How to iron out economic volatility

For the best part of a century, modern macro-economic policy has sought to tame the bulls and bears that plague the economy. Recessions hit workers and their families hardest, but they also deter firms from making long-term investments. When the economic environment is uncertain, risky projects are placed on the backburner, and growth stalls. With a smoother business cycle, living standards grow more rapidly.

Like other countries, Australia sought to achieve macro-economic stability by taking monetary policy out of the hands of politicians and giving it to the Reserve Bank of Australia. While monetary policy will always be the main tool of stabilisation, its effects on the economy are uneven, operating primarily on business investment and capital-intensive consumption.

The other form of macro-economic stabilisation is fiscal policy via taxes and government spending. In the past 15 years, the most prominent use of fiscal policy has been the Working Nation package - a multi-billion dollar spending program designed to counter the effects of the 1992 recession. While the package probably did some good, we now know that because of lags in spending on capital construction projects, its effect was not fully realised until 1994, when the recession was over.

One way of dealing with the problem of lags in spending is to abandon the use of fiscal policy for macro-economic stabilisation. This has essentially been the approach adopted by the Howard government. This is unfortunate. In hard times, governments should have the flexibility to use debt-financed fiscal policy to bring the economy out of recession.

How can we use fiscal policy to stabilise the economy without the risk that it will be hijacked for partisan advantage?

One proposal, mooted variously by Princeton economist Alan Blinder and Australian economist Nicholas Gruen, is to allow an independent authority to control a small portion of fiscal policy. The government would still decide big-picture issues, such as where government money should go and how progressive the tax system should be. But an independent authority such as the RBA could be given the power to adjust tax rates up or down by up to one percentage point, to smooth the economic cycle.

The change would affect both corporate and personal income tax rates. Unlike other tax changes, which cannot take effect until the next financial year, flexible fiscal policy would have an immediate impact. Small changes in the marginal tax rate can quickly have an effect on employees' pay packets and corporate revenues, influencing consumer and business spending decisions. Independent fiscal policy will also provide a check on the fiscal imprudence of governments.

One criticism of this proposal is that the Charter of Budget Honesty Act, under which the federal government commits to balancing the budget over the business cycle, already ensures sound fiscal policy. But monitoring and enforcing the charter is difficult. Even if it were not difficult, an independent fiscal authority has the ability to act more quickly than the parliamentary budget process to address economic downturns.

Another criticism is that placing a portion of fiscal policy in the hands of bureaucrats is undemocratic. Much the same argument was once made about independent monetary policy, which seemed similarly radical 20 years ago.

Harvard University economist Alberto Alesina proposes a straightforward way of deciding which tasks should be in the hands of independent experts, and which in the hands of politicians. Politicians are best suited to resolving questions of values, such as whether we should spend more money on education or defence. In contrast, independent experts such as the Reserve Bank are best at highly technical tasks and management processes where the policy goals are generally agreed, such as smoothing fluctuations in the economic cycle.

How might this be implemented? Gruen proposes an interim step, an "advisory fiscal authority", which could evolve into a fully independent authority. Such a modest reform should not "scare the horses", yet would still take us along the path towards providing the RBA with both monetary and fiscal levers. Ultimately, an independent fiscal authority would improve our ability to smooth economic fluctuations, ensuring less volatility in the economy.