Showing posts with label fiscal policy. Show all posts
Showing posts with label fiscal policy. Show all posts

Friday, December 15, 2023

Chalmers finds a better way to get inflation down: fix the budget

There’s an important point to learn from this week’s mid-(financial)-year’s budget update: in the economy, as in life, there’s more than one way to skin a cat.

The big news is that, after turning last year’s previously expected budget deficit into a surplus of $22 billion – our first surplus in 15 years – Treasurer Jim Chalmers is now expecting this financial year’s budget deficit to be $1.1 billion, not the $13.9 billion he was expecting at budget time seven months’ ago.

Now, though $1.1 billion is an unimaginably huge sum to you and me, in an economy of our size it’s a drop in the ocean. Compared with gross domestic product – the nominal value of all the goods and services we expect to produce in 2023-24 – it rounds to 0.0 per cent.

So, for practical purposes, it would be a balanced budget. And as Chalmers says, it’s “within striking distance” of another budget surplus.

This means that, compared with the prospects for the budget we were told about before the federal election in May last year, Chalmers and Finance Minister Katy Gallagher have made huge strides in reducing the government’s “debt and deficit”. Yay!

But here’s the point. We live in the age of “central bankism”, where we’ve convinced ourselves that pretty much the only way to steer the economy between the Scylla of high inflation and the Charybdis of high unemployment is to whack interest rates up or down, AKA monetary policy.

It ain’t true. Which means Chalmers may be right to avoid including in the budget update any further measures to relieve cost-of-living pressures and, rather, give top priority to improving the budget balance, thereby increasing the downward pressure on inflation.

The fact is, we’ve always had two tools or instruments the managers of the economy can use to smooth its path through the ups and downs of the business cycle, avoiding both high unemployment and high inflation. One is monetary policy – the manipulation of interest rates – but the other is fiscal policy, the manipulation of government spending and taxation via the budget.

This year we’ve been reminded how unsatisfactory interest rates are as a way of trying to slow inflation. Monetary policy puts people with big mortgages through the wringer, but lets the rest of us off lightly. This is both unfair and inefficient.

Which is why we should make much more use of the budget to fight inflation. That’s what Chalmers is doing. The more we use the budget, the less the Reserve Bank needs to raise interest rates. This spreads the pain more evenly – to the two-thirds of households that don’t have mortgages – which should be both fairer and more effective.

Starting at the beginning, in a market economy prices are set by the interaction of supply and demand: how much producers and distributors want to be paid to sell you their goods and services, versus how much consumers are willing and able to pay for them.

The rapid rise in consumer prices we saw last year came partly from disruptions to supply caused by the pandemic and the Ukraine war. There’s nothing higher interest rates can do to fix supply problems and, in any case, they’re gradually going away.

But another cause of the jump in prices was strong demand for goods and services, arising from all the stimulus the federal and state governments applied during the pandemic, not to mention the Reserve’s near-zero interest rates.

Since few people were out of job for long, this excessive stimulus left many workers and small business people with lots to spend. And when demand exceeded supply, businesses did what came naturally and raised their prices.

How do you counter demand-driven inflation? By making it much harder for people to keep spending so strongly. Greatly increasing how much people have to pay on their mortgages each month leaves them with much less to spend on other things.

Then, as demand for their products falls back, businesses stop increasing their prices and may even start offering discounts.

But governments can achieve the same squeeze on households by stopping their budgets putting more money into the economy than they’re taking out in taxes. When they run budget surpluses by taking more tax out of the economy than they put back in government spending, they squeeze households even tighter.

So that’s the logic Chalmers is following in eliminating the budget deficit and aiming for surpluses to keep downward pressure on prices. This has the secondary benefit of getting the government’s finances back in shape.

But how has the budget balance improved so much while Chalmers has been in charge? Not so much by anything he’s done as by what he hasn’t.

The government’s tax collections have grown much more strongly than anyone expected. Chalmers and his boss, Anthony Albanese, have resisted the temptation to spend much of this extra moolah.

The prices of our commodity exports have stayed high, causing mining companies to pay more tax. And the economy has grown more strongly than expected, allowing other businesses to raise their prices, increase their profits and pay more tax.

More people have got jobs and paid tax on their wages, while higher consumer prices have meant bigger wage rises for existing workers, pushing them into higher tax brackets.

This is the budget’s “automatic stabilisers” responding to strong growth in the economy by increasing tax collections and improving the budget balance, which acts as a brake on strong demand for goods and services.

There’s just one problem. Chalmers has joined the anti-inflation drive very late in the piece. The Reserve has already raised interest rates a long way, with much of the dampening effect still to flow through and weaken demand to the point where inflation pressure falls back to the 2 per cent to 3 per cent target.

We just have to hope that, between Reserve governor Michele Bullock’s monetary tightening and Chalmers’ fiscal tightening, they haven’t hit the economy much harder than they needed to.

Read more >>

Monday, October 30, 2023

Why it's doubtful we need another interest rate rise

There’s nothing the media likes more than an interest rate rise on Melbourne Cup day. It’s surprising how often it’s happened, and many in the financial markets have convinced themselves that’s what we’ll get next Tuesday. And the good news is that, despite the radical reform of moving to a mere eight board meetings a year, the Reserve Bank has ensured that meetings on cup day will continue.

What I’m not sure of is whether, if we do get a rate rise next week, it will be happening by accident or design. In central banking, getting your timing right is just as important as it is in a comedy routine.

It was no surprise last week when new Reserve Bank governor Michele Bullock used her first big speech to make sure everyone noticed her bulging anti-inflation muscles. “There are risks that could see inflation return to target more slowly than currently forecast,” she warned.

“The board will not hesitate to raise the cash rate further if there is a material upward revision to the outlook for inflation,” she said. She added some qualifications but, predictably, neither the markets nor the media took much notice of them.

Any new governor would have said the same in their first speech. Trouble is, her tough statement about not being willing to return to the 2 to 3 per cent inflation target “more slowly than currently forecast” came just the day before publication of the consumer price index for the September quarter.

And while it showed the annual rate of inflation continuing to fall from its peak of 7.8 per cent at the end of last year to 5.4 per cent nine months later, it also showed the quarterly inflation figure rising from 0.8 per cent to 1.2 per cent.

This was 0.2 percentage points or so higher than the markets – and, they calculate, the Reserve – were expecting. Bingo! Rate rise a dead cert. All the big four banks are laying their bets accordingly.

But the main reason for the slightly higher number was a rise in petrol prices, which contributed 0.25 percentage points of the 1.2 per cent. This rise comes from insufficient supply: the higher world price of oil, forced up the OPEC oil cartel and others trying to increase the price by restricting their supply.

It does not come from excessive Australian demand – which is the one factor the Reserve can moderate by increasing interest rates. Similarly, the next-biggest price increases, for newly-built homes (imported building materials), rents (surge in immigration) and electricity (Ukraine war) aren’t caused by anything a rate rise can fix.

So I think the case for yet another rate rise is weak. As Bullock clearly demonstrated elsewhere in her speech, the Reserve’s single, crude instrument, raising interest rates, delivers most of its punishment to the quarter or so of households with big mortgages.

Too many of these people are really hurting, and the full hurt from rate rises already made has yet to be felt. The economy is slowing, consumer spending is hardly growing, real income per person is falling.

And, as Treasury secretary Dr Steven Kennedy noted in a speech last week, last financial year’s budget surplus of $22 billion shows the budget’s “automatic stabilisers” are working hard to help the Reserve restrain demand – a truth that’s been completely missing from the Reserve’s commentary. That’s gratitude for you.

But if, having thought hard about such a small change to the “outlook for inflation”, Bullock decides a further rate rise isn’t warranted, what are the money market punters (and I do mean people making bets) going to think, considering all her chest-beating? That she speaks big but carries a soft stick?

There are a few things she – and her urgers in the financial markets (most of whom have never in their lives had reason to worry about the cost of living) – need to remember.

First, at this late stage in the game, we really are into fine-tuning. And acting because a revised forecast means we’ll return to target later than we had expected suggests you’ve forgotten what every governor needs always to remember: as with all economists, the Reserve’s forecasts are more likely to be wrong than right.

They can be wrong by a lot or wrong by a little. Worst, they can prove too optimistic or too pessimistic. If your previous forecast was wrong, what makes you so sure your next one will be right? When it comes to forecasts, the person making the actual decisions needs to be the biggest sceptic.

Second, the Reserve’s previous forecast was for inflation to be back to the top of the target range by the first half of 2025. If its latest forecast pushes that out to the second half, what’s so terrible about that? How much extra pain for young people with huge mortgages does that justify?

Ah, says the Reserve, the reason we can’t wait too long to get inflation back to target is that, the longer we leave it, the greater the risk that business’ and workers’ expected rate of inflation rises above the target range.

If that happened, we’d need much higher interest rates and much more pain to get expectations back down to the only range we’ve decided is acceptable.

This is true in principle but, in practice, it’s mere speculation. The fact is, the world’s central bankers have no hard evidence on how long it takes for inflation expectations to adjust – a few years or a few decades.

I’m old enough to remember that when inflation returned, in the late-1960s and early-’70s, it took a decade or two for expectations to adjust. The smarties used to advise youngsters to borrow as much as anyone would lend them. Why? Because real interest rates were negative.

But when a decade or two of tough inflation fighting eventually got expectations down to what became the target range, after the recession of the early ’90s, they’ve shown zero sign of moving for 30 years. Not even during the present inflation surge.

So when nervous-nelly governors decide to err on the safe side, they’re deciding to beat young home buyers even further into the ground. Either sell your house or starve your kids.

Finally, in her answers to questions last week, Bullock implied that the risk of rising inflation expectations was now so great that the Reserve could no longer afford the nicety of distinguishing between supply-side shocks and price rises driven by excessive demand.

Whatever the cause, continuing delay in getting inflation back to target presented such a threat to expectations that rates would have to keep rising regardless.

