In a major speech yesterday, Treasury deputy secretary David Gruen reviewed the roles of fiscal and monetary stimulus in handling the recession, and in doing so demolished whatever is left of the coalition’s argument that the government spent too much in response to the global financial crisis.
In a little-reported address to the Australian Business Economists Annual Forecasting Conference, Gruen started from the orthodox position that monetary rather than fiscal policy was the best tool to respond to economic slowdown, partly because fiscal measures take so long to implement, and partly because, in open economies, unilateral fiscal stimulus tended to drive up the exchange rate, neutering the stimulatory effect.
Gruen doesn’t argue that orthodoxy has now been turned on its head. Instead, he explains that the GFC was unusual in being global and obvious. Unlike the early 1990s recession, it didn’t creep up on policymakers. Once Lehman Brothers had collapsed, the world knew it was in for a severe economic shock, enabling policymakers and central bankers to scramble. And the worldwide nature of fiscal stimulus packages, as country after country spent up big to offset the effects, meant there was no exchange rate impact.
And in Australia, the government and the Reserve bank moved very rapidly. The government’s first fiscal response was rolling out by December — compared to the Keating government’s “One Nation” response to the early 1990s recession, which took years to roll out.
Another reason for the relative success of the stimulus measures was their impact on consumer confidence. As a non-economist, it seems to me this is one of the key lessons of the response to the GFC — the importance of heading off big declines in consumer and business confidence that mean a vicious circle of reduced spending, job losses and economic contraction. Australia avoided that, particularly after we learnt from the March quarter accounts that the economy had avoided technical recession. Gruen’s words are worth quoting at length and should be borne in mind by future generations of policymakers.
It appears that the expansionary macroeconomic policy response was large enough and quick enough to convince the community — both consumers and businesses — that the slowdown would be relatively mild (indeed much milder than most forecasters, including the Australian Treasury, had earlier expected). If that inference is correct, it is also important. It implies that, on this occasion, expansionary macroeconomic policy was able to generate a favourable feedback loop in the economy.
The stimulus measures were also more successful than anticipated because Treasury modelled quite conservative assumptions about their multiplier effects. It assumed only 60% of the cash handouts would make it into the domestic economy — 30% would be saved, 10% spent on imports — and 85% of infrastructure spending (the other 15% would go on imports). The impact on economic growth, however, suggests Treasury’s assumptions were too conservative. Gruen also draws on academic work to suggests monetary stimulus is significantly less stimulatory — one-third of one per cent GDP impact for every one per cent drop in interest rates in the first two years and one-sixth of one per cent in the third year.
Significantly, as Gruen notes, there are significant lags in monetary policy impacts. That means that, while the GDP impact of the fiscal stimulus measures will actually be contractionary from the first quarter next year, monetary policy, which has yet to return to normal settings, will continue to provide stimulus for years to come.
So Joe Hockey and Malcolm Turnbull were right — monetary and fiscal policy are now moving in opposite directions. It’s just that it’s the government’s fiscal policy that is contractionary, and the RBA’s monetary policy that is expansionary — not, as they maintained, the other way around.
Gruen also explained why the government targeted schools. We’ve all tended to assume it was primarily for political reasons — the government could spend money across the entire country, burnish its “Education Revolution” credentials and receive an electoral reward from grateful parents at the ballot box in 2010. That may have been part of it, but Gruen notes that targeting schools meant a faster stimulus: school have
a number of elements to enable speedy construction. School land is available immediately without the need for planning approval; hence no planning delays. Further, schools chose from standard designs rather than developing their own, to speed up construction. School-based infrastructure spending has the advantage of providing stimulus to almost every population area of the country; useful because the economic slowdown was expected to be geographically widespread. Finally, school infrastructure projects have low import content, which raises the domestic stimulatory impact.
Gruen also demolishes the line that the government “spent too much”. Economists such as Henry Ergas (Gruen doesn’t mention Warwick McKibbin, still on the RBA board despite his persistent attacks on the government) ignore the massive and long-lasting economic impact of high rates of unemployment, in terms of lost skills, productivity and income. Gruen pointed to a study showing university graduates entering the labour market in a recession “suffer sizeable initial earnings losses, losses that persist for a period estimated at between eight and 15 years”.
Ultimately, Gruen says, Australia was able to head off the recession primarily because its financial system was intact and it had the fiscal capacity to respond, courtesy of the Budget policies of Labor and Liberal governments.
The GFC might have been an unusual crisis compared to previous recessions, and monetary policy might be better suited to milder downturns, but fiscal stimulus is not as poor an option for such crises as we’ve been led to think.