Last year, after the arrival of the pandemic and the coronacession as governments locked down the economy to stop the spread of the virus, we witnessed a rare economic event: a changing of the guard in the main policy instrument used to stabilise demand as the economy moved through the business cycle. Monetary policy stepped back and fiscal policy stepped forward. Governments always turn to fiscal policy when recessions arrive, but this change also has deeper, more structural causes, as we shall see. But first, a quick history of the relationship between fiscal policy and monetary policy.
For the first 30 years following World War II, the main policy instrument used was fiscal policy, with monetary policy playing a subsidiary, supporting role. That changed in the late 1970s when the advanced economies acquired a serious problem with high and rising inflation, and “stagflation” destroyed confidence in the simple (Phillips curve) trade-off between inflation and unemployment and the Keynesian approach to managing the macro economy. The conventional wisdom became that monetary policy, conducted by an independent central bank, should be the main instrument used for stabilising demand, with fiscal policy playing the subsidiary role.
Fiscal policy resumes its pre-eminence
But roughly 30 years later, the coronacession has a seen a reversion to fiscal policy playing the dominant role in short-term stabilisation, leaving monetary policy as a back-up. On the face of it, this was because the need for stimulus was so great and because, with interest rates already so low, monetary policy was left with little room to move. In the recession of the early 1990s, for instance, the official interest rate was cut by more than 10 percentage points. In the response to the global financial crisis of 2008-09, the rate was cut by more than 4 percentage points. In the response to the coronacession, the RBA has been able to cut by less than 1 percentage point before taking the cash rate virtually to zero, at 0.1 per cent. Since March last year the RBA has also resorted to “quantitative easing” – buying second-hard government bonds from the banks and paying for them merely by crediting amounts to the banks’ exchange-settlement accounts with the RBA. But how much this does to stimulate demand for goods and services (as opposed to demand for assets such has houses and shares) is open to doubt. By contrast, the federal budget has provided a total of $250 billion in direct stimulus over serval years, equivalent to 13 per cent of nominal GDP in 2019-20. (This compares with stimulus in response to the GFC of 6 per cent of GDP in 2008-09.)
Secular stagnation diminished the effectiveness of monetary policy
However, behind these immediate reasons for fiscal policy resuming the leading role are deeper, structural factors. As Treasury Secretary Dr Steven Kennedy has observed, there has been “a fundamental shift in the macroeconomic underpinnings of the global and domestic economies, the cause of which is still not fully understood”. This is a reference to the “secular stagnation” or “low-growth trap” into which the developed economics – including Australia – have fallen in the years since the GFC. Your modern, independent central bank – and the policy mix that gave top billing to monetary policy – was designed to cope with the problem of high and rising inflation. But, as former Reserve governor Ian Macfarlane has explained, inflation in the advanced economies has been falling for the past 30 years and is now below central bank targets. Low inflation means low nominal interest rates, of course. And, as Treasury’s Kennedy has reminded us, the global real interest rate, similar to the “neutral” interest rate – the real official rate that’s neither expansionary nor contractionary – has been falling steadily for the past 40 years. This has been due to structural developments that drive up savings relative to the willingness of households and firms to borrow and invest, he says. This “is likely due to some combination of population ageing, the productivity slowdown and lower preferences for risk among investors,” he says.
All this says that fiscal policy’s return to primacy over monetary policy is not just a temporary development, but the culmination of structural forces building up over decades, suggesting this will be a lasting change. It may be many years before inflation returns as a problem.
Fiscal policy and monetary policy: pros and cons
In considering the choice between using fiscal policy or monetary policy to manage demand, economists have identified three “lags” or delays involved in the process of the economic managers using either instrument to bring about change. First is the “decision lag”: how long it takes to decide what should be done. Second is the “implementation lag”: how long it takes before the decision can be put into effect. Third is the “impact lag”: how long it takes for the decision to work its way through the economy and have its full effect on the behaviour of households and businesses.
Monetary policy’s great advantage is that it can be changed so quickly and easily, by a decision of the RBA board (this covers the decision lag and implementation lag), whereas fiscal policy changes involve possibly protracted development of measures and consideration by cabinet (the decision lag), and then often delays before the measures can be put into effect (the implementation lag). But, once implemented, monetary policy changes probably take longer to have their full effect on the economy (the impact lag) than do fiscal policy changes.
And fiscal policy measures – whether on the tax or spending sides of the budget - can be targeted to fixing particular problems, whereas monetary policy is a “blunt instrument” or one-trick pony: it uses interest rates to encourage or discourage borrowing and spending. Fiscal policy includes the budget’s automatic stabilisers (to which, Kennedy has argued, the JobKeeper wage subsidy scheme and the temporary JobSeeker supplement, being open-ended, were temporary additions).
Economists at the IMF and elsewhere argue that fiscal policy multipliers are higher than earlier believed. This is partly because leakages to imports are less significant when all major governments are stimulating simultaneously in response to the same global shock (such as the GFC or a pandemic). But it’s also because the effect of fiscal stimulus isn’t reduced by the “monetary policy reaction function” – the decisions of independent central banks to raise interest rates because they fear the fiscal stimulus will add to inflation pressure.
Finally, monetary policy’s comparative advantage relative to fiscal policy is controlling inflation, not stimulating demand when the economy is again caught in a liquidity trap (secular stagnation). The same applies when the economic managers need to hold the economy together during a lockdown, then boost it back to life when the lockdown ends).
Now let’s turn to the basic facts you need to know about the two arms of macroeconomic management and how they are now being used to help the economy recover from the coronacession.