This means that if our return to target is delayed by supply-side problems – mismatches in the transition to renewable energy, leaps in meat and veg prices caused by extreme weather, or higher oil prices caused by worsening conflict in the Middle East – the home buyers cop it.

In this era of continuing supply shocks, failure to distinguish between the causes of price rises would be a recipe for deep recession. The Reserve’s professed “dual mandate” – full employment – would be out the window.

Read more >>

Monday, September 11, 2023

How Philip Lowe was caught on the cusp of history

Outgoing Reserve Bank boss Dr Philip Lowe was our most academically outstanding governor, with the highest ethical standards. And he was a nice person. But if you judge him by his record in keeping inflation within the Reserve’s 2 to 3 per cent target – as some do, but I don’t – he achieved it in just nine of the 84 months he was in charge.

Even so, my guess is that history will be kinder to him than his present critics. I’ve been around long enough to know that, every so often – say, every 30 or 40 years – the economy changes in ways that undermine the economics profession’s conventional wisdom about how the economy works and how it should be managed.

This is what happened in the second half of the 1970s – right at the time I became a journalist – when the advent of “stagflation” caused macroeconomists to switch from a Keynesian preoccupation with full employment and fiscal policy (the budget) to a monetarist preoccupation with inflation and monetary policy (at first, the supply of money; then interest rates).

My point here is that it took economists about a decade of furious debate to complete the shift from the old, failing wisdom to the new, more promising wisdom. I think the ground has shifted again under the economists’ feet, that the macroeconomic fashion is going to swing from monetary policy back to fiscal policy but, as yet, only a few economists have noticed the writing on the wall.

As is his role, Lowe has spent the past 15 months defending the established way of responding to an inflation surge against the criticism of upstarts (including me) refusing to accept the conventional view that TINA prevails – “there is no alternative” way to control inflation than to cut real wages and jack up interest rates.

If I’m right, and economists are in the very early stages of accepting that changes in the structure of the economy have rendered the almost exclusive use of monetary policy for inflation control no longer fit for purpose, then history will look back more sympathetically on Lowe as a man caught by the changing tide, a victim of the economics profession’s then failure to see what everyone these days accepts as obvious.

Final speeches are often occasions when departing leaders feel able to speak more frankly now that they’re free of the responsibilities of office. And Lowe’s “Some Closing Remarks” speech on Thursday made it clear he’d been giving much thought to monetary policy’s continuing fitness for purpose.

His way of putting it in the speech was to say that one of the “fixed points” in his thinking that he had always returned to was that “we are likely to get better outcomes if monetary policy and fiscal policy are well aligned”. Let me give you his elaboration in full.

“My view has long been that if we were designing optimal policy arrangements from scratch, monetary and fiscal policy would both have a role in managing the economic cycle and inflation, and that there would be close coordination,” Lowe said.

“The current global consensus is that monetary policy is the main cyclical policy instrument and should be assigned the job of managing inflation. This is partly because monetary policy is more nimble [it can be changed more quickly and easily than fiscal policy] and is not influenced by political considerations.”

“Raising interest rates and tightening policy can make you very unpopular, as I know all too well. This means that it is easier for an independent central bank to do this than it is for politicians,” he said.

“This assignment of responsibility makes sense and has worked reasonably well. But it doesn’t mean we shouldn’t aspire to something better. Monetary policy is a powerful instrument, but it has its limitations and its effects are felt unevenly across the community.”

“In principle, fiscal policy could provide a stronger helping hand, although this would require some rethinking of the existing policy structure. In particular, it would require making some fiscal instruments more nimble, strengthening the (semi) automatic stabilisers and giving an independent body limited control over some fiscal instruments.”

“Moving in this direction is not straightforward, but some innovative thinking could help us get to a better place,” Lowe said.

“During my term, there have been times where monetary and fiscal policy worked very closely together and, at other times, it would be an exaggeration to say this was the case.”

“The coordination was most effective during the pandemic. During that period, fiscal policy was nimble and the political constraints on its use for stabilisation purposes faded away. And we saw just how powerful it can be when the government and the Reserve Bank work very closely together.”

“There are some broader lessons here and I was disappointed that the recent Reserve Bank Review did not explore them in more depth,” Lowe said.

So was I, especially when two of Australia’s most eminent economists – professors Ross Garnaut and David Vines – made a detailed proposal to the review along the lines Lowe now envisages. (If Vines’ name is unfamiliar, it’s because most of his career was spent at Oxbridge, as the Poms say.)

But no, that would have been far too radical. Much safer to stick to pointing out all the respects in which the Reserve’s way of doing things differed from the practice in other countries – and was therefore wrong.

In question time, Lowe noted that one of the world’s leading macroeconomists, Olivier Blanchard, a former chief economist at the International Monetary Fund (and former teacher of Lowe’s at the Massachusetts Institute of Technology), had proposed that management of the economy be improved by creating new fiscal instruments which would be adjusted semi-automatically, or by a new independent body, within a certain range.

Lowe also acknowledged the way the marked decline over several decades in world real long-term interest rates – the causes of which economists are still debating – had made monetary policy less useful by bringing world nominal interest rates down close to the “zero lower bound”.

How do you cut interest rates to stimulate growth when they’re already close to zero? Short answer: you switch to fiscal policy.

But what other central banks – and, during the pandemic, even our Reserve Bank – have done was resort to unconventional measures, such as reducing longer-term official interest rates by buying up billions of dollars’ worth of second-hand government bonds.

Lowe said he didn’t think this resort to “quantitative easing” was particularly effective, and he’s right. I doubt if history will be kind to QE.

However, there’s one likely respect in which the ground has shifted under the economists’ feet that Lowe – and various academic defenders of the conventional wisdom – has yet to accept: the changed drivers of inflation. It’s not excessive wages any more, it’s excessive profits.

More about all this another day.

Read more >>

Wednesday, August 16, 2023

Fixing inflation doesn't have to hurt this much

They say that the most important speeches politicians make are their first and their last. Certainly, I’ve learnt a lot from the last thoughts of departing Reserve Bank governors. And, although Dr Philip Lowe still has one big speech to go, he’s already moved to a more reflective mode.

Whenever smarty-pants like me have drawn attention to the many drawbacks of using higher interest rates to bash inflation out of the economy, Lowe’s stock response has been: “Sorry, interest rates are the only lever I’ve got.”

But, in his last appearance before a parliamentary committee on Friday, he was more expansive. He readily acknowledged that interest rates – “monetary policy” – are a blunt instrument. They hurt, they’re not well-targeted and do much collateral damage.

“Monetary policy is effective, but it also has quite significant distributional effects,” he said. “Some people in the community are finding things really difficult from higher interest rates, and other people are benefiting from it.”

Higher interest rates don’t have much effect on the behaviour of businesses – except, perhaps, landlords who’ve borrowed heavily to buy investment properties – but they do have a big effect on people with mortgages, increasing their monthly payments and so leaving them with less to spend on everything else.

That’s the object of the exercise, of course. Prices – the cost of living – rise when households’ spending on goods and services exceeds the economy’s ability to produce those goods and services. So economists’ standard solution is to use higher interest rates to squeeze people’s ability to keep spending. Weaker demand makes it harder for businesses to keep raising their prices.

Trouble is, only about a third of households have mortgages, with another third renting and the last third having paid off their mortgage. This is what makes using interest rates to slow inflation so unfair. Some people get really squeezed, others don’t. (Rents have been rising rapidly, but this is partly because the vacancy rate is so low.) What’s more, some long-standing home buyers don’t owe all that much, so haven’t felt as much pain as younger people who’ve bought recently and have a huge debt.

Who are the people Lowe says are actually benefiting from higher interest rates? Mainly oldies who’ve paid off their mortgages and have a lot of money in savings accounts.

In theory, the higher rates banks can charge their borrowers are passed through to the savers from whom the banks must borrow. Some of it has indeed been passed on to depositors, but the limited competition between the big four banks has allowed them to drag their feet.

So the “significant distributional effects” Lowe refers to are partly that the young tend to be squeezed hard, while the old get let off lightly and may even be ahead on the deal. And the banks always do better when rates are rising.

All this makes the use of interest rates to control inflation unfair in the way it affects different households. And note this: how is it fair to screw around with the income of the retired and other savers? They do well at times like this but pay for it when the Reserve is cutting interest rates to get the economy back up off the floor.

But as well as being unfair, relying on interest rates to slow the economy is a less effective way to discourage spending. Because raising interest rates directly affects such a small proportion of all households – the ones with big mortgages – the Reserve has to squeeze those households all the harder to bring about the desired slowdown in total spending by all households.

In other words, if the squeeze was spread more evenly between households, we wouldn’t need to put such extreme pressure on people with big mortgages.

Lowe has been right in saying, “Sorry, interest rates are the only lever I’ve got.” What he hasn’t acknowledged until now is that the central bank isn’t the only game in town. The government’s budget contains several potential levers that could be used to slow the economy.

We could set up an arrangement where a temporary rise in the rate of the goods and services tax reduced the spending ability of all households. Then, when we needed to achieve more spending by households, we could make a temporary cut in the GST.

If we didn’t like that, we could arrange for temporary increases or decreases in the Medicare levy on taxable income.

Either way of making it harder for people to keep spending would still involve pain, but would spread the pain more fairly – and, by affecting all or most households, be more effective in achieving the required slowdown in spending.

The least painful way would be to impose a temporary increase or decrease in employees’ compulsory superannuation contributions. That way, no one would lose any of their money, just be temporarily prevented from spending it at times when too much spending was worsening the cost of living.

Our politicians and their economic advisers need to find a better way to skin the cat.

Read more >>

Monday, July 31, 2023

Another rise in interest rates is enough already

Whatever decision the Reserve Bank board makes about interest rates at its meeting tomorrow morning – departing governor Dr Philip Lowe’s second-last – the stronger case is for no increase. Indeed, I agree with those business economists saying we’ve probably had too many increases already.

