Fiscal policy and monetary policy
There are two broad actions that can be undertaken to intervene in an
economy that is facing a downturn. Monetary policy refers to action by the central
bank to lower interest rates, encouraging higher rates of borrowing and
investment, and improving cash flows for debtor households and firms as the
size of repayments decreases.
The other approach is for the government essentially to pump money into
the economy by running or increasing budget deficits. This can take many forms
including tax cuts, tax rebates, or direct government spending such as
government‑funded construction of infrastructure, but all borrowed
expenditure has to be repaid in the future. The various economic stimulus
measures that are the focus of this inquiry include a mix of cash payments,
some tax breaks and various forms of infrastructure expenditure.
One of the 20th century's pre-eminent economists, John
Maynard Keynes famously wrote:
The ideas of economists and political philosophers, both when
they are right and when they are wrong, are more powerful than is commonly
understood. Indeed the world is ruled by little else. Practical men, who
believe themselves to be quite exempt from any intellectual influences, are
usually the slaves of some defunct economist. Madmen in authority, who hear
voices in the air, are distilling their frenzy from some academic scribblers of
a few years back.
But even he may have been surprised at the frequency with which his
ideas were lauded and contested during this inquiry, over 60 years after
his death. His name has become synonymous with the idea that in a recession, when
there is a deficiency in private demand due to low business confidence, the
government can usefully stimulate total spending in the economy by either
increasing payments to households or cutting their taxes so that they will
spend more, or directly spending money itself on infrastructure payments. This,
it is said, will reduce the extent to which lower demand leads the economy to
operate below capacity with increased unemployment, with both commensurate
social and economic costs.
Keynes expounded the case for an 'activist' fiscal policy, most notably
in his influential book, the General Theory.
It became the economic orthodoxy of the post‑war years up until the
1980s, when classical monetarist theory began to prove itself. The basic
approach to managing the business cycle was adopted by most governments. Even
Richard Nixon said "we are all Keynesians now".
The Keynesian approach was widely adopted worldwide to stave off the
effects of the global financial crisis and was enthusiastically applied by the
Government in Australia.
But not all witnesses accepted the basis of the Keynesian approach:
The standard theory of recession is wrong. That is my
conclusion from a number of years of research on these issues. The use of
Keynesian demand side theories to restore growth to economies in recession is
misconceived... Keynesian stimulus, as we have had here in Australia and in
America and elsewhere, is actually an obstacle to returning to economic growth
and full employment rather than being any kind of assistance.
...we have actually gone back into a world where, rather than
letting the economic institutions—the market and those government
instrumentalities such as the Reserve Bank and what have you—actually operate
and let the automatic stabilisers operate, an activist fiscal policy has been
adopted. I think that is very much a backward step.
One aspect of this is to assert that business cycles are inevitable and
nothing should or can be done, at least through fiscal policy, to moderate
...economies are subject to periods of rapid growth and periods
of recession and therefore the overreaction to the downturn at the beginning of
this year has been wrong. We have not had the need for this kind of stimulus to
be taken because the business cycle would actually have covered most of the
change that we need to have anyway.
Other witnesses espoused an alternate view that accepts the idea that
fiscal policy can be effective and should be employed:
...there is a logic, when the private sector suddenly does not
want to borrow and wants to contract and de-leverage, for someone who has a
strong balance sheet to come in and temporarily go in the other direction, not
permanently but just for a temporary period. That is a stabilising thing to do...
...it is important, where government can, to try to smooth the
economic cycle and not simply to see this additional two percentage points of
unemployment as being a statistic but as being many young people whose
livelihoods will be better if they do not spend a scarring period of
unemployment early in their careers.
Some people seem to be suggesting that the stimulus has had
no impact on the economy. To take up that point, I would just ask: where did
the money go? If you pump billions of dollars into the economy and we have not
observed any inflation, it has gone somewhere. It has obviously created jobs,
employment and income for the people who received that money.
The prescription from economic analysis is clear, that major
fiscal expansion is warranted in response to deficient demand. The concerted
expansion in many countries is easing recession.
Treasury argued that the debate on the efficacy of fiscal policy is a
debate about the size of the 'fiscal multiplier'. This is the ratio of the
consequent increase in GDP to the size of the fiscal stimulus.
