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Keywords:

  • exchange rate;
  • fiscal stimulus;
  • Global Financial Crisis
  • E62;
  • E63

Abstract

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

Governments have reacted to the economic slowdown arising from the Global Financial Crisis by injecting a fiscal stimulus into their economies. This policy will be ineffective when the country has a floating exchange rate, because the resulting inflow of funds will cause the exchange rate to appreciate, offsetting the stimulus effect. The experience of the Great Depression has suggested a better package of policies to deal with a global slowdown.


1. Introduction

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

The technical aspects of the Global Financial Crisis (GFC; specifically, the losses from subprime lending) have largely worked themselves out although there may be some further secondary losses. However, the major problem now is one of confidence or, as Keynes would have expressed it, low animal spirits. Governments have the task of devising policies to achieve short-term stabilisation without creating further difficulties in the future.

The purpose of this article is to survey the possible policy actions and to consider what would be the most appropriate package. The policies considered are:

  • • 
    fiscal stimulus which will be discussed in terms of deficit spending arising from tax cuts, increased personal benefits or public works;
  • • 
    monetary (interest rate) policy;
  • • 
    wages policy; and
  • • 
    a group of policies such as bank guarantees, increased trade barriers and financial re-regulation, once thought to be discredited, but which have re-emerged in political life.

2. Deficit Spending

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

The Australian Government introduced a spending package of around $10 billion before Christmas in 2008 and a $42 billion package in February 2009. The budget is expected to remain in deficit for some time. We will say nothing about the more ludicrous aspects of this policy – handouts to taxpayers, payments to the dead or people living overseas, subsidies for pink bats that will need to be imported, school halls that are not needed, etc. Most commentators support some form of deficit spending and they often represent it as a return to Keynesian thought. Certainly, Keynes did recommend such a policy as appropriate for the period in which he was writing (the 1930s). However, current conditions in Australia differ from those faced by Keynes in two important respects. First, we have a floating exchange rate whereas exchange rates in the 1930s were quasi-fixed. Second, Australia has a very low (probably negative) personal savings ratio.

The reason that a budget deficit is undesirable in Australia can be explained in terms of the twin deficits relationship which, in terms of the national accounts, is an identity and, in terms of intended expenditures, is an equilibrium condition.

It says:

  • image

where M refers to imports, X refers to exports, I refers to investment, S indicates savings, G stands for government spending, T for taxes, CAD = MX is the current account deficit (the negative of net exports) and Df = GT is the budget deficit.

Therefore,

  • image

This relationship was developed to explain the link between the government budget and current account deficits. The problem for economic policy-makers in Australia is that household saving is close to zero so that, if the budget is in balance, private investment must be funded by offshore borrowing. A government budget surplus eases the pressure on the current account. The rubric that a government should maintain a surplus over the cycle hardly answers this need.

Tatom (2006) points out that for the United States there is little correlation between the current account and budget deficits. However, this is to be expected. The relationship given before is an identity, but if the (IS) term is left out, there is no reason for there to be a strong relationship between the remaining two terms.

There is a cognitive dissonance in our understanding of the economic role of budget deficits/surpluses. The recent surpluses were seen as necessary to pay down public debt. In fact there is no reason why a government should not run a deficit if the borrowing is used in productive investment. Also, a reasonable amount of outstanding government debt (risk-free assets) is useful in providing an anchor for financial markets. A recent criticism of the government’s packages – generational inequity – is also invalid. If the packages work, future generations will be better able to meet the obligations arising from them. The question is: Do they work? The true reason for budget surpluses is to offset our very low saving rate and to prevent current account crises. It appears that in creating surpluses we have been, in the words of T.S. Eliot, doing the right thing for the wrong reason. The problem with this situation is that there is a strong temptation to stop doing the right thing once the original reason is identified as false.

Assume now that the government increases its deficit (or reduces its surplus). Assume also:

  • • 
    the deficit has no monetary effects, that is, it does not affect interest rates. This is the case in Australia where the Reserve Bank of Australia (RBA) sets the cash rate;
  • • 
    investment is not sensitive to income; and
  • • 
    savings is approximately zero (in fact, it has recently increased a little).

Then the increased deficit will simply affect the CAD. The reduction in net exports will offset the increase in the deficit (reduction in the surplus) so that aggregate demand is unchanged. The exchange rate will appreciate to be consistent with the higher CAD. The appreciation of the currency will cause consumers to substitute foreign goods for domestic goods.