If so – and I hope I’m wrong – we’ll miss the “narrow path” to the sought-after “soft landing” and hit the ground with a bang. We’ll have the recession we didn’t have to have. (That’s where recession is measured not the lazy, mindless way – two successive quarters of “negative growth” – but the sensible way: a big rise in unemployment over just a year or so.)

For those too young to know why recessions are dreaded, it’s not what happens to gross domestic product that matters (it’s just a sign of the looming disaster) but what happens to people: lots of them lose their jobs, those leaving education can’t find decent jobs, and some businesses collapse.

Market economists usually focus on guessing what the Reserve will do, not saying what it should do. (That’s because they’re paid to advise their bank’s money-market traders, who are paid to lay bets on what the Reserve will do.)

That’s why it’s so notable to see people such as Deloitte Access Economics’ Stephen Smith and AMP’s Dr Shane Oliver saying the Reserve has already increased interest rates too far.

Last week’s consumer price index for the June quarter gave us strong evidence that the rate of inflation is well on the way down. After peaking at 7.8 per cent over the year to December, it’s down to 6 per cent over the year to June.

As we’ve been told repeatedly, this was “less than expected”. Yes, but by whom? Usually, the answer is: by economists in the money markets. Here’s a tip: what money-market economists were forecasting is of little interest to anyone but them.

That almost always proves what we already know: economists are hopeless at forecasting the economy. Even after the fact, and just a week before we all know the truth. No, the only expectation that matters is what the Reserve was expecting. Why? Because it’s the economist with its hand on the interest-rate lever.

So, it does matter that the Reserve was expecting annual inflation of 6.3 per cent. That is, inflation’s coming down faster than it thought. Back to the drawing board.

The Reserve takes much notice of its preferred measure of “underlying” inflation. It’s down to 5.9 per cent. But when the economy’s speeding up or slowing down, the latest annual change contains a lot of historical baggage.

This is why the Americans focus not on the annual rate of change, but the “annualised” (made annual) rate, which you get by compounding the quarterly change (or, if you can’t remember the compounding formula, by multiplying the number by four).

Have you heard all the people saying, “oh, but 6 per cent is still way above the target of 2 to 3 per cent”? Well, if you annualise the most recent information we have, that prices rose by 0.8 per cent in the June quarter, you get 3.3 per cent. Clearly, we’re making big progress.

But the next time someone tells you we’re still way above the target, ask them if they’ve ever heard of “lags”. Central Banking 101 says that monetary policy (fiddling with interest rates) takes a year or more to have its full effect, first on economic activity (growth in gross domestic product and, particularly, consumer spending), then on the rate at which prices are rising. What’s more, the length of the lag (delay) can vary.

This is why central bankers are supposed to remember that, if you keep raising rates until you’re certain you’ve done enough to get inflation down where you want it, you can be certain you’ve done too much. Expect a hard landing, not a soft one.

Since the road to lower inflation runs via slower growth in economic activity, remember this: the national accounts show real GDP slowing to growth of 0.2 per cent in the March quarter, with growth in consumer spending also slowing to 0.2 per cent.

How much slower would you like it to get?

The next weak argument for a further rate rise is: “the labour market’s still tight”. The figures for the month of June showed the rate of unemployment still stuck at a 50-year low of 3.5 per cent, with employment growing by 32,600.

But the nation’s top expert on the jobs figures is Melbourne University’s Professor Jeff Borland. He notes that, in the nine months to August last year, employment grew by an average of 55,000 a month – about double the rate pre-pandemic.

Since August, however, it’s grown by an average of 35,600 a month. Sounds like a less-tight labour market to me.

And Borland makes a further point. Whereas the employment figures measure filled jobs, the actual number of jobs can be thought of as filled jobs plus vacant jobs – which tells us how much work employers want done.

This is a better indicator of how “tight” the labour market is. And, because vacancies are falling, the growth in total jobs has slowed much faster. Since the middle of last year, part of the growth in employment has come from reducing the stock of vacancies.

Another thing the Reserve (and its money-market urgers) need to remember is that, when it comes to slowing economic activity to slow the rise in prices, interest rates (aka monetary policy) aren’t the only game in town.

Professor Ross Garnaut, also of Melbourne University, wants to remind us that “fiscal policy” (alias the budget) is doing more to help than we thought. The now-expected budget surplus of at least $20 billion means that, over the year to June 30, the federal budget pulled $20 billion more out of the economy than it put back in.

Garnaut says he likes the $20 billion surplus because, among other reasons, “we can run lower interest rates”.

One last thing the Reserve board needs to remember. Usually, when it’s jamming on the interest-rate brakes to get inflation down, the problem’s been caused by excessive growth in wages. Not this time.

Since prices took off late in 2021, wages have fallen well behind those prices. Indeed, wages haven’t got much ahead of prices for about the past decade. And while consumer prices rose by 7 per cent over the year to March, the wage price index rose by only 3.7 per cent.

This has really put the squeeze on household incomes and households’ ability to keep increasing their spending. And that’s before you get to what rising interest rates are doing.

Dear Reserve Bank board members, please remember all this tomorrow morning.

Read more >>

Monday, July 24, 2023

Beating inflation shouldn't just be left to higher interest rates

Everyone’s heard the surprising news that last financial year’s budget is now expected to run a surplus of about $20 billion, but few have realised the wider implications. They strengthen the case for relying less on interest rates to fight inflation.

But first, the news is a reminder of just how bad economists are at forecasting what will happen to the economy – even in not much more than a year’s time. Which shows that economists don’t know nearly as much about how the economy works as they like to imagine – and like us to believe.

Then-treasurer Josh Frydenberg’s budget in March last year forecast a budget deficit in 2022-23 of $78 billion. By Jim Chalmers’ second go at the budget last October, that became a deficit of about $37 billion.

By the following budget, in May, the best guess had turned into a surplus of $4 billion. And just two months later – and that financial year actually over – the best guess is now a surplus of about $20 billion.

That’s a forecasting turnaround, over the course of only about 15 months, of almost $100 billion, or 4 per cent of gross domestic product.

What did Treasury get so wrong? It grossly underestimated the growth in tax collections. This was partly because it assumed a fall in the prices of our key commodity exports that didn’t happen, thus causing the company tax paid by our miners to be higher than expected.

But mainly because collections of income tax were much higher than expected. The economy grew at close to full capacity, so more people found jobs and many part-time workers got more hours or became full-time.

A huge number of new jobs have been created, almost all of them full-time. Do you realise that a higher proportion of people aged over 15 have paid employment than ever before? The rate of unemployment fell to its lowest in 50 years and many people who’d been unable to find a job for many months finally succeeded.

Obviously, when people find work, they start paying income tax, and stop needing to be paid unemployment benefits. So full employment is excellent news for the budget.

But the rapid rise in the cost of living during the year caused workers to demand and receive higher pay rises, even though those rises generally fell well short of the rise in prices.

So all the people who already had jobs paid more tax, too. But not only that. Our “progressive” income tax scale – where successive slices of your income are taxed at progressively higher rates – means that pay rises are taxed at a higher rate than you paid on your existing income.

Ordinary mortals call this “bracket creep”. Economists call it “fiscal drag”. Either way, the higher rate of tax workers paid on their pay rises also made a bigger-than-expected contribution to income tax collections and the budget balance.

Note that this unexpected move from deficit to surplus in the financial year just past, this underestimation of the strength of tax collections, has implications not only for the size of the government’s debt at June 2023, it has implications for the size of tax collections in the next few years, as well as for the amount of interest we’ll have to pay on that debt this year and every year until it’s repaid (which it won’t be).

In Frydenberg’s budget in March last year, the projected cumulative deficit for the five financial years to June 2026 was just over $300 billion. By the budget in May, this had dropped to $115 billion.

And now that we know last year’s surplus will be about $20 billion, the revised total projected underlying addition to government debt should be well under $100 billion.

Get it? Compared with what we thought less than 16 months ago, the feds’ debt prospects aren’t nearly as bad as we feared. And the size of our “structural” deficit – the size of the deficit that remains after you’ve allowed for the ups and downs of the business cycle – isn’t nearly as big, either.

Which suggests it’s time we had another think about our decision in the late 1970s – along with all the other rich economies – to shift the primary responsibility for managing the macroeconomy from the budget (“fiscal policy”) to the central bank and its interest rates (“monetary policy”).

One of the arguments used by the advocates of this shift was that fiscal policy was no longer effective in stimulating the economy. But our remarkably strong growth since the end of the pandemic lockdowns shows how amazingly effective fiscal policy is.

It’s now clear that fiscal “multipliers” – the extent to which an extra $1 of deficit spending adds to the growth in real GDP – are much higher than we believed them to be.

We know that a big part of the recent leap in prices was caused by shocks to the supply (production) side of the economy arising from the pandemic and the Russia-Ukraine war. But central banks have argued that a second cause was excessive demand (spending), which happened because the stimulus applied to cushion the effect of lockdowns proved far more than needed.

If so, most of that stimulus came from fiscal policy. Our official interest rate was already down to 0.75 per cent before the pandemic began. So, further proof of how powerful fiscal stimulus still is.

But another implication of the $20 billion surplus is that the stimulus wasn’t as great – and its ultimate cost to the budget wasn’t as great – as we initially believed it would be.

In the budget of October 2020, the expected deficit of $214 billion in 2020-21 was overestimated by $80 billion. In the budget of May 2021, the expected deficit of $107 billion in 2021-22 was overestimated by $75 billion. And, as we’ve seen, the deficit for 2022-23 was initially overestimated almost $100 billion.

This says two things: the fiscal stimulus caused the economy to grow much faster than the forecasters expected, even though the ultimate degree of stimulus – and its cost to the budget – was much less than forecasters expect.