Treasury provided fiscal multiplier estimates from the OECD and IMF,
reproduced in Table 3.1.
Table 3.1: OECD and
IMF estimates of fiscal multipliers
Transfers to households
Source: Treasury briefing
paper, p 4.
A recent study by Ilzetzki, Mendoza and Vegh was discussed during the
Committee's final hearing.
Relatively closed economies have long-run multipliers of
around 1.6, but relatively open economies have very small or zero multipliers.
Treasury argued that the Australian economy is in the former category,
and so likely to have a higher multiplier:
They break their sample into those countries that have a high
trade share and those countries that have a low trade share, and the criteria
they use is that your exports plus your imports have to be greater than 60 per
cent. We are very clearly in the category of countries with a low trade share.
Our trade share—exports plus imports—is about 40 per cent.
The multiplier effects may well be higher when Australia acts at the
same time as a number of other countries:
...if there is a global downturn and everyone responds with
fiscal policy then the exchange rate effect is much less important because
everyone is stimulating their economies. If you like, you can think of the
whole globe as a closed economy and in that world the relevant multipliers are
the ones for a fixed exchange rate because the whole world is providing fiscal
The size of the multiplier will vary across the cycle:
If you are in a fully employed economy, our presumption would
be that the multiplier would be close to zero—to the extent that, if you are in
a fully employed economy and the government engages in expansionary fiscal
policy then a range of offsetting things will happen which will completely
crowd that out. Whether it is the private sector responses that you are talking
about or the anticipation that the Reserve Bank will tighten monetary policy in
order to offset it, leading to the exchange rate rising, there are a range of
ways in which that will be offset. In a fully employed economy, I would agree
with you that the best estimate would be a fiscal multiplier of zero. In a
situation such as that Dr Henry talked about earlier, in which private sector
demand is retreating and public sector demand is acting to take its place, the
strong balance of evidence is that such spending has a positive multiplier, and
I think that is accepted by the IMF, the OECD and by most interested observers...
One academic argument against the efficacy of fiscal policy is based on
'Ricardian equivalance'. This idea, popularised by Robert Barro, draws on a
conjecture dating back to the pioneering British economist David Ricardo two
Dr David Gruen of Treasury described the argument to the Committee as
The idea is that consumers who are in a position to smooth
their consumption through time will realise that the extra government spending
now implies extra government debt which will need to be paid back at some time
in the future and they respond by reducing their consumption now...It certainly works
in theory; the question is how relevant it is to the real world...my reading of
the evidence is that it is more convincing for economists than it is for the
Interestingly, even David Ricardo himself did not believe in Ricardian
It remains the view of most economists that only a small proportion of the
population's spending decisions would be based on Ricardian equivalance:
...there is not much empirical support for this motivation
Dr Gruen referred the Committee to his own research on this topic:
Many years ago I went out and asked people how much they knew
about the level of Australian government debt. I then asked academic economists
how much they thought people would know, and it turned out that the academic
economists massively overestimated the amount of knowledge of the people I had
Critics of the Keynesian approach argue that even in a recession,
government spending displaces private spending:
Public debt has the effect of crowding out private investment
and increasing interest rates. So we would have expected Australia to be paying
slightly higher interest rates than it would be if it were not for that net
debt. Certainly I think a very low, negative net debt position is prudent
fiscal policy, and a balanced budget.
Economists generally agree that crowding out can be a problem. Witnesses
disagreed about the extent it would apply in Australia.
Open economy crowding out
Professor Makin argued that the Keynesian arguments are less applicable,
and crowding out concerns starker, in an open economy. His interpretation is
...the budget deficit will add to the foreign borrowing. Other
things remaining the same, this is going to increase interest rates. It must
increase interest rates...there would be a higher risk premium on Australian
borrowing, and the consequence of that will be two losses to the Australian
economy. The first loss will be: the higher interest rates will crowd out
private investment. That private investment means we will have a lower capital
stock than we would have otherwise had, and into the future we will have a
lower growth path. The second cost is the sheer payment of interest abroad,
which will be significant. It is a significant part of Australia’s external
The Nobel Prize winner Robert Mundell demonstrated that quite
some time ago—that if you expand fiscal policy you push up interest rates. This
induces capital inflow, the exchange rate appreciates, and this worsens
competitiveness and worsens the trade account.
