the cycle, meaning the budget balance (net public sector saving or dissaving) would make no net contribution to the CAD over the cycle. In the early 2000s, the Howard government quietly abandoned external stability as a policy objective. This has not changed under the Rudd-Gillard government.

Fiscal sustainability

In the 2012 budget papers, the Gillard government formally articulated a new macro policy objective: ‘fiscal sustainability’. This means avoiding the build-up of an excessive stock of government debt as a consequence of many years of running budget deficits. The perils of excessive debt are now painfully apparent in Europe, where the financial markets’ unwillingness to continue funding some governments is forcing them to adopt policies of ‘austerity’ that are actually counterproductive (pro-cyclical). You can argue the Europeans’ problem was caused by the GFC, with all the borrowing needed to bail out their banks and reinflate their economies. You can also argue their problems have been greatly compounded by the unstable foundations on which their euro currency union was built. But the fact remains that, had they not run up such high levels of public debt before the GFC, they would have been far better placed to cope with its demands. By contrast, Australia’s longstanding implicit objective of fiscal sustainability left us very well placed to cope with the GFC. We were able to spend and borrow heavily to stimulate the economy, and had it been necessary to borrow to rescue our banks we would have been starting with a clean slate. In all these circumstances, it’s not surprising the government has raised fiscal sustainability to the status of a formal objective. Getting back to our earlier position of no net public debt will take a long time.

Faster growth, with greater flexibility

It was under the Hawke-Keating government (1983 to 1996) that the policy makers acquired another explicit objective: faster economic growth, combined with a more flexible economy - one capable adapting to economic shocks (shifts in the aggregate demand or aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

That brings us to the end of the policy objectives, so now let’s look at the five policy instruments used over the years.

Monetary policy

Monetary policy has been assigned the objective of achieving internal balance. The 2012 budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In developed economies, the modern approach to monetary policy involves the adoption of a ‘framework’ to govern the way it’s conducted, including an inflation target and a central bank that’s independent of the elected government ie able to change interest rates without the government’s permission. In Australia, the formal acceptance of the RBA’s independence, and its inflation target, was made by the Howard government in 1996.

Although the mechanics of monetary policy involve manipulation of the overnight cash rate via open market operations (often abbreviated to just market operations), one of the main ways it works is by achieving and maintaining low inflation expectations. Expectations matter because they tend to influence the behaviour of price setters and wage bargainers. The lower expectations are, the easier is for the RBA to keep actual inflation low without having to keep monetary policy tight and growth slow. Part of the inflation target’s role is to ‘anchor’ inflation expectations at between 2 and 3 per cent. But the target’s effectiveness in anchoring expectations rests on the RBA’s credibility - the public’s confidence that it will keep inflation within the target it has set itself. Its credibility came only after it had achieved several years of keeping actual inflation within the target range. The greater its credibility, the faster it can allow the economy to grow. And the more well-anchored inflation expectations are, the less inflation-prone the economy will be.

Implicit in all I’ve just said is that, though the expression of monetary policy’s target deals solely with inflation, it’s quite mistaken to assume the RBA cares solely about inflation and doesn’t care about growth and unemployment. What it actually indicates is the belief that a foundation of low inflation provides the only basis for sustainable growth and low unemployment. Other ways to express the goal of monetary policy is ‘non-inflationary growth’ or, as per the 2012 budget papers, keeping ‘the economy growing at close to capacity, consistent with achieving the medium-term inflation target’.

It’s important to be clear that the target is not an inflation rate of 2 to 3 pc. It’s a rate of 2 to 3 pc ‘on average, over the cycle’. This qualification is very important because it makes it clear the target is to be achieved on average, not at every point in time. It’s what makes the target a ‘medium-term’ target. It means the target doesn’t require the RBA to crunch the economy the moment inflation pops above 3 pc. What it means is that, if inflation rises above the target, the RBA must be able to demonstrate it is taking effective steps to get the rate back down into the target range within a reasonable time, without disrupting growth. Note, too, that the target is symmetrical: having the rate fall below the target range is as much a cause for concern - and for remedial action - as having it rise above the target range.

Because changes in interest rates take up to two or three years to have their full effect on economic activity, the RBA conducts monetary policy on a ‘forward-looking’ or ‘pre-emptive’ basis. It adjusts the stance of policy on the basis of its forecast for inflation over the coming 18 months to two years. It uses the latest actual figures for inflation simply to check its forecast is on track.