Economists know that the budget contains “automatic stabilisers” that limit the private sector’s fall when the economy turns down, but act as a drag on the private sector when the economy’s booming.

We’ve just been reminded that the budget’s stabilisers are working well and have been working to claw back much of the fiscal stimulus, thereby helping to restrain demand and reduce inflation pressure.

Whenever departing Reserve Bank governor Dr Philip Lowe has been reminded of the many drawbacks of using interest rates to manage the economy, his reply has always been: sorry, it’s the only instrument I’ve got.

True. But it’s not the only instrument the government has got. It should break the central bank’s monopoly on macro management and make more use of fiscal policy.

Read more >>

Friday, June 23, 2023

Enjoy the wonderful land of full employment - while you can

I hope that while you’re complaining about the cost of living, you’re also wallowing in the joys of living in an economy that’s reached the sacred land of “full employment” – being able to provide a job for almost everyone who wants one. This is the first time we’ve seen it in 50 years.

You have to say we’ve achieved it not by design, but as an unexpected consequence of our bumbling attempts to cope with the vicissitudes of the pandemic.

We used interest rates and, more particularly, the budget, to stimulate demand (encourage business and consumer spending) and ended up doing a lot more than we needed to. To the economy managers’ surprise, the rate of unemployment fell rapidly to 3.5 per cent – a level most of them had never seen before and never expected to see.

The sad truth is that, during the half century that the high priests of economics were wandering in the wilderness of joblessness, they lost their faith, and started worshiping the false god Nairu, who whispered in their ears alluring lies about the location they were seeking.

But now the wanderers have stumbled upon the promised land of Full Employment, a land flowing with milk and honey.

So now’s the time for us all to sing hymns of praise to one true god of mammon, Full Employment, in all its beneficence and beauty. And here to be our worship leader is Michele Bullock, deputy governor of the Reserve Bank, who published some new soul music this week.

Bullock says it’s “hard to overstate the importance of achieving full employment. When someone cannot find work, or the hours of work they want, they suffer financially. However, the costs of unemployment and underemployment extend well beyond financial impacts.

“Work provides people with a sense of dignity and purpose. Unemployment – particularly long-term unemployment – can be detrimental to a person’s mental and physical health,” she says.

“The costs of not achieving full employment tend to be borne disproportionately by some groups in the community – the young, those who are less educated, and people on lower incomes and with less wealth.

“In fact, for these groups, improved employment outcomes and opportunities to work more hours are much more important for their living standards than wage increases.”

Early in the pandemic and the imposition of lockdowns, we thought we were in for a regular recession. And “the sobering experience from previous recessions had taught us that these episodes leave long-lasting marks on individuals [called “scarring” by economists], communities and the economy.

“For example, if people stay unemployed for too long, their skills may deteriorate or become obsolete and their prospects for re-engaging in meaningful work may decline. This can result in more people in long-term unemployment or, alternatively, people withdrawing from the workforce,” Bullock says.

But, thanks to all the up-front stimulus, there was no recession and, hence, no scarring. Instead, outcomes in the labour market over the past three years “have consistently exceeded the expectations of the Reserve Bank and other forecasters”.

In fact, the share of the Australian population in employment has never been higher – higher even than in the decades between the end of World War II and the mid-1970s, when full employment became the norm.

Today, the number of Australians in a job has increased by more than 1.1 million since late 2021, and the level of employment is now almost 8 per cent above its pre-pandemic level. Get that.

Almost all the gains in employment since the start of the pandemic have been full-time jobs. Strong demand for labour has enabled many previously part-time employees to move into full-time work. This has pushed the underemployment rate – the proportion of people with jobs, but seeking more hours – down to its lowest since 2008.

Bullock says the people who’ve benefited most from all this are those on lower incomes and with less education. Unemployment has tended to decline more in local areas that had weaker employment to begin with.

Young people – those aged 15 to 24 years – who usually suffer most when recessions occur, have seen their rate of unemployment decline by more than twice the decline in the overall unemployment rate.

Long-term unemployment is defined as being without work for more than a year. Last year, a record number of the long-term unemployed found a job, and fewer gave up looking for one.

What’s more, the risk of not being able to find a job within a year declined significantly. So the rate of long-term unemployment is close to its lowest in decades.

Wow. Now, Bullock’s not exaggerating when she says it’s hard to overstate the many benefits – economic and social – of achieving full employment.

But she’s harder to believe when she assures us that, just because the Reserve has hardly spoken about anything other than the need to reduce inflation for the past year and more: “it does not mean that the other part of our mandate – maintaining full employment – has become any less important.

“Full employment is, and has always been, one of our two objectives.”

Well, I’d love to believe that was true, but both the Reserve’s present rhetoric and behaviour, and its record, make it hard to believe.

The Reserve has had independent control over the day-to-day management of the economy for more than 35 years. For almost all of that time we’ve had low inflation, but only now have we achieved full employment – and only by happy accident.

For most of that time it, like most macroeconomists the world over, has been listening to the siren call of the false god Nairu – aka the “non-accelerating-inflation rate of unemployment” – telling it that “full employment” really means an unemployment rate of 5 per cent or 6 per cent.

If you dispute that, answer me this: how many times in the past 35 years has a Reserve Bank boss been able to make a similar speech to the one Bullock gave this week?

Read more >>

Monday, May 29, 2023

Gilding the budget lily: Labor brings in the creative accountants

This month’s budget is not as profligate as its critics claim, but nor is it the deficit-disappearing, penny-pinching budget it was tricked up to be.

When ministerial staffers use words to gild the fiscal lily, it’s called spin doctoring. When the government’s bureaucrats show the treasurer and, more particularly, the finance minister how to do it with numbers, it’s called creative accounting.

So, never fear, Jim Chalmers and Katy Gallagher didn’t need to pay PwC a motza to explain how to make the budget seem better than it was.

No, not the way the former NSW Coalition government paid KPMG to show it how to make its budget balance look better by moving the state’s trains off-budget. Nor has the same firm been paid by another part of the state government to write a report on why it was a bad idea.

There was something a bit odd about the media’s treatment of Chalmers’ second budget. Because the budget’s purpose is to reveal the government’s plans for taxing and spending in the coming financial year, the media give all their attention to the budget balance for the coming year.

Which, this time, is expected to be a deficit of $14 billion, rising to $35 billion the following year, with the budget projected to stay in deficit through to at least 2033-34.

Usually, the media ignore the estimated budget balance in the present financial year, which will end on June 30. It’s “old”. But not this year. This time, a surplus of $4 billion is expected.

Once the media got wind of a surplus, they lost interest in anything else. A surplus! First surplus in 15 years! What an achievement. And after being in power for only a year. How could you get more convincing proof of Labor’s skill as a manager of government finances?

Now, let’s be clear. The expected surplus is perfectly believable, and not the product of creative accounting. But it is the media displaying their economic ignorance.

For a start, in a budget of $630 billion a year, in an economy of $2600 billion a year, a surplus of a mere $4 billion is nothing to get excited about. It’s really a balanced budget, just as much as a deficit of $4 billion would be near enough to a balanced budget.

More significantly, the notion that any treasurer, no matter how wonderful, could turn an expected deficit of $78 billion into a surplus of $4 billion in the space of a year is fanciful. If any pollie should get the credit for it, it would have to be Chalmers’ Liberal predecessor, Josh Frydenberg.

Only he had enough time to do the things capable of helping produce such a result. With the benefit of hindsight, what Frydenberg did was greatly overstimulate the economy, adding to a surge in inflation as well as causing the unemployment rate to fall to 3.5 per cent so workers and businesses paid a lot more income tax.

Another way to look at it is that, had Treasury been better at forecasting, Frydenberg could have forecast a return to budget balance in his last budget.

But this didn’t stop Chalmers and his spin doctors from claiming the credit for himself. Consider this from the budget papers: “The improved fiscal outlook since October largely reflects government decisions to return tax upgrades to budget.”

Talk about twisting the truth. Chalmers wants to take all the credit because, confronted with an unexpected surge in tax collections of $88 billion, he only spent a bit of it.

But, surely, it was the silly media that made all the fuss about the surplus, not that nice young Mr Chalmers. Well, that’s certainly what his spin doctors want you to think – all the adulation came from the crowd.

But they were subtly pushing an easily distracted media in a favourable direction. Consider this. The usual practice in the construction of budget tables is to highlight the coming “budget year”. Not this time. This time it was the old year that got highlighted. So, the $4 billion surplus was shown in bold type, not the $14 billion deficit.

(By the way, as The Australian Financial Review has reported, had Frydenberg’s $690 million [yes, million] deficit in 2018-19 – the one that presaged all the Libs’ happy election talk about “back in black” – been calculated using the same accounting rules under which Chalmers’ surplus was calculated, it would have been a surplus of $7 billion. But no, this isn’t a fiddle, either. The decision to change the rules was made, in prospect, many years earlier by some finance minister named Penny Wong.)

Now we get to the creative accounting, which the Centre for Independent Studies’ Robert Carling, a former NSW Treasury officer, has pointed out. The budget papers make much of the claim that “the government’s spending restraint has limited real [note the real] payments growth to an average 0.6 per cent over five years from 2022-23 to 2026-27”.

Wow. Now that’s what I call restraint. What an achievement. Elsewhere in the papers we’re told that this compares with real average spending growth of about 4 per cent in the eight years before the global financial crisis, and 2.2 per cent over the eight years before the pandemic.

Wow. What restraint the Albanese government is showing. Except that pollies usually quote budget figures over the four years of the budget year plus three years of “forward estimates”. So, why is the 0.6 per cent an average over five years?

Because the extra year includes in the sum the pre-budget year ending in a month. And, purely by chance, real government spending in 2022-23 is expected to fall by 4.3 per cent.

By contrast, real spending in the coming year will grow by 3.7 per cent. Then comes projected annual real growth of 0.6 per cent, 1.9 per cent and 1 per cent.

