Saturday, March 21, 2015

Why fiscal policy may be making a comeback

For four decades, fiscal policy has been the poor relation among the tools available for countries to use to stabilise demand as their economies move through the ups and downs of the business cycle. Monetary policy has been the preferred instrument. But this may be about to change.

Monetary policy refers to the central bank's manipulation of interest rates, whereas fiscal policy refers to the government's manipulation of taxation and government spending in the budget.

Of course, in those four decades fiscal policy hasn't been completely friendless. In times of recession, politicians have almost always resorted to budgetary stimulus, sometimes against the advice of their econocrats.

In the policy response to the global financial crisis in late 2008, aimed at preventing it turning into a worldwide depression to rival the depression of the 1930s, there was an instinctive resort to budget spending in addition to the sharp easing of monetary policy.

The fiscal response was partly because the North Atlantic economies needed to lend money to their banks, but also because demand needed bolstering at a time when households and businesses, conscious of their high levels of debt and the diminished value of their assets, were in no mood to spend no matter how low interest rates were.

Urged on by the International Monetary Fund, all the major economies engaged in huge fiscal stimulus at the same time. This succeeded in averting depression and getting their economies on a path to recovery.

But by then the North Atlantic economies had high levels of public debt, and the ideological opponents of fiscal activism fought back, persuading Britain and the rest of Europe to abandon fiscal stimulus and instead cut government spending and raise taxes, even while their economies were still very weak.

Unsurprisingly, the result was to prolong their recessions and force them to resort to ever more unorthodox ways of trying to stimulate their economies with monetary policy.

In this column last Saturday we saw Dr Philip Lowe, deputy governor of the Reserve Bank, accepting that monetary policy had become a lot less effective around the developed world, but arguing this would cease to be so after the major advanced economies had finally shaken off the Great Recession in about a decade's time.

But a leading American economist, Professor Lawrence Summers, of Harvard, a former US Treasury secretary, argues that monetary policy's reduced effectiveness could last for the next quarter of a century.

This is because he sees world interest rates staying very low for at least that period. In all the recessions since World War II, the US Federal Reserve has had to cut its official interest rate by an average of 4 percentage points to get the economy moving again.

If interest rates stay low, the Fed (and other central banks) won't have room to cut the official rate to the necessary extent before hitting the "zero lower bound". This will make economic managers more dependent on fiscal policy to provide stimulus.

Why does he expect interest rates to stay low for so long? Because, at base, interest rates are the price that brings the supply of saving into balance with the demand for funds for investment.

And, in the developed economies, Summers sees less investment occurring because of weak or falling population growth, because capital equipment gets ever cheaper and possibly because of slower technological advance.

On the other hand, he sees higher rates of saving because more of the growth in income will be captured by high-income earners, with their higher propensity to save.

So if the supply of saving increases while the demand for funds decreases, real interest rates will be very low, even after all the quantitative easing (money creation) is unwound. Continuing low inflation will keep nominal interest rates low.

Summers argues that, over the decades, the popularity of fiscal policy has fluctuated with economists' changing views about the size of the fiscal "multiplier" – the size of the increase in national income brought about by a discretionary increase in government spending.

The latest view, coming from the IMF, is that the fiscal multipliers are much higher than previously believed (particularly for spending on infrastructure, less so for tax cuts). This is mainly because the reduced effectiveness of monetary policy has caused a change in central banks' "policy reaction function".

Whereas in earlier times the central bank would have increased interest rates if it feared fiscal stimulus threatened to worsen inflation (thereby reducing the fiscal multiplier), these days the central bank would be less worried about inflation and pleased to see fiscal policy helping it get the economy growing at an acceptable pace.

But Summers has another point. Lasting low real interest rates not only make monetary policy less effective and fiscal policy more effective, they also mean that lower debt servicing costs allow governments to carry more public debt.

His oversimplified calculation is that if the interest rate on public borrowing halves from 2 per cent to 1 per cent, a government can now carry twice as much debt for the same interest bill.

Let's put this interesting discussion into an immediate, Australian context. We know from the latest national accounts that, at a time when the economy's growth is too weak to stop unemployment continuing to creep up, public sector spending is acting as a drag.

This isn't because of federal government cuts in recurrent spending, but because the states have allowed their annual capital works programs to fall back at a time when private construction activity is falling through the floor and yields (interest rates) on government bonds are the lowest in living memory.

If the Feds had any sense they'd be borrowing big for well-chosen infrastructure projects, thereby reducing the pressure on the Reserve Bank to keep cutting interest rates and risking a house price bubble. The Reserve would love a bit of help from fiscal policy.