Our politicians are now debating the stimulus package. It is hard to tell but, as I wrote yesterday, the main difference between the Government and Opposition is how to handout money to Australians in a way that will work. The Government wants to give households earning less than $100,000 a variety of handouts while the Coalition wants to give households their tax cuts earlier.

(Actually, there is a second difference and I guess it isn’t minor as it amounts to $18 billion. The Government stimulus package is at $42 billion. The Coalition wants to cap it at $25 billion. The Coalition are wrong here because we need that fiscal stimulus to avoid or mitigate a demand-driven recession and the Government’s plan carefully avoids a structural deficit).

If I hand a household $1000 what happens? Let’s start with the theory. First, no one’s long-term or permanent income rises because of this (unless you think that the stimulus from the whole handout policy will be enough to really cut short the recession). That means that you wouldn’t do anything with that $1000 from the government than you would do if you just found it on the street. For a rational economic household that means saving and spending it roughly in the same proportion as you normally do.

But, second, there is a qualifier to this. If your short-term income has taken a shock, you have already adjusted your consumption and savings plans and economic theory tells us that it is saving that bears the brunt of this while you maintain much of your consumption. But that is not good news for what you would do with the marginal $1000. Your consumption is at the level you want so you are likely to take it and save it or pay off debt.

But, third, that all depends on whether you have been able to maintain consumption. It could also be that you find yourself in a situation of liquidity constraints — especially, if you are unemployed or are in December and forking out for presents. In that case, saving is not an option or something that is desired and the money will be spent.

When we are in a situation of an economy-wide liquidity trap, what we want is for money handed out to go straight into economic activity and by-pass the banking route. So we want those handouts to be spent but the rate at which money handed out becomes spent is not one-to-one.

The eyeballed (rather than carefully analysed) evidence from Australia and the US suggests that more money was spent than expected. Expected by whom? Economic analysts and so it could just be that they were plain wrote. So it is not clear whether this can be tied to government handouts but it is consistent with the theory that these might stimulate. (In the US, the data shows that the extra spending came from the segments of the population who actually received the handout and in anticipation of it).

How does this help us in deciding whether the Government, Opposition or neither are right in their proposed handouts? Very little. Martin Feldstein argues that we need to target these to actual spending. He’d like the new home-buyers grants and the insulation deal. But generally, economists are nervous about this type of targeting as it does not allow households to spend money on what they most want or need.

And it is hard to compel spending. Apparently, the Obama administration toyed with sending tax rebates in the form of debit cards that had to be spent. They thought better of it, I guess when it is pointed out that people can adjust their other spending accordingly and so this would just be window-dressing.

Or would it? Nudge tells us that how things are packaged can make a difference; checks versus pay checks. But what difference depends on evidence and we are really short of that. Let’s face it, no one was proposing research projects to see how best to get people to spend money given to them. Indeed, exactly the opposite and that matters.

There is simply no way, right now, to work out whether the government or Coalition handout routes are better as a stimulus. (Although that is a tad strong but I haven’t seen any research that informs on this). In that sense, the debate is pointless on that score. One thing that we should not put up with is the the whole notion that bringing forward tax cuts do anything to improve incentives. That is sheer nonsense. It is the permanent tax rates that do that and having those a few months earlier is surely of no consequence.

My feeling is that we need to pay far more attention to credit policy. The fact that banks haven’t or are slow to pass on interest rate cuts to credit cards is a drain on consumer spending and the effectiveness of monetary policy. That said, the fact that they rush to pass them on to depositors does stimulate!

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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