Old Parliament House, Canberra
July 18, 2007
David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.
In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.
Thinking about a change of government
At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.
But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.
But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.
The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.
But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.
A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.
On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.
Thinking about the next recession
I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.
But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.
So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.
But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.
The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.
I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.
I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.
The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.
Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.
At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.
Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.
Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.
My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.
Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.
Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.
One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.
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July 18, 2007
David Gruen has asked me to talk about the policy issues I believe Treasury should be thinking about in briefing an incoming government, new or returning. I’m not convinced I could give you much useful advice on that score, but I’m going to address the topic quite broadly in the hope of saying something that gives you something to think about, even if - as I suspect is often the case - all I do is help you realise why you don’t agree with me. I’ll also focus fairly heavily on my special subject: the politics of economics.
In thinking about the next government I’m going to err on the side of envisaging a change of government, not because I think it’s a sure thing - I don’t - but because it gives us more interesting things to think about and because preparing a briefing for a new government is a more challenging exercise. It’s possible I may have had more experience than some of you of observing change-overs. In my career I’ve seen three at the federal level: from Whitlam to Fraser in 1975, from Fraser to Hawke in 1983 and from Keating to Howard in 1996.
Thinking about a change of government
At one level you might think that a change-over from Howard to Rudd would be a relatively simple affair given that the remarkable success of existing policies means there’s broad agreement between the two parties on the question of macro management - on the medium term frameworks for monetary policy and for fiscal policy, including balancing the budget on average over the cycle and limiting the growth in revenue as a proportion of GDP. In case any of you have any doubts, I’d remind you that politicians’ behaviour in opposition usually offers a poor guide to their behaviour in government, so that the behaviour of Labor when last in government offers the best guide to its behaviour when next in government. We can expect a Rudd government to be quite conservative and responsible, anxious to lay to rest the popular stereotype that Labor is no good at economic management, anxious to avoid getting offside with the financial markets, anxious to be seen as ‘pro-business’ - more anxious about it than the Libs ever need to bother being - and anxious to avoid being seen as the lackeys of the (in any case, hugely politically weakened) union movement. The more the Libs push that line against Labor in the run up to the election, the more determined a Labor government would be to disprove it in practice. This time there’d be no Accord to give the unions a seat at the Cabinet table.
But it would be a mistake to see the lack of significant difference between the two sides on macro policy as making the briefing of an incoming Labor government a ho-hum affair. That’s because a change of government represents a rare and vitally important point of challenge and opportunity for Treasury. It’s a quickly passing opportunity for Treasury to establish a relationship of two-way trust and loyalty with the new administration. Treasury does so by demonstrating its commitment to apolitical service to the government of the day, by demonstrating that it’s already been giving much thought to the new government’s problems from the new government’s perspective and by demonstrating its competence (including its detailed knowledge of the new government’s stated policies). The more politicised the public service becomes, the more important this welcoming-committee role becomes.
But there’s a second reason the first few days of the new government’s term are of such strategic significance: they represent an unparalleled opportunity to get action on all those issues the outgoing government had consigned to the too-hard basket, including those that most offended the interests of its core constituency.
The first duty of Treasury is to immediately present the incoming government with evidence of a budgetary crisis that demands an immediate and radical response. That’s what John Stone did for the incoming Hawke government even before it had been sworn in and what Ted Evans did for the incoming Howard government in 1996. I’ve seen it done at the state level many times and incoming CEOs of major companies almost invariably do something similar. I call it ‘doing a Mother Hubbard’: we came to government, looked in the fiscal cupboard and were shocked and appalled to discover it was bare. It’s actually a time-honoured trick that will be much harder to pull off in the era of the PEFO. The first point of it is to get all your predecessor’s dirty fiscal linen out in the open while the recognition of those presently hidden, unacknowledged costs can be blamed on your predecessor. It has to be done in an atmosphere of high-drama crisis, so your alibi will stick in the mind of the electorate and so any early economic setback or lack of progress can be excused.
