Prime Minister Scott Morrison and Treasurer Josh Frydenberg (Image: AAP/Lukas Coch)

In the wake of COVID-19 Prime Minister Scott Morrison has shown some willingness to engage in fiscal stimulus.

The PM has flagged spending plans that are “targeted, modest and scalable”. This likely means some help for the sectors most affected by the pandemic at present — higher education and tourism.

Morrison was quick to emphasise that “we’re not a government that engages in extreme fiscal responses”. Translation: I’m no Kevin Rudd and I’m not going to start cutting $1000 cheques.

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At this juncture, the PM has the right response. Universities and the tourism sector are being hammered, but the rest of the economy is largely feeling the flow-on effects from those two sectors. Those effects are much less severe. For now.

The real test for the Morrison government will come if COVID-19 causes severe dislocation in financial markets or a massive contraction on the demand-side of the economy, as occurred during the 2008 financial crisis.

When to use dramatic stimulus

It’s worth reprising why the Rudd-Henry fiscal stimulus was so important to Australia avoiding the worst effects of the 2008 crisis.

After the Lehman bankruptcy in mid-September 2008, global credit markets completely froze up. Banks that relied on short-term funding — often 24-48 hours in duration — to keep their operations afloat saw those funding sources evaporate. Potential lenders needed to hold on to those funds to keep their own operations from folding.

Non-financial businesses radically cut back production and employment. Households slashed spending, leading to a vicious cycle of economic contraction.

All this highlighted the central pathology of financial crises: what matters is not just what I believe is going to happen, but what I believe that you believe is going to happen, and what you believe that I believe is going to happen. And so on.

What is required to overcome this vicious cycle is what I have called the economic equivalent of the Powell doctrine (named for US general and later Secretary of State Colin Powell): “overwhelming force”.

In Australia in 2008 this meant a $52 billion stimulus, the animating idea of which was captured by then treasury secretary Ken Henry’s admonition “go hard, go early, go households”.

The COVID crisis?

Right now, the COVID-19 panic has hit global equity markets hard — with most down around 10% last week. It has led to the cancellation of a number of large conferences and festivals. It may end up severely disrupting the Olympic games.

But it has yet to cause global credit markets — the lifeblood of economic activity — to freeze up. And it has yet to lead households to retreat into a fear-induced spiral of economic contraction…

Unfortunately, there is some meaningful chance that COVID-19 morphs from a public health crisis into a full-blown financial crisis. And if it does, then the Australian government will need to be prepared to use overwhelming fiscal force to rescue the Australian economy.

There is little room for the Reserve Bank to move on monetary policy. There are only 50 basis points of rate cuts left for them use. A typical recession –let alone a depression-level event — involves about 500 basis points of rate cuts. Quantitative easing (buying long-term bonds) could help, but we can’t rely on monetary policy to save us.

The right move for now

Morrison’s “targeted, modest, and scalable” approach is right for now. But he has signalled a kind of allergic reaction to Rudd/Henry-style stimulus irrespective of the circumstances.

That’s worrying and it’s also dangerous. Now is not the time for this government to be painting itself into a corner should the crisis escalate.

Political brand differentiation is all well and good. Well, it’s not actually. But it is a reality. This government has consistently sought to contrast itself as “being able to manage money”, unlike Labor, it claims. But the Australian people will not forgive a government that puts politics ahead of economics and puts party above country.

Morrison casts his government as being fiscally prudent, but also practical and driven by common sense. If this crisis becomes a financial one, then common sense and practicality will need to take precedence over short-term balanced-budget fetishism.

Richard Holden is professor of economics at UNSW Business School.

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