Tuesday, November 30, 2021


Talk to virtual Comview conference

As you well know, thanks to a long period of weak economic growth, we hadn’t made any progress in reducing the federal government’s debt arising from the global financial crisis of 2008-09 before the arrival of the huge budget deficits associated with our response to the pandemic. This has left us – and all the other advanced economies – with levels of public debt higher than anything we’ve known since the period after World War II.

Right now, the economy has yet to recover from the protracted lockdowns employed to deal with the Delta variant of the coronavirus, but the econocrats and most other economists are confident the economy will bounce back almost as strongly and quickly as it did following the end of the initial lockdowns last year. It’s important to remember that the strength of these bounce backs owes much to the huge government spending on the JobKeeper wage subsidy scheme, the temporary Job Seeker supplement and various other assistance programs designed to hold the economy together during the government-imposed lockdowns. The huge loss of household income occurring in a normal recession was thus avoided, leaving people well able to resume spending as soon as restrictions were eased. So there’s no reason to regret the huge increase in public debt. It’s important also to make sure your students understand that the government’s explicit spending decisions explain only part of the huge budget deficits incurred. Much of it is explained by the collapse in tax collections and increased number of people on unemployment benefits – that is, by the automatic operation of the budget’s “automatic stabilisers”. That, too, should be seen as a good thing.

In passing, be clear that, contrary to the “policy mix” of the past 30 years, where monetary policy was the primary instrument used for short-term management of demand, with fiscal policy playing a subsidiary role, fiscal policy has now returned to primacy. To quote this year’s budget papers: “with further support from monetary policy limited, fiscal policy will need to continue to play an active role in driving the unemployment rate lower”.

It’s obvious that budget deficits lead to increased government debt, and only a return to budget surpluses will produce a fall in the absolute level of debt. The underlying cash deficit for last financial year, 2020-21, was $134 billion, or 6.5 pc of GDP, well down on what was expected at the time of the budget in May. This left us with a net debt of $590 billion, or 28.6 pc of GDP. We’ll see the latest estimates of this and future years’ deficits and debt in the mid-year budget update in mid-December. But, though all the pandemic-related assistance measures were temporary, meaning the deficit should fall pretty sharply, all the projections we’ve seen to date show no likelihood of the budget returning to surplus in coming years, “on unchanged policies”.

So, how concerned should we be about our post-post-war record level of debt, and what can or should we be doing to reduce it? And what about the argument of the proponents of “modern monetary theory” who say we should be covering the budget deficit not by borrowing from the public but simply by printing money. And finally, what does the RBA’s resort to “quantitative easing” involve, and how does it relate to the MMT debate?

The changed attitude to public debt

 After the big increase in the federal government’s net debt following the Rudd government’s use of considerable fiscal stimulus to stop the global financial crisis of 2008 causing a severe recession, the government’s view was that, in accordance with the “medium-term fiscal strategy” instituted by the Howard government in 1996, the budget should be returned to surplus as soon as reasonably possible after the economy had recovered. The strategy was to “maintain a budget balance on average over the economic cycle”. That is, the budget would be in deficit during the weak years of the cycle, but this would be offset by surpluses during the strong years, leaving a balanced budget on average, and leaving no net addition to the public debt.

The Abbott government promised to quickly eliminate the debt but, instead, the net debt doubled in nominal terms in the period up to the arrival of the pandemic in early 2020. By then, weak economic growth meant it had taken the Coalition six years just to get the budget back to balance.

The (delayed) budget of October 2020 announced a radical change in the government’s medium-term fiscal strategy. It became to “focus on growing the economy in order to stabilise and then reduce gross and net debt as a share of GDP”. That is, there was no goal to get the budget back to surplus – and, hence, no goal to reduce the public debt in nominal (dollar) terms. Rather, the goal was simply to reduce the size of the debt relative to the size of the economy (nominal GDP). In the government’s oft-repeated slogan: “repair the budget by repairing the economy”.

One of the reasons the advanced economies’ recovery from the Great Recession was so weak was that many of them panicked when they saw how much debt they’d run up and, before their recoveries had properly taken hold, they began cutting government spending and increasing taxes in an effort to get their budgets back to balance. This policy of “austerity”, as its critics called it, proved counterproductive. It weakened their economies’ growth and thus limited their success in reducing budget deficits. This is why Treasurer Frydenberg has repeatedly sworn not to “pivot to austerity policies”.

