In the United States of America, Lawrence Summers tells us that “the case for a fiscal stimulus is stronger than at any time in my professional lifetime”. And most people - other than a few crazy republicans - agree with him. Paul Krugman and Greg Mankiw both add their voice: counter-cyclical measures are needed immediately. The same applies to the United Kingdom and Europe.
So why is the Australian Political Left and so much of the popular media still so debt-allergic? Why do our fiscal authorities refuse to respond to the threat of a recession?
And why are they so reluctant to finance new infrastructure investment at a time when new private investment has a very high risk premium? And why do we fail to recognise that monetary policy faces a breakdown in trust, irrespective of the lending rate?
Is fiscal policy effective?
Fiscal expansion can be effective in stimulating activity if the income effects outweigh the “crowding out” effects. Crowding out occurs through various channels:
- physical crowding out, which stems from demand pressure on productive resources; this only applies when the economy is operating close to full employment; it does not apply to the expected outlook over the next few months;
- direct interest rate responses by the central bank; this assumes a non-accommodating monetary policy, which now seems unrealistic;
- “financial/crowding out”, which occurs through indirect effects on financial markets and business confidence;
- exchange rate movements (with secondary effects on net exports); and
- some forward looking consumption smoothing by private agents (“Ricardian equivalence” effects where people are smart enough to recognise that higher deficit spending will lead to higher taxes later on).
Extreme monetarists play up these leaks, especially the last three. But such extreme circumstances are unsupported by the evidence.
A recent US academic review of the empirical literature on how best to craft fiscal stimulus (authored by Elmendorf and Furman, January 10 and available in Greg Mankiw’s blog) concluded that, provided a discretionary fiscal stimulus is seen as temporary, it would “boost economic activity more quickly than monetary policy” and would usefully supplement and reinforce any monetary stimulus”.
How to overcome implantation lags?
Well used, fiscal policy can clearly be effective as a contra-cyclical tool. But its biggest stumbling block is implementation lags, especially in periods when governments do not control the Senate.
To overcome the reluctance to increase tax rates in boom times, an independent body could be given the power (à la Gruen) to make small upward or downward adjustments to tax rates without the need for Parliamentary approval.
But another rewarding idea would be to have a number of sensible “ready to go” infrastructure projects for quick implementation. The advantages of such a proposal are potentially large.
First, spending increases on infrastructure projects produce a more effective contra-cyclical demand effect per dollar than tax changes - because it initially raises aggregate demand in the economy dollar for dollar, whereas a share of the tax cut is saved.
Second, the benefit-cost ratio on any new infrastructure project is much more favourable if it is started at a time when there is a lot of spare capacity in the engineering and construction industry and if it were sensibly cut off soon as soon as private building finance becomes more readily available (which point to the need to target low-gestation infrastructure).
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About the Author
Fred Argy, a former high level policy adviser to several Federal governments, has written extensively on the interaction between social and economic issues. His three most recent papers are Equality of Opportunity in Australia (Australia Institute Discussion Paper no. 85, 2006); Employment Policy and Values (Public Policy volume 1, no. 2, 2006); and Distribution Effects of Labour Deregulation (AGENDA, volume 14, no. 2, 2007). He is currently a Visiting Fellow, ANU.