But the second purpose of the crisis is to provide a cover for a process by which the incoming government slashes away at those budget measures aimed at its predecessor’s political heartland so as to make room for those measures it has promised to grant its own political heartland. The process also allows the new government to defer or abandon some of its non-core promises. This is a vitally important exercise from Treasury’s perspective because of the need to prevent the new government from merely adding its pet projects on top of its predecessor’s pet projects.
A common practice is for the new government to establish a committee of audit to reinforce the message that it inherited a fiscal mare’s nest, but the Howard government’s experience shows that the auditors need to be selected with care. Give the job to a bunch of academics and they’ll give you a report whose recommendations are too radical to your taste.
On a related theme, I have to tell you that the older I get the more I doubt the pertinence of the old cry in response to election promises, ‘where’s the money coming from?’. The honest answer - which no politician would dare give - is, ‘if and when we win the election, Treasury will tell us’. Why? Because that’s what Treasury’s paid to do: tell the government of the day how it can cover the cost of the policies it wishes to pursue. Hidden in that is a more subtle task: to take the incoming government’s election promises and explain to it how, by adding qualifications and limitations that were not mentioned or explicitly ruled out before the election, it can significantly curtail the budgetary cost of the promise. It may also be able to gain some budgetary leeway by fiddling with the timing of commencement of the program.
Thinking about the next recession
I have a feeling this election won’t be a good one to win. Why not? Because of the high chance that the record expansion phase finally comes to an end sometime in the next few years, leaving us in recession. Think about it: we have a history of governments being thrown out of office after they’ve presided over a recession. That’s true of the Whitlam, Fraser and Hawke-Keating governments, although in Paul Keating’s case there was a one-term lag thanks to John Hewson’s GST/Fightback package. Parties that are in government generally have good reputations for economic management, then lose it during their recession and leave office being regarded as pretty hopeless. The incoming government then does its best to rub in their predecessor’s bad reputation and live off it for as long as possible. The Hawke-Keating government suffered this fate notwithstanding its unprecedented record of economic reform. I might add that, though the Labor government’s poll ratings on economic management weren’t too bad during most of its term, the voters’ views on which party is good at which policy area are terribly stereotyped, meaning that the Liberals’ identification with business gives them a big inbuilt advantage.
But now consider what would happen if the Libs lost office this year and a recession occurred during the new government’s term. The Libs would have managed to enjoy a completed period of more than 11 years in power without a recession, whereas Labor would have plunged the economy into recession within a year or two of regaining power. Nothing could be more calculated to reinforce for the long term the perception Peter Costello has been so successful in inculcating with all his talk about Labor’s Beazley Budget Blackhole, deficits and debt, that the Libs are God’s gift to economic management, whereas Labor simply can’t be left in charge of the till.
So that’s why I say I’m not sure this would be a good election to win. I’m sure that wouldn’t discourage Labor from wanting to win, but I’m equally sure the scenario I’ve just outlined would have occurred to Labor and that, should it win, it will quickly turn its mind to this potential problem. It will do all in its power to blacken the economic reputation of its predecessor in the hope that, should a recession occur reasonably soon after the change of government, it will be able to shift the blame back on the Libs. If I’m right, it will be expecting Treasury to play its part in this exercise.
But now let’s turn out minds to the possible nature of the next recession (and remember that this discussion applies equally to Liberal or Labor governments). Dr Don Stammer, formerly of Deutsche Bank, says no economist or economic journalist is worth feeding unless they’ve lived through at least four recessions and, if they have, they’re entitled to charge a premium for their advice. In my working life I’ve experienced the recession of the mid-70s, the recession of the early 80s and the recession of the early 90s - and they’ve left a lasting impression on me.
The first thing to say is that I don’t see any signs that a recession in imminent. But I don’t believe for a moment that the business cycle has been abolished and nor do I believe our luck can hold forever. Equally, however, I don’t think you ever get much warning that a recession is on the way. They tend to be brought on by what Don Stammer famously calls the X Factor - the factor no one had been expecting. But I do think there are a few things we can say. One is that I don’t think we’ve ever had a recession of exclusively domestic causes. Equally, I don’t think we’ve had a recession of exclusively external causes - though in 2001 we did have a mild world recession that didn’t lead to a downturn here.