In switching from using budget surpluses to reduce debt in absolute terms to using stronger economic growth to reduce debt in relative terms, the government is adopting a change in concern about public debt that has occurred among leading American academic economists, influenced by the advanced economies’ pre-pandemic experience of “secular stagnation” or being caught in a “low-growth trap”. Weak growth makes “fiscal consolidation” (spending cuts and tax increases) harder and unwise at a time when governments should probably be investing more to offset the weakness in business investment. At the same time, the low-growth trap has produced exceptionally low interest rates, meaning the cost of “servicing” (paying the interest on) the public debt is lower than ever.

The government (and Treasury Secretary Dr Steven Kennedy) have taken up the American academics’ simple formulation that, whatever its absolute size, a stable amount of public debt will fall as a proportion of GDP so long as nominal GDP is growing at an annual rate exceeding the average rate of interest on the debt. The interest rates on Australian government debt have been between 1 and 3 pc, whereas our nominal GDP should be growing on average by 4 to 5 pc [inflation of 2.5pc plus real growth of 2.5pc]. The wider the gap between GDP growth and interest rates, the greater the scope for modest continuing budget deficits while the debt still falls as a proportion of GDP.

Several points can be made to reinforce this argument for being less anxious about the size of our public debt. First, as I’m sure you understand (but need to explain to every year’s bunch of students), the financial constraints that make it reckless for an individual household to have ever-growing debt don’t apply to governments, particularly national governments. In practice, governments mainly roll-over their debts rather than repaying them.

Second, measured relative to GDP, Australia’s public debt remains about half the size of most other advanced economies’ debt. Third, according to calculations by Saul Eslake, our projected interest payments on the federal public debt will be about 1 pc of GDP over the medium term to 2032, much lower than we’ve been used to. In the late 1980s it was above 2.5 pc. That is, there was never a time when we needed to be less anxious about the interest burden.

Even so, some respected economists – such as Productivity Commission chair Michael Brennan and former Treasury secretary Dr Ken Henry – have expressed concern that this more relaxed attitude to debt is too risky. Henry worries that, without efforts to get the budget back to balance and surplus, we will have limited scope to make an adequate response to the next fiscal crisis. Brennan worries people will conclude that debt and deficit no long matter, that “we can afford the next and the next ‘one-off’ rise in debt”.

But the new, more relaxed attitude to debt and deficit has also been attacked from the other direction – that this attitude remains more worried about debt than it needs to be – by proponents of “modern monetary theory”.

Modern monetary theory

MMT is a school of economic thought that’s been around for some decades. Its great proponent in Australia has been Professor Bill Mitchell, of my alma mater, Newcastle University. But it’s had a great push from the best-selling book, The Deficit Myth, by American Professor Stephanie Kelton.

There is nothing new about MMT. As the syllabus says, national governments face a choice of whether the finance their deficits via borrowing from the public or via borrowing from the central bank – that is, covering the deficit with newly created money. As recently as the mid-1980s, early in the term of the Hawke-Keating government, Australia followed other advanced economies in introducing the rule that deficits must be fully funded by borrowing from the public. This was at a time when the advanced economies were still struggling to get inflation under control. And, since the decision about how budget deficits should be funded is one to be made by governments, central bankers argue that MMT is about fiscal policy, not monetary policy.

Even so, there is much truth to the contentions of MMT. Like everyone else, we have a fiat currency, issued by the government and not backed by a quantity of some valuable commodity such as gold. So, in principle, governments are free to decide how many dollars to create. The MMTers remind us that it’s strange for us to have an arrangement where the private banking system (the banks in total, not an individual bank) able to create money, but the government prohibiting itself from doing so.

MMT is also right in rejecting the monetarist notion that printing money is always inflationary – “too much money chasing too few goods”. As economists have long understood. It’s not how much money has been created that matters, it’s the command over “real resources” – land, labour and physical capital – that money buys. Inflation occurs only when the demand for real resources exceeds the supply of real resources. To demonstrate the point, since the GFC the central banks of America, Britain, Europe and Japan have created massive amounts of money, yet inflation rates have stayed low or fallen (until the recent disruptions to supply caused by the pandemic). Inflation has stayed low because the demand for real resources has remained low relative to the supply of real resources.

Inflation is a consequence of demand being stronger than supply. At least since the GFC, the developed world’s problem has been the weakness of demand relative to supply. This does much to explain the new-found attention to MMT. What can be done to strengthen demand? Why shouldn’t the government add to demand by spending on lots of worthy projects and just create the money to cover it? This is the great theoretical truth highlighted by MMT: for as long as demand is running behind supply, anything the government spends can add to demand without causing inflation.

