Fiscal policy an essential tool for controlling the economy
Originally published in the Australian Financial Review, 17 September 2023.
In his farewell speech, RBA governor Philip Lowe urged better co-ordination between monetary and fiscal policy. What more should be done?
There was, in fact, co-ordination during the Covid period: both fiscal and monetary policy were strongly expansionary: as it turned out, excessively so. Any lack of co-ordination goes back a decade earlier, in the aftermath of the 2008 financial crisis.
Sensibly, most countries responded to the GFC with budgetary expansion, especially in 2009, when there was a degree of G20 co-ordination. But within a year, burgeoning government debt caused an about-turn, made more pressing by the debt crisis in the Euro-periphery – Greece, Spain, Portugal, Ireland and Italy.
International agencies – the IMF, the OECD and the Bank for International Settlements – all strongly supported this austerity.
Academics, too, urged contraction. The conventional wisdom at the time was that fiscal policy had little effect, either because expenditure would be restrained by the anticipation of future tax increases to repay government debt, or government borrowing would ‘‘crowd out’’ private expenditure through higher interest rates.
The result was a near-universal deficit-contraction for the five years following the GFC, which cut perhaps one per cent off growth in each of these years, resulting in a feeble recovery.
To offset this, central banks – led by the US Fed – invented a range of unconventional monetary policies: near-zero policy rates, quantitative easing (QE) and forward guidance.
The combination of budget austerity and extremely accommodative monetary policy was unfortunate. Low interest rates did little to boost economic activity, but instead inflated asset prices and encouraged speculative short-term trading in financial markets.
By then, concerns about budget deficits had faded in America. Dick Cheney observed that ‘‘budget deficits don’t matter’’. Certainly there was no discipline from the bond-market vigilantes who had hemmed in Bill Clinton’s spending. Ben Bernanke’s QE restrained long-term bond rates: his successors kept them low in the face of Trump’s deficits and, later, the huge Covid deficits.
When time came to return to normal interest rates after the Covid stimulus set off inflation in 2021, the sharp shift from near-zero was painful for all those who had taken decisions of the basis of low interest rates – not only borrowers, but those who had invested in bonds, which experienced capital losses as yields returned to normality.
Where does this experience leave policy co-ordination?
The first lesson is that, contrary to the common views of earlier decades, fiscal policy has a powerful impact on economic activity. The post-GFC austerity ensured a feeble recovery, and the post-Covid expansion was much more effective than expected.
Co-ordination via financial markets (relying on the bond-market vigilantes) doesn’t seem a reliable constraint. In many countries, not least Japan, debt/GDP has far exceeded conventional limits without apparent harm.
But how to keep the desirable disciplines on the two arms of policy – independence to pursue inflation control for monetary policy and structural debt containment for fiscal policy?
Retaining central bank independence makes sense and is largely a matter of retaining the current inflation target.
Fiscal policy presents a far greater challenge.
This was based on faulty data. But the strongest refutation of the small-government doctrine is the economic performance of the Scandinavian economies – and, for that matter, France and much of Europe – demonstrating that good growth is consistent with a substantially larger public sector. The size of government is a societal choice.
This shouldn’t be about doctrine. It is about persuading the community that, if they want a substantial public sector and comprehensive social services, they must pay for them through taxes.
The old analogy between government finances and family budgets doesn’t help. Nor does Polonius’s injunction to “neither a borrower nor lender be”. Governments create long-lasting assets which benefit future generations. Where these don’t operate at a profit, current generations should meet the deficit, but this still leaves room for an appropriate public debt level to build long-lasting, necessary infrastructure.
There may be a role for enhancing automatic stabilisers and even for an RBA-like independent body supplementing these with stabilising adjustments of GST or the superannuation levy, with a clear requirement for cyclical funding neutrality.
There should be enough co-ordination between monetary and fiscal policy to avoid a repeat of the post-GFC period, when the two were pushing in opposite directions. The continuing presence of the Treasury Secretary on the RBA board should be enough to ensure this. Resolving not to repeat QE would reinforce the bank’s separation from budget financing.
But beyond this, the fiscal challenge is the essentially political task of persuading the community to match its desire for public services with its willingness to pay.
Stephen Grenville is a former Reserve Bank deputy governor and a non-resident fellow at the Lowy Institute.