In these circumstances, the increased deficit will have few direct effects, for example, in the form of inflation or changes in interest rates. This is a standard result arising in a floating exchange rate regime under which the monetary authorities can set the domestic interest rate. It is in fact the Mundell-Fleming result (see, e.g. Mundell, 1963). Tatom (2006) points out that the US budget deficit does not affect US interest rates, but this result is not surprising. The US also has a floating exchange rate. There may be an indirect effect if deficit spending has a positive impact on consumer or business expectations but this is a very unreliable channel of influence.

However, the reduced surplus (increased deficit) could lead to a serious current account crisis. The impact of this crisis will depend on the tolerance of global financial markets to large current account deficits and the (related) reactions of the exchange rate.

The long-term impact of deficit spending depends on the productiveness of the assets created by the spending. This suggests that infrastructure investment should be favoured. Increases in the first homebuyers’ grant are particularly suspect because they could easily encourage the subprime lending which was the ultimate source of our economic problems.

The impact of deficit spending can be further elucidated by considering the RBA balance sheet. Table 1 is a simplified version of that balance sheet for December 2008.

Table 1. Reserve Bank of Australia (RBA) Balance Sheet, December 2008 ($million)
AssetsLiabilities
  1. Source: Bulletin of the RBA.

Foreign currency assets89,754Notes on issue51,317
Securities69,823Exchange settlement accounts18,514
  Overseas institutions36,660
  Government deposits15,347
Other assets Other liabilities 39,314
 161,152 161,152

Two preliminary points can be made. First, balances in Exchange Settlement Accounts are almost $18 billion higher than their usual level. That is, banks were unwilling to lend and preferred to deposit cash with the RBA – they voluntarily increased their reserve ratios. This reaction is presumably a result of uncertainty about future funding and it is one dimension of the “credit crunch,” which contributed to the downturn in the Australian economy. Another aspect of the credit crunch is the way in which market interest rates (banks’ cost of funds) rose above the RBA cash rate.

Second, the table shows that as of December 2008 the RBA had already borrowed $36.66 billion from overseas institutions. This figure is usually very small.

When the government runs a deficit, it is forced to cover it by selling bonds, most likely to overseas investors. Initially, government deposits will go up by an equivalent amount, but the government will then spend this money. The RBA must then do something with the assets it has acquired. The alternatives are as follows.

  • • 
    Sell foreign currency assets. It is clear that the Bank does not hold enough of these assets to absorb the projected increase in budget deficits.
  • • 
    Issue additional currency (i.e. print money). This is an undesirable solution because of its inflationary impact.
  • • 
    Sell Treasury bonds to the public, especially overseas investors.

The third alternative is the only feasible reaction, but it is likely that most of the bonds will need to be sold to overseas investors. As already noted, this will produce a higher CAD and also create a “hot money” problem, that is, a danger that the overseas investors will suddenly quit the Australian bond market. Unlike $US, $A is not a reserve currency. Therefore, it is likely to be difficult to sell Australian government bonds. Also, it will be necessary to raise bond rates to sell bonds and this will have a contractionary effect on the economy.

This discussion also illustrates the role of the exchange rate in stabilising the economy. Romer (1991) argues that the Great Depression in the United States was ended not by fiscal stimulus but by monetary expansion brought on by an undervaluation of $US. Valentine (1988) argued on the basis of a macroeconometric model that devaluation of the pound contributed to the Australian recovery from the Depression. Australia now has a floating exchange rate which depreciates to maintain the competitiveness of Australian products. As a result, some self-adjustment has already occurred in reaction to the global downturn. As noted before, a budget deficit will cause the $A to appreciate and reverse this adjustment process.

3. Interest Rate Policy

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

In a floating exchange rate regime, monetary policy is effective because the authorities are able to set the cash rate – although the market sets longer-term rates. In the past decade the Reserve Bank has managed this process very well, generating much less interest rate volatility than the US Federal Reserve Bank. However, the Bank faltered in 2007–2008 by raising rates over a period when the emergence of the subprime crisis was already clear. US writers place its commencement in August 2007 (see Bailey et al., 2008). More recently, it has been very slow to reduce rates in the context of a slowing economy. It should not take rates down to US or Japanese levels because that would simply reproduce the conditions that created the Crisis. Fleckenstein and Sheehan (2008) have examined the way in which very low interest rates in the United States contributed to the Subprime Crisis.

