Saturday, October 18, 2014

Re-writing the re-write of the GFC fiscal stimulus

Economists may be bad at forecasting - even at foreseeing something as momentous as the global financial crisis - but that doesn't stop them arguing about events long after the rest of us have moved on.

That's good. Economists need to be sure they understand why disasters occurred so we can avoid repeating mistakes. They need to check the usefulness of their various models and whether they need modifying.

One thing that causes these debates to go for so long is that economics - particularly academic economics - is based more on theories than evidence. Some theories clash, so empirical evidence ought to be used to determine which hold water.

But economists aren't true scientists. They pick the rival theories they like best and become more attached to them as they get older. They will try to talk their way around evidence that seems to contradict the predictions of their model.

This leaves plenty of room for ideology, for individuals to pick those theories that fit more easily with their political philosophy.

There's been much mythologising of our experience with the GFC. Many punters' memory is that we thought there'd be a bad recession, the Rudd government spent a lot of money, but no recession materialised so the money was obviously wasted.

This isn't logical. You have to consider what economists call "the counterfactual": what would have happened had Kevin Rudd not spent all that money? Maybe it was the spending that averted the recession.

One Australian newspaper has worked assiduously to inculcate the memory that pretty much all Rudd's "fiscal stimulus" spending was wasteful. It went for months reporting every complaint against the school-building program, while ignoring the great majority of schools saying they didn't have a problem, then misrepresented the inquiry findings that the degree of waste was small.

What got the economy growing again so soon after the big contraction in gross domestic product in the December quarter of 2008, we were told, was the return of the resources boom as China's demand for our commodities ballooned. (This ignores that China's economy was hit for six by the GFC, but bounced back after it applied massive fiscal stimulus.)

To bolster the line it was pushing, the paper did much to publicise the views of Professor Tony Makin, of Griffith University. Makin adheres to a minority school of thought among macro-economists that fiscal stimulus never works. He repeated his long-held views when assessing Rudd's efforts.

Early last month, the Minerals Council published a monograph it had commissioned from Makin on Australia's declining competitiveness. Guess what? All the subsequent events have confirmed the wisdom of his earlier forebodings.

Makin used "the classic textbook macro-economic model" to argue that, even during recessions, fiscal policy is ineffective in adding to economic growth in an open economy with a floating exchange rate because it "crowds out" net exports (exports minus imports).

Borrowing to cover the extra government spending tends to push up domestic interest rates, which attracts foreign capital inflow. This, in turn, pushes up the exchange rate. Then the higher dollar reduces the price competitiveness of our export and import-competing industries, thus increasing imports and reducing exports. Any increase in domestic demand is thus offset by reduced net external demand.

Next Makin examined the national accounts showing a strong rebound in growth in the March quarter of 2009 (thus silencing the two-quarters-of-negative-growth brigade) and found the turnaround was explained not by increased domestic spending but by an improvement in net exports.

There you go: proof positive that his long-held views were spot on. He attacked the claim that the fiscal stimulus saved 200,000 jobs, saying "this assertion is based on spurious Treasury modelling of the long-run relationship between GDP and employment". He criticised Treasury's estimates using dubious Keynesian "multipliers" of the addition to GDP caused by the fiscal stimulus.

Treasury quickly released a response to Makin's criticism. His theoretical argument was based on the Mundell-Fleming model (from as long ago as the early 1960s), which assumes unilateral fiscal action, a high degree of openness to trade and perfect mobility of financial capital between countries. (It could have added the assumption that the central bank controls the supply of money rather than the level of short-term interest rates, as ours has long done.)

In reality, all the major economies applied fiscal stimulus in concert, trade accounts for much less of our GDP than it does for most developed countries, and the turmoil of the GFC meant capital mobility was far from perfect at the time (I'd say all the time).

As for his empirical checking, Makin's use of the national accounts failed to consider the counterfactual. It's likely imports fell in that March quarter not so much because the dollar fell heavily (and didn't shoot back up for about a year, once commodity prices had reversed and were on their way to new heights) as because the fear unleashed by the GFC prompted people to postpone planned purchases of imported items. If so, their spending would also have fallen, offsetting to boost from net exports.

Makin's claim that Treasury used multiplier estimates that were long-term rather than short-term is wrong. The whole idea of the stimulus was to boost spending (and confidence) quickly to counter the collapse in confidence. Since the spending measures were always intended to be temporary (and were, despite the mythology) it was always known that the effect on GDP growth would be negative before long.

The short-term multipliers Treasury used were based on the conservative end of the range of estimates calculated for our economy by the International Monetary Fund and the Organisation for Economic Co-operation and Development.

Makin is entitled to his opinions, but he's in a small minority among economists, even the academics. The two international agencies were full of praise for our fiscal stimulus and in no doubt about its effectiveness.