The ‘stance’ or setting of monetary policy being adopted by the RBA at a particular time is assessed by first determining what level of the cash rate would be ‘neutral’ in its effect on economic activity - that is neither expansionary (‘loose’) nor contractionary (‘tight’). Obviously, when the rate is above neutral it’s contractionary and when it’s below it’s expansionary. As a first approximation, the RBA judges the neutral level of rates to be their longer-term average. However, what ultimately matters to the RBA is the level of the market rates actually paid by households and businesses. So when the size of the margin between the cash rate and market rates changes, this shifts the level of the cash rate that can be regarded as neutral. The increase in our banks’ funding costs since the GFC has caused their margin above the cash rate to increase. In response, the RBA has lowered its assessment of the level of the cash rate that’s now seen as neutral. It used to be regarded as about 5 pc, now it’s regarded as about 4 pc. This means a cash rate of 3.5 pc would be regarded as ‘mildly stimulatory’.

Fiscal policy

The objective to which fiscal policy is assigned has changed many times over the years. During the High Keynesian period up to the mid-1970s, it was used as the primary instrument to achieve internal balance, with money policy playing a subordinate role. After the mid-70s, following the world-wide disillusionment with Keynesian fine-tuning and the flirtation with monetarism, the primary responsibility for achieving internal balance was shifted to monetary policy - a lasting consequence of the monetarist attack on the theoretical foundations of Keynesianism.

After the dollar was floated and CADs became a lot higher, the Hawke-Keating government assigned fiscal policy to the objective of achieving external balance and, in particular, to lowering the ‘structural’ (long-term average) CAD. This was based on the identity: CAD = capital account surplus = national investment minus national saving. Since the federal budget balance (strictly, revenue minus recurrent spending) is one of the components of national saving, improving the budget balance by reducing a deficit or increasing a surplus will cause the CAD to be less than it otherwise would be. So that became the goal of fiscal policy: to improve the CAD by improving the budget balance.

After the Howard government became confident the budget was securely back in surplus, it quietly abandoned the objective of external balance. Thereafter, fiscal policy’s de facto role was to support monetary policy in the pursuit of internal balance. During the mid-noughties, however, when the early stage of the resources boom was causing the government’s coffers to overflow and it was pursuing a policy of using spending increases and annual income-tax cuts to hold the surplus down to 1 pc of GDP, fiscal policy became pro-cyclical - it added to the amplitude of the business cycle rather than dampening it. This was because it was effectively preventing the budget’s automatic stabilisers from doing their job of slowing the surge in demand.

In 2008-09, the Rudd government’s prompt response to the GFC and the threat that the global recession would spread to Australia unleashed a huge burst of stimulus spending which propelled fiscal policy to the forefront of efforts to maintain internal balance (although monetary policy was also playing a prominent role, with the cash rate being cut by 3.75 percentage points in four months).

But here’s the point: with the stimulus spending having ceased and the budget expected to return to surplus in 2012-13, the 2012 budget papers nominate a new and different role for fiscal policy: ‘the primary objective of fiscal policy is to maintain the budget in a sustainable position from a medium-term perspective’. That is, the primary objective of fiscal policy is now maintaining ‘fiscal sustainability’.

However, it has also been made clear the budget retains an important role in assisting monetary policy achieve internal balance. How? By allowing the budget’s automatic stabilisers to be unimpeded in doing their job of helping to stabilise demand as the economy moves through the business cycle. The stabilisers bolster aggregate demand when private demand is weak and restrain aggregate demand when private demand is strong. The latter process is known as ‘fiscal drag’ - which is, of course, a helpful thing when you’re trying to keep the growth rate stable.

What does it mean to say fiscal policy’s primary objective is to achieve fiscal sustainability but the automatic stabilisers must be free to assist monetary policy in attaining internal balance? It means the policy makers are drawing a very Keynesian distinction between the effect of the automatic stabilisers (producing the ‘cyclical component’ of the budget balance) and the operation of discretionary fiscal policy (producing the ‘structural component’ of the budget balance). It’s discretionary fiscal policy that’s used to achieve fiscal stability over the medium term.

Everything I’ve just said about the modern roles of fiscal policy is consistent with the ‘medium-term fiscal strategy’. This was established by the Howard government in 1996 as ‘to maintain budget balance, on average, over the course of the economic cycle’. In 2007 the Rudd government changed the wording to maintaining a budget surplus on average - which, when you think about it, is little different. This strategy has been carefully worded to, first, permit the free operation of the automatic stabilisers and, second, permit the use of discretionary fiscal policy to stimulate the economy during a recession - provided this stimulus is withdrawn (wound back in) as the economy begins to recover. That is, the strategy has been designed to accommodate what you could call ‘symmetrical Keynesianism’. Note, the one thing the strategy doesn’t accommodate is long-term borrowing for infrastructure. That is, it doesn’t distinguish between spending for recurrent purposes and spending for capital purposes. This a weakness.