The Reserve Bank Governor's interpretation was that to the extent that
the stimulus package made the economy stronger, this would lead to a higher
...economies which are stronger rather than weaker typically
have a firmer currency relative to what they would have if they were weak. One
reason for that is that in such economies return on capital tends to be
positive and higher rather than lower, which means that foreign funds find it attractive
to come there. Of course, one dimension of that is that such countries, not
always but typically, have a higher interest rate structure across the board
than a country that is comatose. We have low but still positive interest rates,
whereas Japan has them at zero as do a number of countries now.
A similar view was expressed by some business representatives:
We think that the stimulus package has improved domestic confidence
in the Australian economy, the level of investment and the level of activity,
beyond what would otherwise have been the case. We think that that level of
confidence and activity has given foreign investors greater confidence in the
Australian economy and that has contributed to the higher dollar by making us a
more attractive place for investment.
There could be (partly) offsetting effects whereby the stimulus package
puts downward pressure on the exchange rate as some of the extra spending leads
to higher imports:
Any increase in imports must then lead to depreciation of the
exchange rate...any reduction in demand for domestic goods caused by a leakage
into imports will be offset by an increase in demand for domestic goods caused
by a rise in exports.
In total, witnesses did not highlight any impact of the stimulus
measures on the exchange rate, particularly as most of Australia's trading
partners also implemented stimulus packages themselves. Treasury commented:
We have also seen significant movements in the exchange rate,
most of which we would judge to be unrelated to domestic policy settings.
The substantial movements in the exchange rate over the past
12 months are likely to reflect not only shifts in underlying demand for
Australia's commodity exports and subsequent terms of trade impacts, but also
shifts in both risk aversion among investors and sentiment regarding
Australia's relative economic prospects. While the initial fall in the exchange
rate has been a positive for growth, the relatively short duration of the
exchange rate trough, the volatility and the subsequent sharp reversal mean
that the contribution to growth over the past year is likely to have been
modest. In practice, it usually takes some time for trade flows to respond to
exchange rate changes.
The hallmarks of a well-designed fiscal stimulus
There are three criteria which seek to take into account some of the
arguments against fiscal stimulus measures outlined above to ensure fiscal
stimulus packages are successful.
The stimulus needs to be timely, with the stimulus being
applied while the economy is in a downturn and is operating beneath productive
capacity. If a stimulus occurs too late, there is increased danger that the
government spending will occur on top of recovering private demand. As well as
being too late to have any positive effect during the downturn, this would also
increase the risk that the excess demand would fuel inflation and higher
interest rates to the detriment of the economy's recovery. This argument is
often used to prove the superiority of monetary policy as being more responsive
and not subject to political delay or an implementation lag.
A second criterion is that the stimulus be well-targeted.
The stimulus needs to be directed in ways that maximise the multiplier effect
of the government expenditure.
The experience shown by the fiscal stimulus packages have tended to be
of low value and much of the investment by the Government has been of poor
quality that does not provide an economic benefit. Many of the projects were
poorly conceived and have provided very little to the wider community – that
could be perhaps viewed as "make-work" projects, which are very
expensive and provide little benefit.
Over longer time periods, direct government spending also has a high
multiplier effect. Indeed, every dollar of direct government spending flows
through to the economy directly. However, direct government expenditure can
take some time to be approved by parliament and then further time to get
underway. For instance, the lead time on infrastructure projects such as
highway construction can take months to years, potentially coming too late to
be useful. As a result, direct government expenditure in the form of
infrastructure projects will generally have an implementation lag.
Standard textbook analysis will tell you that fiscal stimulus
in an open economy with a floating exchange rate is ineffective, except if it
is productive. That is to say fiscal stimulus in the form of a consumption‑enhancing
expenditure is ineffective.
The third criterion is that stimulus measures should be temporary.
This is because the longer stimulus measures are applied, the greater effect
they have on the long-term national budget. The effects of higher national debt
are discussed above.