One advantage of monetary policy is that its setting can be changed very quickly. An expansion of government spending, if it is to be done effectively, cannot be done quickly. It takes time to identify and organise productive infrastructure projects. Therefore, the authorities should rely on monetary policy in their initial reaction to a downturn.

One problem with the discussion of monetary policy in Australia is the obsession with the banks’ willingness to “pass on” changes in the cash rate. In fact, there is nothing to pass on. What matters are movements in the banks’ cost of funds (i.e. longer-term market interest rates) and these rates have risen because of the market pressures arising from the Crisis. The Reserve Bank could clarify this debate by publishing an index of banks’ cost of funds.

4. Wage Restraint

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

So far, little has been said about the impact of wage increases on the slowdown. In the 1930s, a wage reduction occurred in the interests of “sharing the burden.” It would be counterintuitive and counterfactual to argue that real wages do not affect unemployment (see Valentine, 2004). In this environment the government should be urging wage restraint. However, it appears that the rate of wage increase rose rather than fell in the second half of 2008.

In commenting on possible changes in wages policy, the Prime Minister says (Rudd (2009, p. 26)):

Neo-liberals such as Alan Moran, of the Australian Institute of Public Affairs, argue that the cost of the recession should be borne by employees, through wage cuts and retrenchment – exactly the position of the US Treasury Secretary Andrew Mellon at the outset of the Great Depression.

This comment draws on a line of thinking that has surfaced in recent discussions of recovery policy. It is based on a concept of “fairness.” We should discover who was responsible for the Crisis and only those people should pay any cost. In fact, we have all suffered a loss already and the major aim now must be to minimise further losses. The choice posed by the Prime Minister is non-existent; the actual choice is between wage cuts or retrenchment.

The government could consider suspending the superannuation guarantee charge (SGC) for a short period. Such a policy could be combined with a staged increase in the SGC percentage in later years to minimise the unfavourable long-term effects of its suspension on the saving ratio. In the long-run we need more savings, but not in 2009. That is, we need to save for a rainy day but not on a rainy day. Alternatively, the Commonwealth Government could subsidise the states in return for an equivalent reduction in payroll tax.

As a long-term policy, it might be useful to tie the SGC to the RBA commodity price index. This will mean that more will be saved when the economy is doing well, but less when it is facing hard times. In the latter case, the cost of labour is reduced so that unemployment is contained. Alternatively, the SGC could be linked directly to the unemployment rate.

5. Other Policies

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

A number of other policies have been suggested or actually introduced to deal with the Crisis. First, the government has guaranteed deposits with deposit taking institutions and banks’ offshore borrowings. These guarantees made explicit the implicit guarantees which have existed for some time. They were necessary to ensure that banks had access to funding and to precent a “credit crunch” from developing. As already noted, the initiative was not entirely successful in achieving the latter objective. There are two problems with this policy, which are as follows.

  • • 
    They reinforce “moral hazard” in which managements take excessive risks because they believe that the government will bear the cost if things go wrong.
  • • 
    There were unintended consequences. For example, there were outflows of funds from deposit funds which were not guaranteed. Some managed funds had to suspend withdrawals to deal with the outflows.

Nevertheless, the extent of moral hazard arising out of a guarantee of deposits is not as great as that arising from the related policies adopted in other countries. These involved “bailing out” banks often by buying shares in them (a process often described roughly as “nationalisation”). In these cases, the management is protected which could provide it with an incentive to increase its level of risk taking. In particular, to the extent that the support of banks arises because they are “too big to fail,” they have an incentive to become bigger, for example, by increasing their leverage.

Second, the Crisis has led to demands for financial reregulation. Rudd (2009) is a typical example. These demands have reversed the results of discussions in the seventies and eighties of the last century, which concluded that financial regulation had been extended to a point where the costs far exceeded the benefits. It is true that the Crisis indicates a need for some adjustments but wholesale re-regulation is certainly not called for. The things that could be done include:

  • • 
    put lending under a single regulator (in Australia, the Australian Prudential Regulation Authority (APRA) would be the desirable choice) and ensure that it is done in line with traditional credit standards;
  • • 
    as suggested by Valentine (2007), these standards should include a maximum loan-to-valuation ratio (LVR), which can be reduced if an asset price bubble is emerging;
  • • 
    as Neal (2008) has argued, hedge funds need to be regulated especially with respect to disclosure of their degree of leverage. As many of these funds are registered in tax havens, this regulation would have to be done on an international basis; and
  • • 
    the role of credit rating agencies needs to be reconsidered and their basic conflict of interest (their fees are paid by the issuers of the paper they are rating) removed.