I deduce from this that our economy goes into recession when some external disturbance combines with some domestic imbalance or vulnerability. I don’t think we have to look far to find the most likely source of domestic vulnerability: our extraordinarily heavily indebted household sector. It’s highly vulnerable to a sudden fall in employment - from whatever cause - which would make it impossible for affected households to maintain their mortgages. This threatening atmosphere could put the wind up many employed but heavily indebted households which, in their efforts to reduce their exposure, could significantly slow their consumer spending. The contraction would come not so much from the direct effect of newly unemployed households as from the indirect, contagion effect on other indebted households.
I believe that, when it comes to dealing with recessions, it’s important not to get caught fighting the last war. I say this because of my painful experience with the recession of the early 90s. Early in that process, despite widespread gloom and doom in the business community, Treasury was confidently predicting just a ‘soft landing’. Treasury argued that the prime domestic cause of the two previous recessions - in the mid-70s and early 80s - had been wage explosions and, since this time wages were well under control thanks to the Accord, this downturn was not likely to be severe. I bought that argument and loudly and confidently predicted a soft landing, knowing to ignore all the contrary anecdotal evidence I was hearing. As it transpired, the landing was anything but soft. So that proved a terribly wrong call on my part and caused me a lot of grief in the office, where all the anecdote merchants tried hard to convince the editor of my incompetence.
The problem with that analysis was that, as is the bias of most macro economists, it sought evidence and explanations for recession only in the real economy, ignoring the financial economy. But, as Ian Macfarlane was the first to explain publicly, financial factors were the key cause of that recession and its severity. The deregulation of the financial system and the admission of foreign banks had led to an orgy of business borrowing associated with successive asset price booms in the stock market followed by the commercial property market. When high interest rates eventually caused the music to stop, the corporate sector found itself heavily leveraged and highly exposed, many with assets that were no longer worth what had been paid for them. The response was that the corporate sector, including the banks themselves, entered a protracted period of ‘balance sheet repair,’ which involved running down debts by cutting investment spending, cutting staff and otherwise cutting expenses. The problem with this, of course, is that it spreads the problem to other firms, which deepens and prolongs the adjustment period.
Now, the point I want to make is that, in thinking about the next recession, we shouldn’t focus exclusively on what could go wrong in the real economy, but remember that we could again be clobbered by the financial side. For a long time I believed that we’ve got so proficient at controlling inflation - we’ve become so vigilant - that the next recession couldn’t possibly involve the usual train wreck of inflation getting away and interest rates being held so high for so long that a deep recession becomes inevitable. If so, the next recession would be a mild one. I no longer think that because, as Ian Macfarlane made pretty clear in his Boyer Lectures last year, the smart money is expecting the repair of household balance sheets to be the major domestic cause of the next recession. That means it’s likely to be severe and protracted - especially when measured the way politicians and the electorate measure the severity of recessions: by the effect on unemployment, not the effect on output.
At present, thanks to the long-lasting salutary effect of the last recession our corporate sector is not highly geared. But should the next recession be delayed and the private equity craze continue (which it may not), by the time the next recession does arrive we could find ourselves with a highly geared corporate sector as well as a highly indebted household sector. If so, expect the next recession to be doubly severe.
Here it’s important to remember what I think of as a cross between Goodhart’s Law and Murphy’s Law. When monetary policy manages to get a handle on goods and services price inflation control, it tends to encourage the emergence of a problem it finds much harder to handle, credit-fuelled asset price booms. To put it another way, when the economy has been growing strongly and steadily for some time, businesses in search of ever-growing profits tend to become emboldened to take on more risk by gearing up. We see the perfect demonstration of this in the private equity fashion. Trouble is, we all know it will end in tears. Note that here we see one reason for the perpetuation of the business cycle, where the very success of the expansion phase sows the seeds of its eventual destruction.