The stimulus package, as announced by the Government, is planned to
continue to roll out until 2012. This is clearly not a temporary fiscal
Despite this, the Governor of the Reserve Bank believed the stimulus
packages well met the temporary and timely criteria, although acknowledged the
questions about the effectiveness of the targeting.
I think it is pretty hard not to conclude that it was quite
timely. It was very fast. The bulk of it is temporary. Notwithstanding the
discussion earlier about 2011 effects, the big impacts are in 2009, which is
presumably the year in which the economy would need the most support. On the
targeting, that is probably where people are going to differ about just what
should be targeted.
Interaction between fiscal and monetary policy
While three per cent was the lowest the Reserve Bank's official cash
rate has ever been, and similar interest rates had not been this low since the
1950s, nonetheless it would have been possible for the Reserve Bank to take
them down to (near) zero as has been done in some overseas countries. This
would have been consistent with a less expansive fiscal policy, as discussed by
Professor Tony Makin.
However most economists believe that taking interest rates this low would
not have been a desirable setting for monetary policy:
Yes, monetary policy becomes less effective the closer you
get to zero.
I think it is immeasurably to Australia’s advantage that,
however we have arrived where we are, we do not find ourselves with the
overnight rate at zero,
...cutting interest rates to very low levels is something that
you do if there is no alternative, but that there are attendant dangers in
having extremely low interest rates, certainly for any extended period of
time...After all, one of the arguments presented about what led to this global
mess was an extended period of ultra-low interest rates in the US.
The Governor of the Reserve Bank elaborated on this trade-off:
In principle, at the level of logic, of course I guess they
[the Government] could take a sequence of decisions which slow down the demand
in the economy which would otherwise be occurring and that would presumably
have some impact on the outlook, including for inflation, and therefore we
would be on a different course from the one we would otherwise be on. So in principle
that is possible. I still think though that one should also ask the prior
question of whether that is a better set of outcomes. Is it the best outcome to
have a huge budget surplus and very low interest rates? There is often a
presumption that that is good. I am not sure I share that presumption because
there are things that go wrong with very low interest rates and there are
possibly reasonable things that the governments can do with the money. I am a
bit reluctant to accept that presumption.
It is hard to quantify the trade-off between monetary and fiscal policy
There is an interesting question out there as to what
expenditure is fiscally equivalent to a one percentage point cut in interest
rates. I wanted to have that number to present to you today but...My quick skim
of the literature suggests it is not there.
The Committee acknowledges the lack of desirability of reducing the
official cash rate to zero. However, the Committee does consider that scope
existed to lower it further, without leading to a huge budget surplus.
One view is that monetary policy is more nimble and can 'fine tune'
around fiscal policy:
We are sufficiently uncertain as to what the path out of the
downturn will be that I think it makes sense just to let fiscal policy roll and
let monetary policy, which takes effect much faster, do the finetuning.
The consensus that emerged in the 1980s...was that there were
considerable limitations in using fiscal policy to finetune the
economy...monetary policy is probably better able to play that role. But
certainly I never interpreted that consensus as implying that, when an economy
is hit with an unprecedented negative shock, one should expect that monetary
policy could play all of the role.
It can be argued that the present crisis was unusually well-suited to allowing
consideration of how best to employ both monetary and fiscal policy:
One of the things that made this crisis so unusual and
unprecedented—certainly from Australia’s perspective—was that we got such a
strong and unequivocal signal from the rest of the world in the middle of
September that something truly catastrophic was happening in the global capital
markets. We were very confident—and that confidence grew over a period of just
a couple of weeks—that an enormous negative shock was coming our way. The shock
had arrived in the sense that it had already had an impact on share markets and
the exchange rate, as you explained, and it was very clear that that was going
to lead to a very substantial negative shock to the real economy...That is an
extremely unusual situation and it radically changes the calculus of whether
discretionary fiscal policy is a good idea or not.
An alternative view is that monetary policy is always far more effective
than fiscal policy:
Unquestionably monetary policy is more effective. Monetary
policy in an open economy works largely through the exchange rate, and we saw
that. We saw that the relaxation of monetary policy by 425 basis points over a
short period of time was a reason for the exchange rate depreciation...