It is important that this process does not involve the prohibition of or unnecessary restriction of the use of the financial instruments or processes which were abused in the run up to the Crisis. These include derivatives, leverage and the securitization of mortgages. Equity release (borrowing on equity in homes) is desirable because it releases savings for investment in more productive (i.e. higher-yielding) activities.

Third, there have been some unfortunate moves towards increased trade protection. Demands to “buy American” or “buy Australian” have emerged. These calls neglect one of the major lessons of the Great Depression – that precipitating a trade war deepens and lengthens the recession rather than the reverse. It is accepted that the depth of the Great Depression was greatly increased by the Smoot-Hawley tariff in the United States which provoked similar tariffs in many other countries (see Scitovsky, 2008, p. 147).

One objective of tariffs is to maintain a high level of wages in the protected industries. It was argued earlier that it is actually desirable to reduce wages in a severe downturn. A tariff supports the wages of some workers at the expense of the jobs of others. It has been argued that the Smoot-Hawley tariff retarded recovery in the United States because it supported an inappropriately high level of wages (see, e.g. Smiley, 2002, p. 63). Tariffs protect some workers’ jobs and income, but put others into unemployment. Also, tariffs cause consumers to pay higher prices for their purchases and this burden falls disproportionately on poorer consumers, that is, tariffs are regressive. It is to be hoped that political leaders can resist populist pressure to repeat this error.

6. Conclusion

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References

There is a package of policies which can be used to minimise the impact of the GFC on Australia. It is the package which would have moved Australia out of the Great Depression (see Valentine, 1988). It also represents the consensus on the US recovery in the 1930s. This package includes:

  • • 
    a lower interest rate policy;
  • • 
    changes which reduce labour costs for employers;
  • • 
    facilitating a low value for $A; and
  • • 
    judicious expenditures on productive infrastructure projects.

However, it is unwise to expand the budget deficit because this will cause an appreciation of $A which will offset the stimulatory effect of the deficit and could lead to current account problems.

References

  1. Top of page
  2. Abstract
  3. 1. Introduction
  4. 2. Deficit Spending
  5. 3. Interest Rate Policy
  6. 4. Wage Restraint
  7. 5. Other Policies
  8. 6. Conclusion
  9. References
  • Bailey, M.N., Litan, R. and Johnson, M.S. (2008), ‘The Origins of the Financial Crisis’, Paper 3, Fixing Finance Series. Brookings Institution, Washington.
  • Fleckenstein, W.A. and Sheehan, F. (2008), Greenspan’s Bubbles. McGraw Hill, New York.
  • Mundell, R. (1963), ‘Capital Mobility and Stablization Policy under Fixed and Flexible Exchange Rates’, Canadian Journal of Economics, 29, 47585.
  • Neal, P. (2008), ‘The Subprime Mortgage Crisis: Lessons for Regulators’, Policy, 24 (2), 1925.
  • Romer, C.D. (1991), ‘What Ended the Great Depression’, Working Paper No. 3829, National Bureau of Economic Research.
  • Rudd, K. (2009), ‘The Global Financial Crisis’, The Monthly, February, 209.
  • Scitovsky, T. (2008), ‘Tariffs’, in Durlauf, S.N. and Blume, L.E. (eds), The New Palgrave Dictionary of Economics, 2nd edn., Vol. 8. Palgrave Macmillan, New York; 1459.
  • Smiley, G. (2002), Rethinking the Great Depression. American Ways Series, Chicago.
  • Tatom, J.A. (2006), ‘Not All Deficits are Created Equal’, Financial Analysts Journal, 62 (3), 1219.
  • Valentine, T.J. (1988), ‘The Battle of the Plans: A Macroeconometric Model of the Interwar Economy’, in Gregory, R.G. and Butlin, N.G. (eds), Recovery from the Depression. Cambridge University Press, Cambridge, 15272.
  • Valentine, T.J. (2004), ‘Real Wages and Unemployment: State of the Debate’, Agenda, 11 (4), 30720.
  • Valentine, T.J. (2007), ‘The Regulation of Investments’, Paper presented to 36th Australian Conference of Economists, Hobart, September, Economic Papers, 27 (3), 27285.