So in theory, MMT is correct. The econocrats’ objection to it is practical rather than theoretical. If you tell our fallible politicians they can spend as much as they like without bothering to borrow until we reach the point where the “output gap” has been eliminated and aggregate demand is running in line with “potential” – that is, the economy has reached full employment of all real resources – how will you get them to resume covering their spending by borrowing once that point has been reached? Even before you reach that point, how will you get fallible politicians to worry about stopping government spending that wastes real resources when government spending seems like a free lunch? This is what explains RBA governor Dr Philip Lowe’s vehement rejection of MMT. He sees himself responsible for achieving non-inflationary growth. He doesn’t want a new system in which the politicians tell him how much money they want him to create.

Quantitative easing

Short-term interest rates in the US and the other major advanced economies had got to very low levels before the global financial crisis of 2008 precipitated the Great Recession of 2008-09. The US Federal Reserve needed to cut its policy interest rate (the Fed funds rate) a long way to apply sufficient monetary policy stimulus, but was already close to the “zero lower bound”. So it resorted to “unconventional measures”. It intervened directly into particular financial markets that had frozen to get them trading again, and extended its conventional measures, of only influencing short-term interest rates, to lowering longer-term interest rates further out along the maturity “yield curve”. This is “quantitative easing”. Similar to conventional monetary policy, you buy longer-dated second-hand bonds, which forces up their price and so reduces their “yield” (interest rate). Since government bonds set the “risk-free” base on which private sector lending rates are set, this lowers the rates paid by people borrowing for longer fixed-rate periods. The central bank pays for the bonds it buys simply by crediting the accounts of the banks it buys from. That is, it creates the money out of thin air. Once the Fed adopted QE it was soon joined by the Europeans, Brits and Japanese.

It’s not clear that QE does much to encourage borrowing for consumption of goods and services or for business investment, rather than borrowing to buy assets such as houses and shares. But it is clear that the extra outflow of created dollars lowers the country’s exchange rate relative to the currencies of other countries. This lower exchange rate does stimulate the economy of the country engaging in QE by improving the international price competitiveness of its export and import-competing industries. This, however, adds to the reasons the other big advanced economies lost little time in also resorting to QE: so that their exchange rates wouldn’t appreciate against the US dollar.

In principle, once their economies had recovered from the Great Recession the Fed and other big central banks should have stopped buying second-hand bonds and started selling the bonds they’d bought back into the market, thus pushing rates back up to where they had been. It didn’t really happen. Rather, interest rates were still exceptionally low when the pandemic arrived. The Fed and the others leapt into another round of QE.

In Australia, the success of our efforts to avoid being sucked into the Great Recession, and our policy interest rate being a fair bit higher than those of the major advanced economies, meant we didn’t engage in QE at that time. It seems clear that Lowe had his doubts about the effectiveness of QE. But once the severity of the pandemic became clear in late March last year, the RBA cut the cash rate to 0.25 pc (and, in November, to 0.10 pc) and engaged in QE. It guaranteed that it would buy as many bonds as needed to keep the yield on three-year government bonds at the same rate as the cash rate. This was design to assure the financial markets that the cash rate wouldn’t be increased for at least the next three years. This was intended to encourage people to take advantage of the low, emergency-level interest rates. It also had the effect of encouraging the banks to offer very low fixed-rate home loans.

From November 2020, the RBA also announced it would buy $100 billion worth of second-hand federal and state government bonds with maturities of five to 10 years, at the rate of $5 billion a week. This was intended to lower interest rates further out along the yield curve. When the $100 billion had been spent in February this year, the RBA announced it would spend a further $100 billion, although it later decided to cut the rate at which it was buying bonds to $4 billion a week. Early this November, the RBA decided to discontinue limiting to 0.1 pc the yield on the Australian government bond maturing in April 3024. This made it possible for the RBA to decide to increase the cash rate in 2023, even though its forecast still suggested no increase would be needed before 2024.

Purchases of $200 billion worth of second-hand bonds represent about 20 pc of the total stock of federal public debt, meaning the RBA’s purchases of second-hand bonds would be about as much as the government’s issue of new bonds to cover the huge budget deficits it’s been running since the arrival of the pandemic. As part of QE, the cost of the RBA’s bond purchases has been covered merely by creating money, of course. So, despite Lowe’s vehement rejection of the MMT argument that the government fund its deficits by creating money rather than borrowing from the public, his QE has achieved essentially the same effect. The government will have to pay the RBA interest on the bonds the central bank has bought – and in due course, redeem the bonds when their term expires – but, since the government owns its central bank, this will just be a book entry inside the federal public sector. But though you and I can say MMT and QE amount to the same thing, Lowe would insist they are very different. How? MMT means the decisions about how much money to create are made by the fallible politicians, QE leaves the decisions about money creation in the hands of the independent central bankers. So the MMT advocates have had a qualified win.