Now let me introduce a complication I’ve been thinking about lately, but haven’t yet resolved in my mind. In the past 10 or 15 years it’s become terribly fashionable to analyse the challenges of business life in terms of ‘risk management’. I’ve even seen business types getting climate change and emission trading legitimised in their minds by branding it as risk management. Risk management can be about risk spreading, but easily degenerates into nothing more than risk shedding. Businesses can shift risk to their customers, but for the most part they shift it to their employees. I suspect that the protracted period of companies seeking to maintain double-digit profit growth by eternal cost cutting involves a lot of risk-shifting to employees. It’s not greatly relevant to Australian circumstances, but the classic example of risk-shifting to employees has been the move from defined-benefit to defined-contribution pension schemes - which has made older employees far more vulnerable to vagaries of the sharemarket. Another example is the advent of just-in-time inventory management, where firms’ economising on inventory costs has shifted the risk and cost of supply-chain disruption to their employees - who are now far more likely to find themselves temporarily laid off because of, say, a strike at a supplier’s factory. I don’t think there’s much doubt that Work Choices - including the neutering of the unfair-dismissal provisions and reduction in the availability of redundancy payments - has greatly increased firms’ ability to shift risks to their employees. Added to that you have the growth in casual employment, the conversion of employees into contractors and the widespread use of labour-hire firms.
My point is that this risk-shifting trend may have altered the internal dynamics of recessions in ways that are hard to predict. If in a downturn firms are better able to limit the fall in their profits by more easily cutting their wage bills - and thus their employees’ and erstwhile employees’ incomes - does this make the recession less severe or more? If Work Choices gives employers the upper hand in industrial relations, does this mean a recession is likely to see more lay offs or more workers on four-day weeks - that is, is the pain more concentrated on a few or more evenly spread across the many? Does it make much difference? One possibility is that the greater freedom to dispense with the services of casuals, contractors, labour-hire workers and even permanent employees means unemployment will shoot up much earlier than it did. The corollary, however, should be that the absence of labour hoarding means unemployment recovers earlier. We shall see.
Now for a more positive note. If I’m right in predicting that the next recession is more likely to arise from some disruption giving rise to adverse balance sheet effects than from a loss of control over inflation, that does have one big advantage. It means the macro managers ought to feel free to respond to the downturn by the quick and wholehearted application of stimulus. The Reserve Bank can afford to slash interest rates in the way the Fed did in 2001. That’s one of the rewards from our return to good control. Similarly, with general government net debt eliminated, there’s no impediment to the government adding significant discretionary fiscal stimulus on top of the reversal in the automatic stabilisers. There maybe some political embarrassment arising from the way the medium-term fiscal strategy has degenerated into the promise of eternal surpluses, but in the pressures of the moment that will be quickly cast aside.
Here it may be useful to recall the experience of the last recession, where it was originally argued that all the discretionary stimulus should come exclusively from monetary policy, with fiscal policy holding to its medium-term goal apart from the automatic response of the automatic stabilisers. This is what produced the most amazing budget of my career, the only one delivered by John Kerin who, with Paul Keating skulking on the backbench, proceeded to be more Keating than Keating, and stood up in the middle of the recession (August 1991) and declined to kick-start the economy. (That budget was also remarkable for being delivered in the early afternoon without a lockup, thereby uniquely demonstrating that the lockup serves no economic purpose, but survives purely as an instrument of media management.) The joke of all that, of course, was that once Keating became prime minister a few months later, he lost little time in organising the hugely stimulatory mini-budget of February 1992. And the lesson of all that is that the politician who can resist the temptation to use the budget to stimulate the economy during a recession has yet to be born. That being the case, it makes more sense for Treasury to switch to recommending a stimulatory stance of fiscal policy as soon as possible.
One last point since I suspect that some of you have never experienced a recession during your working lives. The burden of recessions is felt very unevenly. Some people lose their jobs, others lose their businesses, while the great majority of people are little affected. Overtime will dry up and their real wage may slide a little, but you’ll even find the odd person doubting that the recession is real because the restaurants are still full. Even so, recessions are highly unpleasant times for economists (and economic commentators) to be alive. The public turns on economists, history is rewritten to blame them for everything, the public is not prepared to entertain discussion of any economic issue bar getting unemployment down, and the period of gloom and doom - the regular encounters with punters who can’t see how the economy will ever get back on its feet again - lasts interminably. Two or three years. So if you’ve never lived through a recession, be warned: they’re no fun.
