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Tag Archives: fiscal policy


June 6, 2012

THE key comments in the Reserve Bank’s announcement of a quarter-percentage-point cut in the cash rate to 3.5 per cent yesterday were that market sentiment had deteriorated since the cash rate was lowered by a half a percentage point on May 1, and that households and businesses continued ”to exhibit a degree of precautionary behaviour, which may continue in the near term”.

They are descriptions of the consequences of fear, basically. The central bank also said that Europe’s economy had weakened and that growth in China had slowed, but those developments and more recent signs that America’s economic recovery is slowing are symptoms of the erosion of confidence that has accompanied the escalation of Europe’s sovereign debt crisis.

We are dealing with a less extreme but nevertheless worrying version of the economic arrhythmia that flowed from the collapse of Lehman Brothers and the near-collapse of the global financial system in September and October 2008.

Business activity ground to a halt after the Lehman collapse, plunging the world into an economic downturn that fed back into the financial markets, producing a second market slide.

This time it is producing the Reserve’s ”precautionary behaviour”. Deals are being postponed, and business investment proposals are being reconsidered. Market activity is almost exclusively focused on capital preservation instead of capital growth, and household spending is being cut back to essentials.

As the Reserve notes, the flight from risk has intensified in the past month. Anecdotal reports of a sudden downturn in activity and demand are circulating, and there are two possible conclusions.

The first is that inaction is rational behaviour. In times such as this, fortune does not necessarily favour the brave, and in most cases won’t.

The second is that there is no reason to be confident that this ”risk-off” behaviour will end soon. Europe is the key, and in Europe there are no quick fixes, and some looming hurdles in Greece’s election of June 17 and the tightening squeeze on the Spanish government as it deals with a recession-induced revenue downturn and the prospect of rescuing its banking system from property losses that could run to €100 billion ($A128 billion).

It looks as if Spain is going to need a lifeline, an injection of capital directly into its banks if not a Greek-style government bailout, and finance ministers from the G7 nations were in a conference call last night to consider their options.

The erosion of confidence and its potential to feed back and undermine economic growth is the main target of the latest cash rate cut, and while the Reserve did not say outright yesterday that it had more room to cut the cash rate, it does: in that respect Australia is almost uniquely placed. Official short-term interest rates in the United States and Japan are already at zero per cent, effectively. They are sitting at 1 per cent in Europe, and as bad as Europe’s situation is, the European Central Bank is not expected to cut its key rate when it meets later today because it wants to preserve what little firepower it has left.

Northern-hemisphere governments, meanwhile, are so loaded with debt that the debate about whether austerity programs should be replaced by growth programs is surreal – they have very little borrowing power left.

Here there is plenty of latent borrowing power, despite the opposition’s bleatings about the size of the debt load. Treasurer Wayne Swan is sticking to the May budget’s target of a surplus in 2012-13, but he could push the target out by a year and deliver additional fiscal stimulus without endangering Australia’s triple-A credit rating.

Today’s national accounts should confirm that while Australia is still a two-speed economy, with strong growth in Western Australia and Queensland and much weaker growth in Victoria and New South Wales, its overall rate of expansion is 3 per cent-plus a year, not far from the long-term trend.

Growth needs a boost in the east, and yesterday’s rate cut helps, but as the Reserve noted in its statement yesterday, bank lending rates are already slightly below the long-term average.

They will fall again now, although the big banks are unlikely to pass on the full quarter of a percentage point cut. Their borrowing costs are rising again as fear about Europe intensifies, and the battle they are waging for customer deposits that they must build in order to meet tough post-crisis funding ratios is also keeping the price of deposit funding relatively high. The Reserve had cut its cash rate by 1 percentage point in three steps ahead of yesterday’s meeting, and deposit rates had only fallen by about half as much.

Australia is nevertheless still growing, still on an income drip-feed from a commodity demand boom that has slowed but not died, and almost uniquely placed among the developed industrial nations to respond to any further weakening in either the domestic or global economy.

Of the OECD group of nations, only Canada is in a comparable position. We are still a lucky country.

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May 19, 2012

Secretary of the Treasury, Dr Martin Parkinson, says a tougher budget would have put jobs at risk.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.

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Tim Colebatch
April 17, 2009

AMID rising optimism that the global financial crisis could end sooner than expected, the International Monetary Fund has issued a new warning that the crisis is likely to be “unusually long and severe” and followed by only a “sluggish” recovery.

An analysis of past recessions in Western countries prepared for the IMF’s half-yearly World Economic Outlook, concludes that this recession, unlike those in recent decades, has several features that are likely to make it deeper and more protracted than normal.

The analysis, released overnight, finds that:

*Recessions that stem from financial crises endure longer and go deeper than those with their roots in macro-economic problems.

*Recessions that engulf the world last longer and are followed by weaker recoveries than those restricted to a single country.

*Counter-cyclical monetary policy is largely ineffective in tackling a financial crisis, but expansionary fiscal policy “seems particularly effective in shortening recessions associated with financial crises, and (in) boosting recoveries”.

*Developing countries are likely to face problems in accessing finance even after recovery sets in, as the new fear of risk among global investors will fade only slowly.

The fund’s warnings come after US President Barack Obama sought to rally American morale by talking of “glimmers of hope” in the US economy, while markets globally have enjoyed a sustained rally, raising hopes that the crisis might end sooner than expected.

It also comes as China reported a surprisingly strong rebound in investment in the cities, both in infrastructure and in property development.

The IMF analysis, commissioned well before any of these events, was released in advance of the half-yearly meetings of the fund and the World Bank in Washington next week. The IMF will release its updated Global Financial Stability report on Tuesday and its new forecasts for the global economy on Wednesday. Finance ministers will meet the following weekend.

It notes that by the end of 2008, 15 of the 21 richest countries were already in recession, on the simple definition of two consecutive quarters of negative growth. The IMF says all Western countries, including Australia, will end up there.

“The results (of this analysis) suggest that recessions associated with financial crises tend to be unusually severe, and their recoveries typically slow,” it concluded.

The IMF warned that “overleveraged economies” were unlikely to bounce back quickly through strong growth in domestic private demand, as they would require “a prolonged period of above-average saving”. It did not name them, but Australia is clearly one of them.

It again spelt out the case for a strong fiscal policy response, with the Government acting as the “spender of last resort” to break the negative feedback between weaknesses in the financial sector and the real economy.

“Given the shortfalls in both domestic private demand and external demand, policy must be used to arrest the cycle of falling demand, asset prices, and credit,” the IMF argued. “However, evidence indicates that interest rate cuts are likely to have less of an impact during a financial crisis … (whereas) fiscal policy can make a significant contribution to reducing the duration of recessions associated with financial crises.”

But even with “coherent and comprehensive action”, it concluded, “recovery is likely to be slow and relatively weak”.