Why the huge fall this year? Partly, I suspect, because of the effect of temporary pandemic spending programs coming to an end. But also because the indexation of various spending programs was lagging the huge rise in the consumer price index, which is the inflation measure used to calculate the “real” change.

What’s worth remembering from this little fiddle is: never trust calculations of average spending growth into the future. The first year will be close to the truth, but the projections for subsequent years will always be way too low because they’re based on the assumption of unchanged policies, whereas it’s certain that spending plans will have grown by the time we get there.

The first treasurer to con me with this averaging trick was Chalmers’ former boss, Wayne Swan. But Swan got his comeuppance by making himself a laughing-stock when he treated Treasury’s forecasts of future budget surpluses as in the bag. Turned out they weren’t.

The assumptions that policies won’t change and that targets will always be achieved are the reason the budget papers’ “medium-term” projections of deficits and debt 10 years into an unknowable future shouldn’t be taken seriously.

In both sense of the word, they are calculated to mislead.

Read more >>

Friday, May 26, 2023

What they don't tell you about how the budget works

Now we have some space, there are things I should tell you that there’s never time for on budget night. If you don’t know these things, the media can unwittingly mislead you, and the government spin doctors can knowingly mislead you.

A budget’s just a plan for how much income you’re expecting in the coming period, and what you want to spend it on. Governments have budgets and so do businesses and families.

You may think you know a lot about budgeting and that all you need is common sense, but the federal government’s budget ain’t like any other budget you’ve known.

Where people go wrong is assuming the government’s budget is the same as their own household budget, only much bigger. Families budget so they don’t end up spending more than they earn.

But governments often spend more than they raise in taxes – run at a “deficit” – and only occasionally spend less than they raise – run a “surplus”. When they run deficits, they borrow to cover it; when occasionally they run a surplus, they can pay back a bit of it.

Governments can borrow, and keep borrowing, in a way families can’t. Why? Because they can’t go broke. When they run short of money, they can do what no family can do: order all the other families to give them money. It’s called taxation.

And national governments can go one step further and print their own money. Money is just a piece of plasticky stuff that’s worth, say, $50. Why is it worth $50? For no reason other than that the government says it is, and everyone believes it.

Actually, these days the government doesn’t print money so much as create it out of thin air, by crediting bank accounts. This is done not by the government itself, but by a bank the government owns: the Reserve Bank. It created hundreds of billions during the pandemic (although now the Reserve is making the government gradually pay it back, by actually borrowing the money).

Everyone knows that whatever you borrow has to be paid back. What’s more, you have to keep paying interest on the debt until it is paid back. Parents know they have to get any home loan paid back before they retire.

The trouble with a family is that eventually it dies. The kids grow up and start families of their own, then mum and dad pop off. But governments don’t die. The nation’s government acts on behalf of all the families in the country. There are always some families dying, but always others taking their place.

This is why families have to pay back their debts, but governments don’t – and often choose not to. Because governments go on and on, the main way they get on top of their debts is by waiting for the economy to outgrow them, so the size of their debt declines relative to the size of the economy.

Remember, unless you add to it, a debt is a fixed dollar amount, whereas the size of the economy – gross domestic product – grows with inflation and “real” economic growth.

The final thing making government budgets different from family budgets is that a particular family’s budget is too small to have any noticeable effect on the economy, whereas the federal budget is so big – about a quarter the size of the economy – that changes the government makes in its spending and taxing plans can have a big effect on an individual family’s budget and indeed, many families’ budgets.

But it also works the other way: what happens to one family won’t have a noticeable effect on the budget, but what happens to many families – say, everyone’s getting bigger pay rises, or many families are cutting back because they’re having trouble coping with the cost of living – certainly will affect the budget.

What common sense doesn’t tell you is that there’s a two-way relationship between the budget and the economy. The budget can affect the economy, but the economy can affect the budget.

Whenever a treasurer announces on budget night that he (one day we’ll get a she) is expecting the budget deficit to turn into a surplus, the media usually assume this must be because of something he’s done.

Possibly, but it’s more likely to be because of something the economy did. In this month’s budget, it’s because the economy’s been growing strongly, leading families and companies to earn more income and pay more tax on it.

Because many in the media imagine the government’s budget is the same as a family’s budget, they assume that budget deficits are always a bad thing and surpluses a good thing.

Not necessarily. If the budget was in surplus during a recession, that would be a bad thing because it would mean that, by raising more in taxes than it was spending, the budget would be making life even harder for families.

Only when the economy’s growing too fast and adding to inflation pressure is it good to have the budget in surplus and so helping to slow things down. And deficits are a good thing when the economy’s in recession because this means that, by spending more than it’s raising in taxes, the budget’s helping to prop up the economy.

But not to worry. When the economy goes into recession, the budget tends to go into deficit – or an existing deficit gets bigger – automatically. Why? Because people pay less tax and the government has to pay unemployment benefits to more people. Economists call this the budget’s “automatic stabilisers”.

Hidden away in the budget papers you find Treasurer Jim Chalmers quietly admitting he has no intention of trying to pay off the big public debt he inherited. His “overarching goal” is to “reduce gross debt as a share of the economy over time”.

Finally, for a family, a $4 billion surplus is an unimaginably huge sum of money. But for a federal government, it’s petty cash.

Read more >>

Monday, May 22, 2023

Our big risk: fix inflation, but kiss goodbye to full employment

If you think getting inflation down is our one big economic worry, you have a cockeyed view of economic success. Unless we can get it under control without returning to the 5 to 6 per cent unemployment rate we lived with in recent decades, we’ll have lost our one great gain from the travails of pandemic: our return to full employment.

And if we do lose it, it will demonstrate the great price Australia paid for its decision in the 1980s to join the international fashion and hand the management of its economy over to the central bankers.

There has always been a tricky trade-off between the twin objectives of low inflation and low unemployment. If our return to full employment proves transitory, it will show what we should have known: that handing the economy over to the central bankers and their urgers in the financial markets was asking for inflation to be given priority at the expense of unemployment.

In his customary post-budget speech to economists last Thursday, Treasury secretary Dr Steven Kennedy began by explaining to academic economists why their claim that the budget was inflationary lacked understanding of the intricacies of economics in the real world.

But his strongest message was to remind economists why full employment is a prize not to be lost.

Whereas early in the pandemic it was feared the rate of unemployment would shoot up to 15 per cent and be difficult to get back down, the massive fiscal (budgetary) stimulus let loose saw it rise only to half that, and the remarkable economic rebound saw it fall to its lowest level in almost 50 years.

“This experience is altering our views on full employment,” Kennedy says. “One of the stories of this budget – one that risks being lost – is the virtue of full employment.”

For one thing, near-record low unemployment and a near-record rate of participation in the labour force are adding to demand and to our capacity to supply goods and services.

This time last year, Treasury was expecting a budget deficit of $78 billion in the financial year ending next month. Now it’s expecting a surplus of $4 billion. Various factors explain that improvement, but the greatest is the continuing strength of the labour market.

As I explained last week, this revision has significantly reduced the projected further increase in the public debt and, in consequence, our projected annual interest bill on the debt every year forever. It has thereby significantly reduced our projected "structural" budget deficit although, Kennedy insists, has not eliminated it.

And getting a higher proportion of the working-age population into jobs – and having more of the jobs full-time – improves our prospects for economic growth and prosperity.

There’s no source of economic inefficiency greater than having many people who want to work sitting around doing nothing. And adding to the supply of labour is not, of itself, inflationary.

But let’s not confuse means with ends. The most important benefit of full employment goes not to the budget or even The Economy, but to those people who find the jobs, or increased hours of work, they’ve long been seeking.

Kennedy reminds us that the greatest benefit goes to those who find it hardest to get jobs. While the nationwide unemployment rate has fallen by 1.6 percentage point since before the pandemic, it has fallen by 3.2 percentage points for youth, and by 2.3 percentage points for those with no post-school education.

This is where we get to Kennedy’s observation that recent experience is altering Treasury’s views on full employment.

The obvious question this experience raises is: why have we been willing to settle for unemployment rates of 5 to 6 per cent for so long when, as he acknowledges, “the low rate of unemployment and high levels of participation [in the labour force] have been sustained without generating significant wage pressures”?

Short answer: because economists have allowed themselves to be bamboozled by modelling results. Specifically, by their calculations of the “non-accelerating-inflation rate of unemployment” – the NAIRU.

As Kennedy says, the unemployment rate consistent with both full employment and low and stable inflation isn’t something that can be seen and directly measured. So, as with so many other economic concepts, economists run decades of inflation and unemployment data through a mathematical model which estimates a figure.

Economists have redefined full employment to be the 5 or 6 per cent unemployment rate their models of the NAIRU spit out. They think using such modelling results makes decisions about interest rates more rigorous.

But that’s not true if you let using a model tempt you to turn off your brain and stop thinking about whether the many assumptions the model relies on are realistic, and whether more recent changes in the structure of the economy make results based on averaging the past 30 years misleading.

It’s now pretty clear that, at least in recent years, NAIRU models have been setting the rate too high, thus leading the managers of the economy to accept higher unemployment than they should have.

There are at least three things likely to make those modelling results questionable. One is that, as a Reserve Bank official has revealed, the models assume inflation is caused by excessive demand, whereas much of the latest inflation surge has been caused by disruptions to supply.

Professor Jeff Borland, of Melbourne University, points out that the increasing prevalence of under-employment in recent decades makes the models’ focus on unemployment potentially misleading, as does the increasing rate of participation in the labour force.

Third, unduly low unemployment and job shortages are supposed to lead, in the first instance, to wage inflation, not price inflation. But this turns to a great extent on the bargaining power of unionised labour, which many structural factors – globalisation, technological advance, labour market deregulation and the decline in union membership – have weakened.

If the NAIRU models adequately reflect these structural shifts I’d be amazed.

