Milton Friedman is wrong again. There is such a thing as a free lunch — it’s monetary policy and here’s why.
One lesson of the global Great Recession is that fiscal policy matters: it always has and always will. But in the last 10 or 15 years, talking about fiscal policy as a macro policy tool has been as unfashionable as purple flares. The market became obsessed with monetary policy and the power of central banks. Yet in the policy response to the Great Recession of 2008-2009, fiscal policy is assuming even greater influence than monetary policy. Indeed, fiscal policy mattered in the period from about 2002 to 2007, but in the US, the UK and especially Australia, it was applied pro-cyclically and actually helped to fuel the bubble that has now burst, plunging the world into recession.
Let’s look at the situation in Australia. In recent times, the RBA seems content to take a back seat to the government’s fiscal policy changes with only 2 rate cuts since December 2008 and only a piddling 25 basis point rate cut since February. And even now, the market is unsure whether the RBA will again pause in May or opt for another baby step 25 basis point reduction in the cash rate.
No one thinks the RBA will cut more than 25 basis points, despite the collapse of the economy. This is extraordinary. Substantial interest rate cuts should be delivered — soon and aggressively. Australian policy rates, at 3%, are about the highest in the industrialised world. Yet the economy is not much better than the US and Canada, for example, where policy interest rates are flirting with zero and cannot be cut any further.
In a clear illustration of the shortcomings of monetary policy, policy interest rates in around a dozen countries are at, or are precariously close to zero and are unable to be cut further. In those countries, interest rate adjustments are unable to be delivered and central banks are starting to revert to printing money to avoid deflation and to try to arrest the plummeting growth rates.
In addition, with this constraint on official interest rates, authorities in the US, Japan, Canada, the UK, most of Europe and elsewhere have had to resort to massive budget deficits as they tackle their recessions. As a result, there are serious and valid questions being asked about the sustainability of the budget deficits, the impact of the public sector debt burden that is being unleashed and how governments will be able to repair budget balances when the economic recovery emerges.
In Australia, there should be no such problem. Cash rates at 3% can be cut — and cut a lot!
But the stubbornness of the RBA in cutting rates in recent months has seen the AUD become worryingly overvalued and is seeing the government consider yet more fiscal measures aimed at stimulating the economy as it deals with the RBA’s reluctance to cut rates further.
The federal budget next month will reveal the extent of the government’s concern about the economy. To date, a mix of pre-emptive fiscal flamboyance, the powerful application of fiscal policy’s automatic stabilisers and a government working desperately to minimise the depth an duration of the recession has seen a budget surplus of 2% of GDP in 2007-08 to a prospective deficit of 4% of GDP in 2010-11.
This is appropriate given the extent of the recession in Australia, but it means that there is a strong risk that in the event of a disappointing global backdrop in the next few years, the budget deficit will remain large and could even increase.
It’s obvious from the raft of RBA commentary and the minutes from the monthly RBA Board meetings that the easing in fiscal policy is expected to stimulate growth.
The elephant in the room over these comments is that had fiscal policy not been eased so aggressively, monetary policy could have been even easier. The RBA may never say that, but you don’t have to be Glenn Stevens to arrive at the conclusion that the current expansionary fiscal settings are holding back the RBA when it comes to interest rate cuts.
When interest rates are well above zero, there can be a trade off between fiscal and monetary policies.
In the simplest terms, the RBA should keep cutting rates, perhaps aggressively, while the Rudd Government should hold a firm line on fiscal policy in the 12 May Budget.
This is not to say that from now on, fiscal policy can do no more to help the economy. It can. The recession demands that all policy levers are positioned for expansion. Yet there are risks to longer run policy credibility if the balance of policy stimulus generates uncomfortably large fiscal deficits for an extended period, leaving a legacy of unwelcome government debt.
Cutting interest rates does not cost the taxpayer (and future taxpayers) 1 cent. It’s free! It helps to boost demand, boost investment, boost spending and, via a lower-than-otherwise AUD, it boost exports.
At the push of a button, announcing a reduction in the cash rate, the RBA can enhance the cash flow of those with debt, encourage a greater amount of borrowing and spending, create incentives to reduce savings and help boost the export sector with a lower AUD.
Fiscal policy stimulus, depending on its exact nature, does stimulate the economy, but at a potentially massive cost of adding to the budget deficit, adding to the level of government debt and can create a debt servicing impost that reduces potential economic growth.
During the Great Recession, there is no doubt that Treasury and the RBA have been comparing notes on what to do. While Treasury Secretary Ken Henry is a member of the RBA Board, liaison between the government and the RBA has been frequent, serious and outside scheduled RBA meetings.
So what to do?
There is absolutely no doubt that fiscal policy should be set to allow the automatic stabilisers to cushion the down turn and some well targeted fiscal easing is essential for effective and sensible economic policy management.
But given the relative position of the monetary and fiscal policy arms and with an eye to the future, the best policy advice right now would see the government and RBA determining what is a firm line on the Budget (avoiding a structural deterioration in fiscal policy) allowing for more aggressive interest rate cuts.
A growth-neutral budget would allow the RBA to quickly lower the cash rate to 2% or less while preserving the government’s fiscal integrity. The AUD would no doubt weaken with a rate cut, which is good news as it would provide essential support to an otherwise woeful export outlook, given the world recession and pathetically weak commodity prices.
But wait…there’s more!
And when the recovery comes, the RBA can, at the push of a button, lift interest rates and keep a tight lid on the inflationary effects of that growth recovery. Fiscal policy, by contrast, can to some extent repair itself via automatic stabilizers, provided a tightish reign is kept on policy now. However, too easy fiscal policy now requires politically difficult and unpalatable cuts in spending / increases in taxes and – worse still – relies on the whackos and over-represented crack pots in the Senate to pass such policy changes.
It’s unclear just how this potential policy trade off will pan out in the next few weeks with the 12 May Budget popping up between the regular monthly RBA meetings.
If the government can hold its nerve on fiscal policy – as we hope – the RBA can cut, and cut hard. It the government is too loose in its Budget, the RBA may hold off rate cuts as it looks at the fiscal stimulus to work its way through the economy.
Think of it: a fiscal package costing tens of billions of dollars, or interest rate cuts, costing nothing. In a few years, either having to present a budget of spending cut, higher taxes or allow the ‘independent’ RBA to hike interest rates. Hmmm. Simple.
It also shows that Milton Friedman has been proved wrong again. There is such a thing as a free lunch — and it was right under his nose and it’s under the nose of policy makers in Canberra and Sydney — it’s monetary policy!