These days, best-practice macro management involves laying down ‘frameworks’ to govern the conduct of policy instruments, particularly fiscal and monetary policies. The frameworks often involve the establishment of medium-term strategies and targets. The framework for fiscal policy is established by the Charter of Budget Honesty Act, passed by the Howard government in 1998. The charter requires governments to set out their medium-term strategy in each budget, along with their shorter-term fiscal objectives and targets. It also requires full reports on the fiscal outlook and the economic outlook to be made public at the time of the budget, in the middle of each financial year and immediately after an election is called. It sets out arrangements for the costing by Treasury and the Department of Finance of the election promises made by both government and opposition - although the costing of policies for the non-government parties is now carried out by the Parliamentary Budget Office. When the Rudd government unveiled its second fiscal stimulus package in February 2009, the charter required it to set out its ‘deficit exit strategy’ at the same time. In this strategy the Rudd government imposed various restrictions and targets on itself to ensure it didn’t end up breaching its medium-term fiscal strategy.

How do you judge the ‘stance’ of fiscal policy - whether it’s expansionary, neutral or contractionary? The old Keynesian way involved working out the cyclical and structural components of the budget balance, then determining the likely net effect of all the discretionary policy decisions announced in the budget on the structural component. A worsening in the structural balance represented an expansionary stance of policy; an improvement represented a contractionary stance.

These days, however, many macro economists use a simpler approach favoured by the RBA, which ignores the cyclical/structural distinction - and hence the distinction between the effect of the stabilisers and the effect of discretionary decisions - and focuses on the expected change in the overall budget balance - the direction of the change and the size of the change. So, for example, a large expected reduction in a budget deficit would be classed as a ‘quite contractionary’ stance of policy. In my judgement, a change needs to be bigger than 0.5 percentage points of GDP to be significant. One exceeding 1 percentage point is a big deal. Note, it’s a bit odd to have the RBA choosing to ignore the distinction between the roles of the stabilisers and discretion in assessing the stance of policy, at a time when the government is using the distinction to explain how fiscal policy can have two objectives: to assist monetary policy in achieving internal balance in the short term, and to achieve fiscal sustainability in the medium term.

As covered in the Year 11 syllabus, the budget has three effects on the economy: on the strength of demand, on the allocation of resources, and on the distribution of income. In all our focus on its effect on demand in Year 12, I think it’s important not to forget to examine the effects of this year’s budget on allocation and redistribution. It’s often the case that a government’s micro-economic reform measures have major implications for the budget. And many budget measures have implications for the distribution of income, whether or not that was their purpose. Sometimes budget measures are directly aimed at influencing demand; sometimes they have a quite different motivation - even one that’s purely political. Remember that all budget measures affect demand, whether or not that was the reason for them being taken.

Exchange-rate policy

In the days after the breakdown of the Bretton Woods system of fixed exchange rates anchored to the US dollar in the early 1970s, when many developed countries’ currencies were floating while ours remained fixed, it could be thought that the government’s ability to make discretionary changes to the value of our dollar constituted an instrument of policy. When a world commodity boom caused a surge in export income, for instance, the dollar could be revalued to help fight the inevitable inflation pressure (and also redistribute some of the proceeds from the export industry to the rest of the economy). In the years immediately before the dollar was floated in 1983, it was known that Treasury favoured a slightly overvalued dollar as an aid to fighting inflation.

It’s clear the decision to float the dollar involved abandoning the possibility of using the exchange rate as an instrument of policy. In practice, however, we’ve seen that the strong (but far from perfect) correlation between the dollar and our terms of trade means the floating dollar does a much better job of helping to limit the inflationary effects of commodity booms than did discretionary adjustments to the fixed exchange rate. This may explain why, in a speech after the 2012 budget, the Secretary to the Treasury, observed that ‘monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments’.

Incomes policy

During the decades of the arbitration system of industrial relations and centralised wage-fixing until the abandonment of the national wage case in 1994, the government had a wages policy in the sense that it sought to influence the growth of wages directly by seeking to persuade the Industrial Relations Commission to limit the wage rises it granted to all award workers. This became known as an incomes and prices policy after the election of the Hawke government in 1993 and the implementation of its ‘incomes and prices accord’ with the union movement. In practice, however, it remained a wages policy, because the Accord period involved no attempt by the Labor government to influence non-wage incomes such as profits, dividends, interest and rent, nor to control the prices of goods and services (leaving aside the investigative role of the Prices Surveillance Authority). But the Accord arrangement lapsed with the election of the Howard government in 1996, meaning the government lost any instrument for trying to influence wages directly. Now wage rates are influenced indirectly via monetary policy.

