Tuesday, 1 November 2011

Fiscal vs Monetary Policies

There aren't too many economic dinosaurs left who think that there is no link or some form of complementarity between fiscal and monetary policies. Each has a role to play in managing the business cycle and national savings yet each has its own 'specialities' when it comes to what each should best target.

In isolation, interest rate hikes and cuts are neither good nor bad just as Budget surpluses and deficits are neither necessarily good nor bad. What matters is the context for each policy position relative to the various signposts for the business cycle.

Right now, with an investment boom and what until recently looked to be an economy running at or even through full capacity, the need for fiscal consolidation is paramount. And the Government is certainly delivering with the fastest and most aggressive fiscal turnaround that Australia has recorded. In simple terms, the current fiscal contraction has the multiple objectives of dampening public demand to allow the private sector to grow, at the same time replenishing government savings as insurance against the next negative economic shock sometime in the future.

This fiscal contraction has complemented the demand management task of the RBA. The peak cash rate in the last tightening cycle (that ended yesterday) was 4.75%. This was the trough in cash rates in other cycles! The RBA has noted on many occasions the fact that fiscal policy is contractionary, meaning that the government is working with it to temper demand in the economy

And the proof of the success of overall policy is in the pudding. Inflation in underlying terms has been around or below the middle of the RBA 2-3% target for more than a year now. The September quarter underlying inflation rate of 0.3% was the lowest in 14 years. The RBA and other sensible analysts see it staying comfortably within target for the next couple of years. Just 3 years ago, recall with horror the fact that underlying inflation was what in modern terms was a Weimar Republic-esk 5.0%. Isn't it marvelous to see what can be done with sensible monetary and fiscal policy settings.

In closing, it is worth recalling how bad fiscal policy was in the period 2005 to 2007. While Budget surpluses were recorded, there were too small. With every windfall dollar gained, it was recycled into the economy through misguided spending and unhelpful tax cuts. These boosted demand and inflation and meant that the RBA had to hike to an eventual peak cash rate of 7.25%. Fiscal policy was throwing fuel on the fire while monetary policy was trying desperately to hose down those inflation pressures.

The policies were not in sync.

Thankfully that massive economic error of the Howard and Costello Government is a thing of the past and the current government seems hell bent of keeping a tight reign on fiscal policy, thereby allowing the RBA to do the work in support growth. And obviously, this will be done through easier monetary policy over the next year or so.

1 comment:

  1. Hello Stephen, are you a proponent of Modern Monetary Theory (MMT) and if so, how do your views on Australian monetary policies and inflation fit with your views on MMT?

    Two of the best debates on MMT I've seen are shown below.

    Future Fund, Sovereign Wealth Fund (SWF) and Modern Monetary Theory (MMT)

    MMT - Introducing Bartonland, and its modern monetary system; Explaining modern monetary theory, and the difference between gross and net private debt

    I wonder if the economic errors of the Howard/Costello government came about because the failed to fully comprehend modern monetary theory? What do you think?