It's the budget, not interest rates, that must save the economy

According to a leading American economist, there are two views of the way governments should use their budgets ("fiscal policy") in their efforts to manage the macro economy as it moves through the business cycle: the old view – which is now wrong, wrong, wrong – and the new view, which is now right.

In late 2016, not long before he stepped down as chairman of President Obama’s Council of Economic Advisers and returned to his job as an economics professor at Harvard, Jason Furman gave a speech in which he drew just such a comparison.

I tell you about it now because, with our economy slowing sharply, but the Reserve Bank fast running out of room to cut its official interest rate so as to stimulate demand, it’s suddenly become highly relevant.

Furman says the old view has four key principles. First, "discretionary" fiscal policy (that is, explicit government decisions to change taxes or government spending, as opposed to changes that happen automatically as the economy moves through the ups and downs of the cycle) is inferior to "monetary policy" (changes in interest rates) as a tool for trying to stabilise the economy.

This is because, compared with monetary policy, fiscal policy has longer "lags" (delays) in being put into effect, in having its intended effect on the economy and in being reversed once the need for stimulus has passed. Scott Morrison’s inability to get his tax cut through Parliament by July 1, as he promised he could, is a case in point.

Second, even if governments could get their timing right, stimulating the economy just when it’s needed, not after the need has passed, discretionary fiscal stimulus wouldn’t work.

It could be completely ineffective because, according to a wildly theoretical notion called “Ricardian equivalence”, people understand that a tax cut will eventually have to be paid for with higher taxes, so they save their tax cut rather than spending it, in readiness for that day. Yeah, sure.

Or it could be partially ineffective because the increased government borrowing need to cover the budget deficit would force up interest rates and thus "crowd out" some amount of private sector investment spending.

Third, use of the budget to try to boost demand (spending) in the economy, should be done sparingly, if at all, because the main policy priority should be long-run fiscal balance or, as we call it in Oz, "fiscal sustainability" – making sure we don’t end up with too much public debt.

Now, I should explain that this view is the international conventional wisdom that eventually emerged following the advent of "stagflation" in the early 1970s, and the great battle between Keynesians and "monetarists" that ensued.

But Furman adds a fourth principle to the old view of fiscal policy: policymakers foolish enough to ignore the first three principles should at least make sure that any fiscal stimulus is very short run, so as to support the economy before monetary stimulus fully kicks in, thereby minimising the harm done.

Remind you of anything? The package of budgetary measures – the cash splashes and shovel-ready capital works – designed mainly by Treasury’s Dr Ken Henry after the global financial crisis in 2008 which, in combination with a huge cut in interest rates, succeeded in preventing us being caught up in the Great Recession, was carefully calculated to be "timely, targeted and temporary".

Furman says that, today, the tide of expert opinion is shifting to almost the opposite view on all four points.

That’s because of the prolonged aftermath of the financial crisis, the realisation that the neutral level of interest rates has been declining for decades, the better understanding of economic policy from the past eight years, the new empirical research on the impact of fiscal policy, and the financial markets’ relaxed response to large increases in countries’ public debt relative to gross domestic product.

Furman admits that this "new view" of the role of fiscal policy is essentially the "old old view" dating back to the Keynesian orthodoxy that prevailed between the end of World War II and the mid-1970s.

Furman outlines five principles of the new view of fiscal policy. First, it’s often beneficial for fiscal policy to complement monetary policy.

This is because the use of monetary policy is constrained by interest rates being so close to zero.

This isn’t new: the real interest rate has been trending down in many countries since the 1980s and was already quite low before the financial crisis.

Second, in practice, discretionary fiscal policy can be very effective. Experience since the crisis shows that Keynesian “multipliers” (where stimulus of $1 adds more than that to GDP) are a lot bigger than formerly thought.

And when you apply fiscal stimulus at a time when private demand is weak, there's little risk of inflation, so central banks won’t be tempted to respond by tightening monetary policy and lifting interest rates, thus countering the fiscal stimulus.

Third, governments have more “fiscal space” to run deficits and increase debt than formerly believed. The economic growth that fiscal stimulus causes means nominal GDP may grow as fast or faster than the increase in government debt.

Partly because of reform, the ageing of the population won’t be as big a burden on future budgets as formerly thought.

Fourth, if government spending involves investment in needed infrastructure, skills and research and development, it not only adds to demand in the short term, it adds to the economy’s productivity capacity (supply) in the medium term.

And finally, when countries co-ordinate their fiscal stimulus – as they did in their initial response to the financial crisis - the benefit to the world economy becomes much greater. This is because one country’s “leakage” through greater imports is another country’s “injection” through greater exports, and vice versa.

It seems clear Reserve Bank governor Dr Philip Lowe understands all this.

But whether the present leaders of Treasury, and Treasurer Josh Frydenberg’s private advisers, have kept up with the research I wouldn’t be at all sure.