With the country plunged into recession we must be realistic about the challenge we face. Monetary policy is likely to be less effective than at any time since the Great Depression and given the scale of the downturn we must embrace fiscal policy to ensure a robust recovery.
Conventional thinking about macroeconomic policy assigns central banks a leading role in managing the business cycle. The task of fiscal policy has been to stabilise the public debt. It is time to reverse this thinking.
In past recessions, the Reserve Bank of Australia has lowered the cash rate substantially to encourage spending. For example, during the global financial crisis rates were lowered some 400 basis points.
No room to move
But before the pandemic the cash rate stood at 75 basis points. Many commentators expressed concern about Australia’s ability to fight the next downturn — the RBA simply had no room to move. And those fears have been realised. The RBA would like to reduce rates but it simply can’t.
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One problem is that nominal interest rates cannot be much below zero. People can hold money under the mattress and earn a zero return — the RBA can’t force people to hold deposits at a bank and earn a negative return.
However, it can provide some stimulus. While it can’t lower the current cash rate below zero, it can promise to keep the cash rate low. This lowers long-term interest rates, stimulating investment and spending.
This is the purpose of the RBA’s “yield curve control” policy introduced in March. By buying and selling three-year treasuries to maintain a yield of 25 basis points, the RBA signalled it intended to keep the cash rate at 25 basis points for at least the next three years.
This “low for long” interest rate policy was judged effective in the United States and elsewhere during the GFC. But there are reasons to think it will be less effective in 2020.
This is because of the fall in what the RBA calls the neutral interest rate: the long-run interest rate of the economy. The stimulus of monetary policy depends on how much cash rates can be reduced below the neutral interest rate. And this gap has declined dramatically.
To understand this, the neutral rate is the sum of the RBA’s inflation target and the long-run real interest rate. Globally, long-term real interest rates have declined substantially over the past 30 years, reflecting factors including demographics and lower productivity growth which have increased savings and decreased interest rates.
The RBA estimates Australia’s neutral real rate is now 1%, having been broadly stable at 2.5% before 2007.
Bigger the gap, better the deal
And here is the central problem. The power of monetary policy depends on the gap between the cash rate and the long-run neutral rate. This gap measures how cheap funds are relative to normal times. The bigger the gap, the better the deal. The current deal is not that great by historical standards. Monetary policy is simply less effective.
Because low neutral rates partly reflect long-term trend developments, monetary policy might never have the firepower to lift the economy out of recession.
But there is a remedy. Low neutral rates mean the economy wants to save more than it invests. To discourage saving, interest rates fall. The neutral rate would not fall if there was greater demand for spending that makes use of these funds.
In Australia only the public sector can fulfill this demand. The household sector holds staggering levels of debt by global standards, and the business sector has shown little appetite for investment, even before the pandemic.
The government needs to start borrowing.
Spending financed by government borrowing will be highly effective for three reasons:
- Each dollar spent will have a large effect on aggregate demand, because the RBA’s “low for long” monetary policy means nominal interest rates won’t rise and discourage private investment
- RBA policy also means debt is cheap to finance and can be paid for by future increases in the tax base through economic and population growth
- By using the large pool of savings, government borrowing might help raise the long-run neutral rate making monetary policy more effective.
Yet despite this, while the Prime Minister Scott Morrison renewed his commitment to infrastructure spending yesterday, he appeared to rule out additional measures arguing “it is not a wise or responsible course” and even “dangerous”.
Putting aside the facts that employment has fallen substantially in many sectors, not just construction, and that the employment benefits from infrastructure spending will accrue only over the medium to long term and doesn’t target women and the young, what is remarkable is that we are again being told that economic salvation lies in a balanced budget.
One of the lessons of the GFC was that countries that moved too quickly to embrace austerity did so at the cost of a slow recovery, with unemployment remaining unnecessarily high. And counter to the sound finance narrative, failure to provide fiscal support meant a slower return to budget balance and further pressure to cut essential services in some countries.
With low gross and net debt positions, as a fraction of national income, Australia has capacity to pursue large-scale fiscal spending to support the economy. Low nominal interest rates ensure these debts are sustainable.
To avoid a protracted recession, there is no alternative to fiscal stimulus.