There is general agreement that it is undesirable for monetary and
fiscal policy to be at odds. However evidence was received arguing both that
this was the case in Australia and not. The Committee considers that Australia
is facing a distinct likelihood that these two arms of policy will be working
against each other. Indeed, the recent twenty five basis point increase in the
official cash rate is specifically intended to slow the economy being sped up
by the Government's fiscal policy.
Alternative stimulus approaches
Tax cuts as an alternative
Many economists argue that tax cuts would be a more effective means of
stimulating the economy than one-off payments or government spending:
Had they gone down the road of, say, finding ways to reduce taxes...which
would have a direct effect on business profitability and on cash flow then the
reaction within the business community would have been a lot stronger. Not only
would employment have been protected in the way that the stimulus was intended
but it would be much more general... using the payroll tax system might have
been the optimum.
a [income] tax cut would be better than a spending
initiative...it would allow individuals to spend the money in better ways than
those in which the government would spend the money.
Other economists prefer spending to tax cuts as a short-term stimulus:
My read of that [summary of economic literature] is that the
multipliers are highest for infrastructure, next highest for consumer handouts
and lowest for business tax breaks. The impact of business tax breaks on the
economy seems to be fairly low.
Some have argued that these should have been permanent tax
cuts. The difficulty with that is that it does put you into a fiscal position
which is pretty hard to unravel unless you are willing to make some hard
choices on the expenditure side.
Treasury considered the cash payments to be superior to a tax cut on the
grounds that they were faster to implement and would have a one-off effect on
the budgetary fiscal balance. Permanent or semi-permanent tax cuts would have
built in a long-term decrease in tax revenues and negative effect on the fiscal
Behavioural economic theory suggests that cash payments administered in
a lump sum were more likely to be spent when compared to the smaller, regular
amount that would result from tax cuts.
However, the work of Milton Friedman and his permanent income hypothesis
states that the choices made by consumers regarding their consumption patterns
are determined not by current income but by their longer-term income
expectations. In essence, transitory, short-term changes in income have little
effect on consumer spending behaviour.
There are other alternative approaches to preserving employment in a
downturn, such as more direct labour market programmes. Views differed about
...a lot of the stimulus might be better spent through direct
job creation, particularly through community organisations and local
councils—again, I think, an effective way of not just spending money but
spending it in regions that can absorb it and also in a way that can create
jobs where they are needed most.
My read of the literature on active labour market programs is
that wage subsidies are more effective than direct job creation schemes. But we
do not have a great deal of high-quality evidence on how best to create jobs in
the Australian context. It would be nice to have some really rigorous studies
and randomised trials that compared wage subsidies, direct job creation and
training, which are the three main things we think about doing in a downturn.
Preparation for future recessions
Some witnesses commented that the quality of spending in the stimulus
packages would be better if thought had been given to possible projects before
the recession hit:
In a perfect world, you would have a long list of
infrastructure things that you would get out, dust off and turn on when the
need comes. I have been through a few cycles now and I have not seen that
happen quite so easily yet, because it is not feasible to do that.
The main lesson is that it is actually hard to spend a lot of
money quickly. I think that, given that Australia can and will have other
recessions in the future, we would be well served by beginning to prepare for
recessions before they occur. By that I mean that, if people find it a
challenge to spend a lot of money very quickly, there is no reason we cannot
have a list of important but not urgent projects that are ready to go at any
point in time. There is no reason that local councils and other organisations
could not be encouraged to prepare lists of exactly such shovel-ready projects...
The problem with this idea is that while economic theory operates in a
perfect world, the real world is not like this and it appears that a number of
the projects have been selected on the grounds of being more in the vein of
political spending rather than income-generating infrastructure.
This idea could be aligned with another recent proposal to deal with
lags in implementing fiscal policy. A paper cited by witnesses to this inquiry
refers to a proposal that the legislature agree to a fiscal stimulus package
that would take effect only if a specific triggering event occurred. The
trigger suggested was a three-month fall in employment. As well as allowing
negotiations to occur before the stimulus was needed, a further benefit
could be that:
...this approach could boost household and business confidence
by making clear that fiscal stimulus would be used against a serious economic
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