Micro-economic policy

Micro-economic policy (also known as structural policy) was recognised as a policy instrument when the Hawke-Keating government began pursuing what it called micro-economic reform. At the time, Mr Keating portrayed the role of micro reform as to reduce the CAD by making Australia firms more competitive on international markets. But academic economists soon demolished this argument of political convenience, pointing out that only policies which caused an increase in national saving relative to national investment could reduce the CAD. The true objective of micro reform is faster growth, with greater flexibility.

Note that, despite its name, micro-economic policy is an instrument of macro management. What distinguishes it from the other instruments is that rather than working on the demand (spending) side of the economy, it works on the supply (production) side. As well, demand management has a short-term focus, whereas micro-economic policy works over the medium to longer term. Over the medium term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing.

The sources of growth in the economy’s productive capacity - and thus the ‘potential’ rate at which it can grow - are: growth in the population of working age combined with the rate of participation in labour force, growth in education and skills (ie human capital), growth in investment in housing, business equipment and structures, and public infrastructure, and (multi-factor) productivity. Thus the supply side grows each year, as does demand. While ever the economy retains spare production capacity, aggregate demand can grow faster than aggregate supply. Once the idle capacity has been used, however, the rate at which the supply side is growing sets the upper limit on the rate at which demand and production can grow without causing inflation pressure. It follows that achieving faster growth involves increasing the economy’s potential growth rate.

Micro policy works mainly by reducing government intervention in markets to increase competitive pressure, which leads to increased efficiency and productivity. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - is assumed by most economists to have led to a surge in the rate of productivity improvement in the second half of the 90s. But the return to more normal rates since then suggests micro reform has failed to achieve the hoped-for lasting increase in the rate at which the economy can grow.

Micro reform seems to have been more successful at making the economy more flexible and resilient in the face of economic shocks. Greater competition within many product markets, the floating of the dollar and the move from centralised wage-fixing to bargaining at the enterprise level, in particular, have greatly reduced the problem of cost-push inflation pressure and made the economy significantly less inflation-prone. It may also be argued the greater flexibility accorded to employers by industrial relations reform has made the economy less unemployment-prone, as shown by their changed response to staff retention (their preference for shorter hours rather than lay-offs) in the mild recession of 2008-09. The more flexible the economy becomes, the easier it is for the macro managers to achieve internal balance and a stable rate of economic growth.

While micro reform focused initially on reducing government intervention in markets to encourage greater efficiency, under the Rudd-Gillard government the focus has shifted to trying to achieve higher productivity by reforming and increasing the investment in human capital (education and training) and public infrastructure. The carbon pricing arrangement to which it has devoted so much attention is intended not so much to increase productivity as to help avoid the loss of productivity that climate change would cause.

Macro lags and the assignment of instruments

A long time ago the macro managers identified three lags (delays) that make their task of managing demand quite difficult. The ‘recognition lag’ is the delay in them recognising that some aspect of the macro economy is not working well and requires a policy response. This lag is caused partly by delay in the publication of economic indicators for a particular period.

The ‘implementation lag’ is the delay between realising a policy response is required, deciding what the response should be and actually putting it into implementation.

The ‘response lag’ is the delay between the time the policy measure takes effect and the time the economy has fully responded to it. Policy measures almost invariably take longer to change people’s behaviour than we expect them to.

These practical considerations have influenced the macro managers’ choices on whether to rely on fiscal policy or monetary policy for internal balance. The length of the recognition lag would be the same for both policies, but monetary policy has a clear advantage in the case of the implementation lag. The RBA board meets every month and, if necessary, it can consult more frequently by phone. Once a decision to change the cash rate has been made, the market operations needed to bring it about can be done quite simply the same day. In contrast, the changes to government spending or taxation needed to alter the stance of fiscal policy involve many meetings of the Cabinet, in which all the possibilities and ramifications are debated. In practice, the stance of fiscal policy can be changed only once a year in the budget or, at best, twice a year if a mini-budget is brought down.

Fiscal policy probably performs better on the response lag than monetary policy does. It takes a long time - two to three years - for a change in interest rates to have its full effect on demand and inflation. As we’ve seen, however, the RBA seeks to reduce this problem by taking a forward-looking approach, basing decisions about changes in the official interest rate on its forecast for inflation.

A further practical consideration is that fiscal policy is harder to tighten politically. Politically, it's easy to loosen fiscal policy. The public never objects to increased government spending or to cuts in taxes. But when the time comes to tighten fiscal policy, there is always much objection to cuts in particular spending programs or to increases in particular taxes. Though an increase in interest rates is never popular, it’s easier to achieve politically than spending cuts or tax increases.