Secretary of the Treasury, Dr Martin Parkinson. Photo: Andrew Meares
The Treasury says managing demand is the affair of monetary policy.
IN CASE you missed it, the secretary to the Treasury has spelt it out: with the budget’s planned return to surplus next financial year, fiscal policy is being put back in the cupboard and the ”policy mix” returned to ”normal”.
In his annual post-budget speech, Dr Martin Parkinson outlined the ”macroeconomic framework” – the respective roles of fiscal policy (the manipulation of government spending and taxation) and monetary policy (the manipulation of interest rates by the Reserve Bank).
”The primary responsibility for managing demand to keep the economy on a stable growth path consistent with low inflation” had been allocated to monetary policy, he said.
So, ”normal” is for monetary policy to be doing most of the work in keeping the economy steady. Its aim is ”to maintain inflation between 2 and 3 per cent, on average, over the cycle”. But, as you see, this doesn’t mean the Reserve focuses on inflation to the exclusion of all else.
While keeping inflation low may be the target, the goal is non-inflationary growth – growth that should keep unemployment low.
And a key part of the mechanism for achieving low inflation and steady, job-creating growth is, in Parkinson’s words, ”anchoring inflation expectations”.
But if monetary policy is the main policy instrument used to keep the economy on an even keel, what is fiscal policy’s role?
Parkinson says its key objective is ”to maintain fiscal stability from a medium-term perspective”. That is, to ensure we don’t run so many budget deficits that, in time, we build up a level of government debt that becomes unsustainable.
But this is Parko’s key message: ”Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policy should work together to support activity, such as during the global financial crisis.”
Let’s unpack that mouthful. As we saw here last weekend, the budget contains ”automatic stabilisers” that cause the budget balance to deteriorate when the economy turns down and improve when the economy turns up. So, the budget acts automatically to stabilise the economy as it moves through the business cycle – public sector demand expands automatically at times when private sector demand is weak, and contracts automatically when private demand is strong.
The next element in Parko’s exposition of fiscal policy’s role is that governments may take discretionary measures that reinforce the effect of the stabilisers, but only in extreme circumstances. In other words, apart from allowing the stabilisers to do their thing, it’s not normal practice for fiscal policy to be used to manage the strength of demand from year to year. That’s the job of monetary policy, for which it’s better suited (because it can be adjusted quickly and easily and in small or large steps).
Parkinson says we’ve had such a ”medium-term” approach since the mid-1980s, ”before evolving into a fully articulated framework with the development of [Peter Costello’s] Charter of Budget Honesty”.
The charter requires the government of the day to announce a ”medium-term fiscal strategy” and Wayne Swan’s strategy is only marginally different from Costello’s: ”to achieve budget surplus, on average, over the medium term”.
This formulation is designed to allow the automatic stabilisers to push the budget into deficit during recessions provided the stabilisers are unimpeded in returning the budget to surplus and any stimulus spending is ended.
This means that, over time, all the deficits incurred during downturns are roughly offset by all the surpluses achieved during upswings. The surpluses are used to pay off the deficits, thus keeping the level of government debt steady and sustainable over time.
gerry's blogistic digression 