What is clear is that the Reserve Bank’s understanding of contemporary wage-fixing is abysmal. As yet, it has no one on its board with wage-fixing expertise, its extensive consultations with business leaders exclude union leaders, and Reserve Bank governor Dr Philip Lowe says little or nothing about wage-fixing arrangements.

And this is despite Lowe’s unceasing worry about the risk of a price-wage spiral and an upward shift in inflation expectations. So far, there’s little evidence of either.

Some increase in unemployment is inevitable as we use the squeeze on households’ disposable income to slow demand and thus the rate at which prices are rising.

But if the Reserve’s undue anxiety about wages and expectations leads it to hit the brakes so hard we drop into recession, and full employment disappears over the horizon, it will be because we handed our economy over to the institution least likely to worry about making sure everyone who wants to work gets a job.

Read more >>

Friday, May 19, 2023

Chalmers and Lowe: good cop, bad cop on the inflation beat

Have you noticed? There’s a contradiction at the heart of Treasurer Jim Chalmers’ budget. Is it helping or harming inflation?

Both Chalmers and Reserve Bank governor Dr Philip Lowe are agreed that our top priority must be to get the rate of inflation down. That’s fine. Everybody hates the way prices have been shooting up. The cost of living has become impossible. Do something!

But while Lowe seems to be just making it all worse, jacking up mortgage interest rates higher and higher, nice Mr Chalmers is using his budget to take a bit of the pressure off, helping with electricity bills, cutting prescription costs and so on.

It’s as though Lowe is the arsonist, sneaking round the bush to start more fires, while Chalmers is the Salvos, turning up at the scene to give the tired firefighters a kind word, a pie and a cup of tea.

Is that how you see it? That’s the way Chalmers wants you to see it, and Lowe knows full well it’s his job to be Mr Nasty at times like this.

But what on earth’s going on? Has the world gone crazy? No, it’s just the usual dance between brutal economics on one hand, and always-here-to-help politics on the other.

Let’s start from scratch. Why do we have an inflation problem? Because, for the past 18 months or so, the prices of the things we buy have been shooting up, rising much faster than our wages, causing the cost of living to become tough for many people.

Why have prices been rising so rapidly? Partly because the COVID-19 pandemic and Russia’s attack on Ukraine caused international shortages of building materials, cars, computer chips and fossil fuels. But also because the massive increase in our governments’ payments during the pandemic left us cashed up and spending big on locally made goods and services.

When the suppliers of the stuff we buy can’t keep up with our demand for it, they raise their prices. The media may call this “price gouging”, but economists believe it’s what happens naturally in a market economy – and should happen because the higher price gives the suppliers an incentive to produce more. When they do, the price will come down.

When inflation takes off like this, what can the managers of the economy do to stop prices rising so fast? They can do nothing to magically increase supply; that takes time. But what they can do is reduce demand – discourage us from spending so much.

How? This is where it gets nasty. By squeezing households’ finances so hard they have to cut their spending. Once demand for the stuff they’re selling falls back, businesses are much less keen to raise their prices.

At present, households are being squeezed from all directions. The main way is that wages aren’t keeping up with the rise in prices. As well, more of the wage rises people are getting is being eaten up by income tax, thanks to “bracket creep”.

And the fall in house prices means home-owning households aren’t feeling as wealthy as they were.

All that’s before you get to Mr Nasty, raising the interest rates paid by people with mortgages, which is particularly tough on young home owners, with more recent, much bigger mortgages.

(You may wonder if this extra pressure on, say, only about 20 per cent of all households is either fair or the most effective way to get total household spending to slow. And you may be right, but you’d be way ahead of the world’s economists, who think the way they’ve always done it is the only way they could do it.)

But what part is the budget – “fiscal policy” – supposed to play in all this? It should be helping put the squeeze on, not reducing it. Now do you see why some are questioning whether Chalmers’ $14.6 billion “cost-of-living relief package” will help or hinder the cause of lower inflation?

The budget balance shows whether government spending is putting more money into the economy, and its households, than it’s taking out in taxes. If so, the budget’s running a deficit. If it’s taking more money out than it’s put back in, the budget’s running a surplus.

The way the Reserve Bank judges whether the budget is increasing the squeeze on households, or easing it, is to look at the size and direction of the expected change in budget balance from one year to the next.

The budget papers show the budget balance is planned to change from an actual deficit of $32 billion last financial year, 2021-22, to an expected surplus of $4 billion in this financial year, ending next month.

That’s an expected tightening of $36 billion, equivalent to 1.6 per cent of the size of the whole economy, gross domestic product.

No doubt such a change is adding a big squeeze to household incomes. But then the budget balance is expected to worsen in the coming financial year, 2023-24, to a deficit of $14 billion. That’s an easing of pressure on households’ finances equivalent to 0.7 per cent of GDP.

Put the two years together, however, and its clear the budget will still be putting a lot of squeeze on households – on top of all the other squeeze coming from elsewhere.

Somewhere in there is most of Chalmers’ $14.6 billion relief package. As a matter of arithmetic, it’s undeniably true that, had the package – which, by the way, is expected to reduce the consumer price index by 0.75 percentage points – not happened, the squeeze would be, say, $10 billion tighter than it’s now expected to be.

But there’s no way, looking at that – and all the other sources of squeeze – the Reserve will be saying, gosh, Chalmers is adding to inflation pressure, so we’d better raise rates further.

Chalmers has said the “stance” of fiscal policy adopted in the budget is “broadly neutral”. Not quite. So, I’ll say the nasty word Mr Nice Guy doesn’t want to: the stance is “mildly contractionary”.

Read more >>

Monday, May 8, 2023

How budget spin doctors manipulate our first impressions

These days, federal budgets are just as much marketing and media management exercises as they are financial and economic documents. That’s because the spin doctors’ role has become central to the way Canberra works. This is just as true under Labor as the Coalition. Media management is a characteristic of government by the two-party duopoly.

Budgets are actually the management plan for controling the government’s spending and tax-raising over the coming financial year. Because you can’t do a budget without first making guesses about what will be happening in the economy at the time, the budget documents contain detailed economic forecasts and commentary about what it has supposed will happen.

These forecasts are taken very seriously on budget night, but rarely referred to again. That’s because this era of dominant “monetary policy” (manipulation of interest rates), conducted by an independent central bank, means it’s the Reserve Bank’s forecasts that matter.

We’ve had those already, on Friday. The financial markets care more about the Reserve’s opinions than the government’s because they’re always trying to guess what the central bank will do to interest rates. What’s more, the RBA revises its forecasts quarterly, so the budget forecasts soon become outdated.

All this means the government’s forecasts can’t be very different from the Reserve’s. Differ by more than half a percentage point, and you get headlines about a split between Treasury and the central bank. Nothing the econocrats hate more (even though there’s unceasing rivalry between the two outfits).

A separate question is what effect the budget, and particularly the new measures it contains, will have on the economy: on gross domestic product, inflation and unemployment. Now that the macroeconomic fashion (aka “best practice”) dictates that the management of demand be left to the central bank – except in emergencies, such as the pandemic – the budget papers will contain little discussion of this.

But the inescapable fact remains that, the federal budget being so big relative to the economy, everything it does affects economic growth. That’s true whether the economic effects were intended or are the unintended consequence of politically driven decisions. All budget measures are political but, equally, all have economic consequences.

At this time of year, many people say they don’t know why the government is bothering to hold a budget when it has already announced the changes it’s making. Well, not quite.

What’s true is that, these days, budgets – and the days leading up to them – are highly stage-managed by the spin doctors. These people are based in the PMO – prime minister’s office – with extension into every minister’s office, via the minister’s press secretary. All paid for by the taxpayer, naturally.

The spin doctors’ job is to use the “mainstream media” to convey to voters an unduly favourable view of the government and the things it’s doing. They do this by exploiting the foibles of journalists and their editors.

Hence, the common trick of releasing potentially embarrassing information late on a Friday, when it’s less likely to make the bulletin. The hope is that, by Monday, the under-reported story is passed over as “old”.

The spinners have the great advantage of a near monopoly over news about what the government is doing. Much of this news is put into press releases, but much is held for selective release to journalists and outlets that are in favour with the government. Write a piece like this one and don’t expect to be popular.

In the olden days, many budget “leaks” really were leaks, the product of journalists talking to bureaucrats and putting two and one together to make four. These days, bureaucrats are forbidden to speak to journos, so most budget leaks have come from the spin doctors, intended to soften us up for what’s to come.

Sometimes, something – say, that the government has decided to increase the JobKeeper payment only for the over-55s – is leaked to just one or two news outlets to “run it up the flagpole and see who salutes”. If it goes over well enough, it will happen. If there’s a big adverse reaction it may never be heard of again.

Any bad news is usually officially announced ahead of the budget, so it won’t spoil the budget’s reception on the night. Lots of small but nice decisions will be announced early, so they don’t get overlooked on the night.

But, particularly if there has been a big pre-announced unpopular measure, the spinners will save some nice, un-foreshadowed hip-pocket measure for unveiling on the night. This, being the only major budget measure that’s “new”, will dominate the media’s reporting. I call it the cherry on top.

As a former treasurer, John Kerin, demonstrated in 1991 – much to the disapproval of Paul Keating - there is no genuine need for reporters to be locked up and allowed to see the budget papers well before the treasurer delivers his speech at 7.30pm, immediately after the ABC evening news.

But the budget “lockup” persists to this day because of its great media-management advantages. It’s of much benefit to have the treasurer’s made-for-telly (that is, full of spin) budget speech broadcast in prime time, rather than after lunch. (The smaller disadvantage is that the ABC gives the leader of the opposition – not the shadow treasurer – right of reply, at the same time on Thursday night.)

