Thursday, March 1, 2018


Comview 2018

Why fiscal policy fell out of favour

  • Advent of “stagflation” in mid-1970s
  • Breakdown of simple Phillips curve
  • Monetarist attack on Keynesianism
  • Monetarists’ slogan: Money matters! 
  • Consciousness of “crowding out”
  • Monetary policy’s shorter “implementation lag”
  • MP became primary instrument for fiscal policy from late 1970s
How the float changed form of crowding out

  • Original belief was that govt borrowing to cover fiscal stimulus would force up interest rates and crowd out private investment.
  • Assumes fixed exchange rate (ER) and closed capital market.
  • Floating ER and globalised capital market mean Aust borrowing too small to influence world interest rate
  • Thus higher spending caused by fiscal stimulus leads to higher CAD and higher capital account surplus (KAS) ie increased capital inflow 
  • Increased capital inflow pushes up $A
  • High ER crowds out exports and import-competing production
Since GFC macro conventional wisdom has flipped
  • Monetary policy now seen as less effective than it was
  • Fiscal policy now seen as more effective
  • Particularly in the case of a synchronised global downturn
  • But also because of seeming “secular stagnation”
Monetary policy now less potent
  • Developed economies: very low interest rates leave central banks less scope to cut policy interest rates – “zero lower bound”
  • Seeming secular stagnation means lower real neutral interest rate and lower inflation rate and inflation expectations 
  • Monetary stimulus works by getting the real policy interest rate lower than the real neutral rate – hard when can’t go below zero
  • Quantitative easing (QE) shown to do more to increase asset prices than demand. Works mainly by lowering ER (ie bad for trading partners)
  • Australia’s story: our rates still a bit above zero, but MP less effective because very high level of household debt makes households reluctant to borrow more, even at very low interest rates
  • Glenn Stevens said he’d never believed that MP had much effect on business investment ie main effect is on households
  • But Philip Lowe says this effect is asymmetric: high debt means interest rate increases will be highly effective in dampening household spending via the cash flow channel
  • Wind-back of QE and rising US interest rates have lowered our ER, providing us with external stimulus 
Fiscal policy now more attractive
  • If MP is now less effective, FP simply becomes more attractive
  • Fiscal multipliers now seen to be much higher than believed in 1980s
  • With inflation now of little concern, less likelihood that FP effectiveness (and size of multipliers) is reduced by “monetary policy reaction function”
  • Although MP’s “implementation lag” is shorter, FP’s “response lag” is shorter (eg cash splash)
  • FP more effective than MP in the case of a synchronised world downturn 
Why synchronisation favours fiscal policy
  • When one country uses fiscal stimulus, some of the higher demand leaks into imports, thus lowering multiplier
  • But when all countries use fiscal stimulus together there are external injections as well as leakages
  • Thus co-ordinated response turns tables in favour of FP
  • Globalisation may make synchronised downturns more likely
  • Existence of G20 (and initial success after GFC) makes co-ordinated response easier and more likely
New views on fiscal multipliers
  • Higher than previously thought when:
  • Low inflation risk removes MP reaction function
  • Co-ordination reduces net external leakage
  • Empirical evidence shows:
  • Higher for govt spending than for tax cuts
  • Higher for capital works spending than public consumption spending
  • Higher for cash bonuses (cash splash) than for tax cuts
IMF's concept of "fiscal space"
  • “The room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy”
  • Moody’s: the difference between a nation’s actual sovereign debt-to-GDP ratio and the limit beyond which the nation could default
Australia's story
  • IMF estimates we have plenty of fiscal space and urges us to use it
  • OECD also urges Coalition govt to use fiscal stimulus to help MP (very low interest rates) get economy moving
  • RBA governors repeatedly urge govt to reduce recurrent budget deficit, but assist hard-pressed MP by increasing infrastructure spending
  • Govt responds in 2017 budget