The monetary policy “framework”
Monetary policy - the manipulation of interest rates to influence the strength of demand - is conducted by the RBA independent of the elected government. Until now it has been the primary instrument by which the managers of the economy pursue internal balance - low inflation and low unemployment. Monetary policy is conducted in accordance with the inflation target: to hold the inflation rate between 2 and 3 pc, on average, over time. The primary instrument of MP is the overnight cash rate, which the RBA controls via market operations.
Recent developments in monetary policy
Because of six consecutive years of below-trend growth since 2011-12, the Reserve Bank cut its cash rate from 4.25 pc to 1.5 pc between the end of 2011 and August 2016. For more than 2½ years after that, it left the rate unchanged – a record period of stability. It’s not hard to see why it left the official interest rate so low for so long: the inflation rate has been below its target range; wage growth has been weak, suggesting no likelihood of rising inflation pressure; the economy had yet to accelerate and had plenty of unused production capacity, and the rate of unemployment shows little sign of falling below its estimated NAIRU of 5 pc, which the RBA revised down to 4.5 pc before the arrival of the pandemic.
But with the economy showing particular weakness in in the second half of 2018, it cut the cash rate three times in 2019, lowering it to 0.75 pc. Then, the advent of the virus led it to cut rates twice in one month, March 2020, lowering the rate to 0.25 pc. As we’ve seen, and despite its previously expressed reservations, it also joined the US Federal Reserve and other major central banks in engaging in quantitative easing. It announced its intention to buy sufficient second-hand government bonds to ensure the “yield” (interest rate) on three-year bonds was no higher than the cash rate. And, to ensure the banks keep lending to small business during the recession, it announced it was prepared to lend to them at the same rate as the cash rate.
By last November, however, the RBA had cut the cash rate to 0.1 pc, along with the target for three-year government bonds. It announced the further measure of spending $100 billion buying second-hand bonds with maturities of 5 to 10 years. Note that all the QE measures are intended to lower the interest rates paid by governments and private firms on longer-term borrowing. Note, too, that the RBA’s extensive purchases of second-hand bonds are equivalent to it funding about half the government’s budget deficit by “printing money”.
Fiscal policy “framework”
Until the arrival of the pandemic, fiscal policy - the manipulation of government spending and taxation in the budget – had been conducted according to the Morrison government’s medium-term fiscal strategy: “to achieve budget surpluses, on average, over the course of the economic cycle”. Since the coronacession, however, the government has adopted a two-phase strategy. Phase one, the economic recovery plan, involves huge fiscal stimulus to promote employment, growth and business and consumer confidence. It will remain in place until the unemployment rate is comfortably below 6 per cent. Phase two will involve a return to the long-standing medium-term fiscal objective. “Future adjustments in the fiscal stance will focus, in the first instance, on ensuring the economic recovery is strong, and over the medium term on stabilising and then reducing gross and net debt as a share of GDP,” the government says.
Recent developments in fiscal policy
At the time of its election in 2013, the Coalition government expressed great concern about the high budget deficit and mounting public debt it inherited, resolving to quickly get on top of both. But it turned out to lack enthusiasm for either cutting government spending or increasing taxes. And the years of below-trend growth caused by secular stagnation meant the debt kept growing and the budget didn’t return to balance until 2018-19. Mr Frydenberg was expecting the budget to return to surplus in 2019-20, but this was overturned by the pandemic, which caused the budget’s automatic stabilisers to go into reverse and return the budget to a large deficit. The government’s massive fiscal stimulus has added further to the deficit and public debt.
The economy’s rebound from the coronacession
The initial lockdown in the economy caused real GDP to contract by more than 7 pc in the March and June quarters of last year. The unemployment rate peaked at 7.5 pc in July, and the under-employment rate peaked at 11.4 pc in September. But, to everyone’s surprise, GDP rebounded strongly in the following two quarters, to end 2020 just 1 pc below where it was in December 2019. By March this year, total employment had rebounded to be a fraction higher than it was a year earlier. The unemployment rate was down to 5.6 pc (compared with 5.1 pc before the virus struck) and the under-employment rate down to 7.9 pc (compared with 8.6 pc). This rebound is positively amazing. It’s explained by four main factors.
First, the coronacession can’t be compared with an ordinary recession. Whereas ordinary recessions are caused by weak demand by households and firms, the corona recession was caused by a government-ordered temporary cut in supply, as federal and state governments sought to suppress the virus by closed our borders, ordered many industries to cease trading and people to leave their homes as little as possible. This meant that, as the lockdown was lifted, people and businesses were able to resume (almost) normal activity. The JobKeeper program was designed to keep workers attached to their employers until the lockdown ended. The JobSeeker supplement was intended to help anyone who did lose their job keep spending. The two programs were highly effective.
Second, the rebound strategy has been hugely effective in restoring employment to roughly where it was before the lockdown. However, the rate of unemployment has fallen by more than would normally happen in response to such a rise in employment. This is because the closing of our border to immigrants has caused the size of the labour force to grow by about half the rate it normally does, thus making it easier for increased employment to lead to reduced unemployment.
Third, when you remember the massive amount of fiscal stimulus the government has applied, it shouldn’t be so surprising that the economy has grown so strongly. What this proves is that fiscal stimulus works.
Finally, some people have concluded that the economy is now “roaring back” and will growing strongly in coming years – by implication, more strongly than it was before the virus arrived. If so, the pandemic will have somehow snapped the rich countries out of the secular stagnation that gripped it. I find this hard to believe. There’s been little change in the structural factors that have caught us in a low-growth trap. Business investment spending, productivity improvement and real wage growth remain low. What’s true, however, is that the economy has yet to feel the benefit of all the fiscal stimulus the government has committed to. About 40 pc of the total $250 billion stimulus has yet to be spent. And the outsized 12 pc household saving rate tells us much of money already spend by the government is still being held by household for future spending. It’s what happens after this stimulus has waned that we should be worrying about.