The other advantage of a lockup is that letting journalists out so late in the day gives them little time to ask independent experts what they thought of the budget. Rather, they’ve spent six hours locked up with Treasury heavies. (I remember one saying to me, long ago: “Not much there to criticise, eh?” )

This media manipulation usually ensures the media’s first impressions are more favourable to the government than they should be, getting the budget off to a good start with the voters. Only on day two do the interest groups finish combing through the fine print and finding the carefully hidden nasties.

All pretty grubby, but true.

Read more >>

Friday, May 5, 2023

RBA review attacks the groupthink of others, but not its own

With more time to think about it, it’s clear the review of the Reserve Bank is not the sweeping blockbuster shake-up overhaul we were told it was. Even if all its recommendations are accepted, ordinary borrowers and savers won’t discern any difference in the way interest rates go up and down. But to those who work at the Reserve, and the small army of people who make a lucrative living second-guessing its decisions, the proposed “modest improvements” are a big deal.

Ostensibly, they’re aimed at getting the Reserve up to “world best practice”. But that’s just a spin doctor’s term for doing things the same way everyone else does them. Where’s the evidence that the conventional wisdom is sure to be “best practice”?

It’s also a way of concealing the colonial cringe. Because the rich world’s financial markets are now so highly integrated, with the biggest rich country’s Wall Street setting the lead, most people in our financial market think that if we’re not doing it the way the US Federal Reserve does it, we’re obviously doing it wrong.

This inferiority complex is reinforced because, for the past 30 years, most other central banks have conformed to the US Fed’s ways – even the world’s best colony-conscious country, Britain, has switched to the Fed’s way.

So, what is the Fed’s way? To have interest rates set by a special committee of outside experts, meeting eight times a year not monthly, with each member employed part-time and getting lots of research assistance.

The monetary policy committee should hold a press conference after every meeting and each member should give at least one speech a year on the topic.

To be fair, the Reserve’s Americanisation was pre-ordained by Treasurer Jim Chalmers’ terms of reference and his decision to have the inquiry led by Carolyn Wilkins, a former Bank of Canada heavy and now Bank of England heavy.

Of course, just because we do things differently to the others doesn’t guarantee we’re doing it better, any more than it means we’ve been doing it worse. I’d say our performance over the past 30 years – since the introduction of inflation targeting – has seen a few missteps, but been at least as good as any of the others.

And if the American way is “best practice”, how come the Fed’s been so heavily criticised for being slow to respond to the inflation surge?

But let’s be frank. The review’s big criticism of the Reserve is that it’s too insular, too inward looking and inbred. Except when one Treasury man got the job, governors are always promoted internally. The present governor joined the bank from high school. External appointments to senior economic jobs are rare.

As the review’s critique implies, the Reserve is a one-man band. The governor’s word is law, with limited tolerance for debate. He runs as much of the show as he chooses to, leaving the boring bits to his deputy.

It suits the governor to have a board stacked with business people because, not being economists, their doubts are easily dismissed. Employees would never disagree with the boss in front of the board, and any reservations the Treasury secretary may have would be raised in private.

There always used to be a union leader on the board, but he was let go as part of John Howard’s efforts to delegitimise the union movement which, in his eyes, was in league with his Labor opponents.

This does much to explain the present governor’s ignorance of labour-market realities. Dr Philip Lowe bangs on unceasingly about wages, but excludes unions from the Reserve’s extensive consultations with business and even welfare groups. I don’t remember hearing that swearword “union” ever pass his lips.

There’s always been an academic economist on the board, but they’re in no position seriously to take on the establishment. The board rarely if ever votes on anything. Rather, the chairman-governor “sums up the feeling of the meeting”.

Note, the Reserve has worked this way for the four decades I’ve been watching it. But it does seem to have become more insular and, as the review charges, more subject to “groupthink”, under Lowe.

The inquiry heard from young ex-Reserve economists saying they’d been warned that expressing doubt about the house line would harm their promotion prospects. I’ve been hearing that lately, too.

It’s madness for the Reserve to recruit the cream of each year’s graduating economists, then tell ’em not to speak unless spoken to. And what a way to train the next governor but three.

So, bring an end to groupthink inside the Reserve? Of course. Get a more vigorous debate around the board table before deciding on rates? Sure.

But here’s the joke. While rightly criticising the Reserve for encouraging groupthink, the report is itself a giant case of groupthink. It accepts unquestioningly the conventional wisdom of recent decades that there’s really only one way you could possibly manage the economy through the ups and downs of the business cycle, and that’s by manipulating interest rates.

Any role for “fiscal policy” – changing taxes and government spending? Didn’t think of that but, no, not really. Just make sure it doesn’t get in the way of the central bank.

We’ve fiddled with interest rates so much we’ve got them down to zero. Should we stop? Gosh no. Just think of some way to keep going. The review accepts that the central banks’ misadventure into “unconventional monetary policy” – UMP – which it sanctifies as “additional monetary policy tools”, is now part of “best practice”.

Really? Competitive currency devaluations are the way to fix the global economy’s ills? Can you hear yourselves?

Apparently, slowing the growth in spending by directly punishing the small proportion of households young and foolish enough to load themselves up with mortgage debt is “best practice”.

No, it’s not. It’s just a sign that the review committee is so caught up by global groupthink that it has never thought there might be a better way.

Read more >>

Monday, March 6, 2023

RBA inquiry should propose something much better

The inquiry into the Reserve Bank, due to report this month, will be disappointing if it does no more than suggest modest improvements in the way it does its job. The question it should answer is: should we give so much responsibility to an institution with such a limited instrument – interest rates – and with such a narrow focus?

In Reserve Bank governor Dr Philip Lowe’s lengthy appearance before the House of Representatives Economics Committee last month, he spent much of his time reminding critics that he only has one tool, so he can’t do anything to resolve the problems they were complaining about.

He’s right. But if the problems are real, and he can’t do anything about them, why should the central bank be the top dog when it comes to managing the economy, and Treasury’s job be limited to worrying about debt and deficit?

Shouldn’t the greatest responsibility go to an institution with more instruments, and ones capable of doing more tricks?

By the way, if you’re wondering why I’ve had so much to say recently about the limitations of monetary policy and the questionable convention of making it dominant in the management of the macroeconomy, it’s because it’s the obvious thing to do while we’re holding an inquiry into Reserve Bank’s performance.

Frenchman Olivier Blanchard, one of the world’s top macroeconomists, recently caused a storm when he tweeted about “a point which is often lost in discussions of inflation and central bank policy”.

“Inflation,” he wrote, “is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers. It stops only when the various players are forced to accept the outcome.”

Oh, people cried, that can’t be right. Inflation is caused when the demand for goods and services exceeds the supply of them.

In truth, both propositions are correct. At the top level, inflation is simply about the imbalance between demand and supply. At a deeper level, however, “distributional conflict” between capital and labour can be the cause of that imbalance.

Businesses add to inflation when they seek to increase their profit margins. Workers and their unions add to inflation when they seek to increase their real wages by more than the productivity of labour justifies.

But this way of thinking is disconcerting to central bankers because – though there may well be a way of reducing inflation pressure by reducing the conflict between labour and capital – there’s nothing the Reserve can do about it directly.

Central banks’ interest-rate instrument can fix the problem only indirectly and brutally: by weakening demand (spending) until the warring parties are forced to suspend hostilities. So distributional conflict is the first thing monetary policy (the manipulation of interest rates) can’t really fix.

Then there’s inflation caused by other supply constraints, such as the pandemic or wars. Again, monetary policy can’t fix the constraint, just bash down demand to fit.

The next things monetary policy doesn’t do are fairness and effectiveness. When we’re trying to reduce inflation by reducing people’s ability to consume goods and services, it would be nice to do so with a tool that shared the burden widely and reasonably evenly.

A temporary increase in income tax or GST would do that, but increasing interest rates concentrates the burden on people with big mortgages. This concentration means the increase has to be that much greater to achieve the desired slowing in total consumer spending.

A further dimension of monetary policy’s unfairness is the way it mucks around with the income of savers. Their interest income suddenly dives when the Reserve decides it needs to encourage people to borrow and spend.

In theory, this is made up for when the Reserve decides to discourage people from borrowing and spending, as now. In practice, however, the banks drag their feet in passing higher interest rates on to their depositors. But it’s rare for the Reserve even to chivvy the banks for their tardiness.

Governments need to be free to encourage or discourage consumers from spending. But where’s the justification for doing this by riding on the backs of young people saving for a home and old people depending on interest income to live on?

The next thing monetary policy doesn’t do is competition. What’s supposed to keep prices no higher than they absolutely need to be is the strength of competition between businesses. You’d think this would be a matter of great interest to the Reserve, especially since there are signs that businesses increasing their “markups” are part of the present high inflation.

But only rarely does the Reserve mention the possibility, and only in passing. It gives no support to the Australian Competition and Consumer Commission’s efforts to limit big firms’ pricing power.

The final thing monetary policy doesn’t do is housing. The Reserve is right to insist that its increases in interest rates aren’t the main reason homes have become so hard to afford.

The real reason is the failure of governments to increase the supply of homes in the places people want to live – close to the centre of the city, where the jobs are – exacerbated by their failure to provide decent public transport to outer suburbs.

But the ups and downs of mortgage interest rates must surely be making affordability worse. To this, Lowe’s reply is that, sorry, he’s got a job to do and only one instrument to do it with, so he can’t be worried about the collateral damage he’s doing to would-be young home buyers.

Well, he can’t be worried, but his political masters can. And if they’re not game to fix the fundamental factors driving up house prices, they should be willing to create an instrument for the short-term management of demand that doesn’t cause as many adverse side effects as using interest rates does.

The one big thing going for monetary policy as a way of keeping the economy on track is that the Reserve’s independence of the elected government allows it to put the economy’s needs ahead of the government’s need to sync the economy with the next election.

But, as various respected economists have pointed out, there’s no reason the government can’t design a fiscal instrument, giving another body the ability to raise or lower it within a specified range, and making that body independent, too.

It’s the Reserve Bank inquiry’s job to give the government some advice on why and how it should make a change for the better.

Read more >>

Monday, February 27, 2023

The rich world should think twice about 'central bankism'

For the best part of 30 years, the governments of the advanced countries have outsourced the management of their economies to independent central banks. For many of those years, this change looked to have been a smart one. Now, not so much.

If the central banks’ efforts to get on top of the huge and quite unexpected surge in inflation that followed the pandemic go too far, and the rich countries end up in a severe recession, the inevitable search for someone to blame will lead straight to the door of the central bank.

After all, it was the central bank that, ignoring all the cries of pain, insisted on raising interest rates as far and fast as it did. And, as would by then be obvious, it misjudged and went too far.

It ignored the first rule for econocrats using a policy tool notorious for its “long and variable lags”: if you keep tightening until you’re sure you’ve got inflation beat, you’re sure to have gone too far.

You kept telling us it wasn’t your intention to cause a recession, but we got one anyway. So, were you lying to us, or just incompetent?

That’s my first point: if we do end up in recession, the independent central banks will get the blame, and there’ll be a posse of angry voters around the world demanding they be stripped of their independence.

But even if – as we hope - the worst doesn’t come to the worst, there’ll still be a strong case for our politicians to ask the obvious question: surely there must be a better way to run a railroad?

The rich world moved to central bank independence in the 1990s for strictly pragmatic reasons: because governments couldn’t be trusted to move the interest rate lever up and down to fit the economic cycle, not the political cycle.

Fine. But this is a democracy. How come a bunch of unelected bureaucrats have been given so much power? The fact is, independent central banking’s legitimacy comes solely because a duly elected government saw fit to grant it that freedom, and the present government hasn’t seen fit to take it away. Yet.

The trick is, if a central bank really stuffs up, voters will be furious, and they’ll turn on the only people they can turn on: the government of the day. You may think that, should a government of one colour be tossed out because of the central bank’s almighty stuff-up, the incoming government of the other colour would be mighty pleased with the central bank.

No way. What it would think is: if those bastards could do it to the others, they could just as easily do it to us. The new government’s first act would be to clip the central bankers’ wings.

The broader point is that independent central banking was not ordained by God. It’s just a policy choice we made at a time when it seemed like a good idea. When circumstances change, and we realise it wasn’t such a good idea, we’ll be perfectly equipped and entitled to change to a different policy arrangement we hope will work better.

Of course, moving away from economic management by interest-rate manipulation wouldn’t please everyone. It wouldn’t please academic economists who’d devoted their lives to the study of monetary economics (and right now, are hoping for a well-paid spot on the Reserve Bank board).

Nor would it suit the industry that, over the past 30 years, has grown up on the pavement outside the central bank’s building, so to speak. All the money market dealers who make their living betting on whether the central bank will change rates this month and by how much. Nor the economists who write the professional punters’ tip sheets.

And it’s a safe bet it wouldn’t suit the big banks, who’d much prefer the economy to be run by their mates down the road in Martin Place, rather than all those unknown bureaucrats and politicians in Canberra.

When you let one institution run the economy day to day for so long, it starts to get proprietorial. It’s in change of the economy and, when problems arise, it must be the outfit that takes charge and does what’s necessary to fix things.

There’s never a time when you admit that some other institution – the government and its Treasury advisers, for instance – should take the running because their instrument, the budget, is more multifaceted and suited to the problem than is your one-trick-pony instrument, interest rates.

And you do this even when the official interest rate is not far above zero. You tell everyone who thinks you’re out of ammo and should leave the running to Treasury and fiscal policy, they’re wrong, and resort to quantitative easing and other “unconventional measures”.

I reckon a big part of the reason what we thought was a problem of holding the economy together while we dealt with the pandemic turned into the worst inflationary episode in 30 years was the uncalled-for intervention of central banks, pushing themselves to the front of the fiscal parade.

And this from the institution that’s spend decades telling us it knows more about inflation than everyone else, cares more about inflation than anything else, and accepts ultimate responsibility to protect us from the supreme evil of inflation.

Today’s conventional wisdom says the present inflation surge was caused by big pandemic and war-caused supply shortages coming at a time when demand had been overstimulated. But a big part of that overstimulation occurred because central banks insisted on coming in over the top of those who were better equipped to respond to the pandemic and, indeed, were responsible for ordering and policing the lockdowns: the federal and state governments.

In Australia, nowhere was this overkill more apparent than in housing. While both federal and state governments were instituting temporary incentives to encourage home building, the central bank was not only slashing the official interest rate to near zero, it was lending to the banks at a hugely concessional rate, and buying second-hand government bonds, so the banks could offer home buyers two and three-year fixed-interest loans.

Throw in a temporary, pandemic-caused shortage of imported building materials, and you have much of our inflation surge being explained by an astonishing 27 per cent leap in the cost of a newly built home.

Why wasn’t there any co-ordination between the three arms of government that caused this avoidable inflationary disaster? Because the central bank is independent. It acts on its own volition.

But also because, when your only tool is a one-trick pony, you end up wearing blinkers. When you can only join the game by putting rates up or putting them down, you just can’t afford to worry about anyone who may be sideswiped in the process.

Read more >>

Friday, February 24, 2023

How about sharing the economic pain arround?

If you don’t like what’s happening to interest rates, remember that although the managers of the economy have to do something to reduce inflation, it’s not a case of what former British prime minister Maggie Thatcher called TINA – there is no alternative.

As Reserve Bank governor Dr Philip Lowe acknowledged during his appearance before the House of Representatives Standing Committee on Economics last week, there are other ways of stabilising the strength of demand (spending) and avoiding either high inflation or high unemployment, which are worth considering for next time.

So, relying primarily on “monetary policy” – manipulating interest rates – is just a policy choice we and the other advanced economies made in the late 1970s and early 1980s, after the arrival of “stagflation” – high unemployment and high inflation at the same time – caused economists to lose faith in the old way of smoothing demand, which was to rely primarily on “fiscal policy” – manipulation of taxation and government spending in the budget.

The economic managers have a choice between those two “instruments” or tools with which smooth demand. The different policy tools have differing sets of strengths and weaknesses.

Whereas back then we were very aware of the weaknesses of fiscal policy, today we’re aware of the weaknesses of monetary policy, particularly the way it puts a lot more pain on people with home loans than on the rest of us. How’s that fair?

Lowe says the conventional wisdom is to use monetary policy for “cyclical” (short-term) problems and fiscal policy for “structural” (lasting) problems, such as limiting government debt.

But it’s time to review what economists call “the assignment of instruments” – which tool is better for which job. The more so because the government has commissioned a review of the Reserve Bank’s performance for the first time since we moved to monetary policy dominance.

It’s worth remembering that the change of regime was made at a time when Thatcher and other rich-country leaders were under the influence of the US economist Milton Friedman and his “monetarism”, which held that inflation was “always and everywhere a monetary phenomenon” and could be controlled by limiting the growth in the supply of money.

It took some years of failure before governments and central banks realised both ideas were wrong. They switched back to the older and less exciting notion that increasing interest rates, by reducing demand, would eventually reduce inflation. There was no magic, painless way to do it.

Macroeconomists long ago recognised that using policy tools to manage demand was subject to three significant delays (“lags”). First there’s the “recognition lag” – the time it takes the econocrats and their bosses to realise there’s a problem and decide to act.

Then there’s the “implementation lag” – the delay while the policy change is put into effect. Lowe described the cumbersome process of cabinet deciding what changes to make to what taxes or spending programs. Then getting them passed by both houses, then waiting a few weeks or months for the bureaucrats to get organised before start day.

He compared this unfavourably with monetary policy’s super-short implementation delay: the Reserve Bank board meets every month and decides what change to make to the official interest rate, which takes immediate effect.

He’s right. While the two policy tools would have the same recognition lag, monetary policy wins hands down on implementation lag.

But on the third delay, the “response lag” – the time it takes for the measure, once begun, to work its way through the economy and have the desired effect on demand – monetary policy is subject to “long and variable lags”.

Lowe said it took interest rate changes 18 months to two years to have their full effect. But I say most budgetary changes – particularly tax changes – wouldn’t take nearly that long. So, that’s a win for fiscal.

The sad truth is that measures to strengthen demand by cutting interest rates, or cutting taxes and increasing government spending, are always popular with voters, whereas measures to weaken demand by raising interest rates, or raising taxes and cutting government spending, are always unpopular.

This meant politicians were always reluctant to increase interest rates when they needed to, Lowe said. This is a good argument for giving the job to the econocrats at the central bank and making them independent of the elected government.

This became standard practice in the rich economies, although we didn’t formalise it until the arrival of the Howard government in 1996. Lowe advanced this as a good reason to stick with monetary policy as the dominant tool for short-term stabilisation of demand.

Against that, using monetary policy to get to the rest of us indirectly via enormous pressure on the third of households with mortgages shares the burden in a way that’s arbitrary and unfair.

What’s more, it’s not very effective. Because such a small proportion of the population is directly affected, the increase in interest rates has to be that much bigger to achieve the desired restraint in overall consumer spending.

But if the economic managers used a temporary percentage increase in income tax, or the GST, to discourage spending, this would directly affect almost all households. It would be fairer and more effective because the increase could be much smaller.

Various more thoughtful economists – including Dr Nicholas Gruen and Professor Ross Garnaut – have proposed such a tool, which could be established by legislation and thus be quickly activated whenever needed.

A special body could be set up to make these decisions independent of the elected government. Ideally, it would also have control over interest rates, so one institution was making sure the two instruments were working together, not at cross purposes.

Another possibility is Keynes’ idea of using a temporary rate of compulsory saving – collected by the tax office – to reduce spending when required, without imposing any lasting cost on households.

They say if it ain’t broke, don’t fix it. It’s obvious now that macroeconomic management needs a lot of fixing.


Read more >>