The Rudd Government is getting it about right

What does the Rudd Government need to be doing to restore the Australian economy back to full health? What do economists have to say?

The first point to make on this subject is (the not very original one) that the Rudd Government is severely circumscribed in respect of what it can do in response to the direct, and indirect, effects of the global financial crisis.

The GFC (the acronym now widely used as a way of describing the complexities of the phenomenon in a shorthand way) has its origins in other parts of the world. But such is the magnitude of the problem that has been created, and the degree of integration of the Australian economy with the international economy - vastly greater than it was in the early 1930s when the effects of the Great Depression were still transmitted very sharply to Australia - that domestic economic activity has been fundamentally and unavoidably affected.

Virtually every element of aggregate expenditure has fallen.

In some respects - for example, expenditure on Australian produced commodities on the part of overseas buyers (i.e. exports) - any Australian government is virtually powerless. If China doesn’t want as much coal as it has demanded in the last few years then there’s not much we can do about it.

In other respects what the government can do is also limited. If someone employed by a mining company is made unemployed and their income suddenly falls then they simply haven’t got the income to spend on consumer goods. And business enterprises won’t undertake investment in new equipment or factories if they don’t think they’ll be able sell the products they produce.

The question is, however: can the government do anything first, to ameliorate the consequences of the GFC and second, to compensate for the fall in aggregate expenditure that will inevitably occur?

The answer to both questions - as the Rudd Government itself more or less explicitly concedes - is: “something, but only something”. Inevitably in 2008-09 and for the next one or two years at least the rate of increase in GDP in Australia will fall to very low and probably, for at least part of that time, negative levels.

The critical question then becomes: “is the government doing as much as it can, and is it doing the right things, to ameliorate, and compensate for, the effects of the fall in expenditure that has been a consequence of the GFC?”

The answer to this question brings out all the stories about economists disagreeing with each other. But most would argue: “yes”; or at least “probably yes”.

The Rudd Government’s measures have sought to stimulate aggregate expenditure by two principal means. The first is increased expenditure by governments directly on a range of “infrastructure” (such as school buildings). The second is one-off cash handouts (i.e. a simple transfer of government revenue) to individuals on the assumption that they will spend at least a large part of this revenue and boost consumption and investment expenditure over and above the levels they would have been in the absence of the transfers. Among other measures is a grant to homeowners to compensate them for expenditure on home insulation.

There has been relatively little criticism of “infrastructure spending”, aside from some questioning about the priorities, and (particularly in respect of encouraging private expenditure on home insulation) in respect of the extent such expenditure will flow out of Australia to foreign-owned enterprises rather than create employment within Australia. Any debate there has been has been focused on the temporal issue: how quickly will this policy translate into actual (employment and income-creating) expenditure given the lead times typically involved? Concern has been expressed that relatively few of the proposed infrastructure projects are “shovel ready” in that they can be started immediately; some have unavoidable lead times of up to several years.

The cash payments have led to greater public debate among economists. The basic rationale of the policy is simple: give people money; they’ll spend it (or at least a large part of it); this will boost consumption expenditure (and indirectly investment expenditure as firms will see a continuing need to produce goods and services to meet sustained consumer demand, and will undertake the fixed business investment they see as necessary to do this).

Not all the revenue will stimulate economic activity in Australia, certainly. Some will “leak” out of the economy as some of the expenditure will be directed to imported goods (and hence will stimulate expenditure in other economies); and some won’t even go to people in Australia in the first place (a surprisingly substantial number of recipients of pensions have returned to their place of birth).

Most controversially and speculatively it has been argued some of the revenue will be saved, or used to pay off accumulated debt, rather than spent. It is in this respect that economists have been most vocal.

But when one “balances out” conflicting views the consensus is that the Rudd government has done what is probably the best thing it could have - particularly in view of the fact that this issue is one not merely of economics but politics as well.

To have not acted was not really an option. If the “stimulus package” will provide less of an economic stimulus to economic activity and employment than some may have hoped it will at least have had some effect and save the government from the charge that it simply “stood by”. No matter how bad circumstances become at least the government can say “it would have been worse had we not acted”.

But - the main point that is made here - is that all of this fails to address the really important questions at the moment.

These are two-fold:

• can we do anything (other than devise a “stimulus package”) to more effectively address the present problem? and
• can we do anything to stop it recurring?

If these questions were what economists were debating they would be rather more widely respected than they are at the moment. Some are, it is true. But the economists being given more air time on current affairs shows are those debating the (rather speculative and ultimately relatively unimportant) question of whether tax cuts or one-off cash payments are likely to have a greater stimulative effect on consumption spending.

On the first of the more important questions set out above, the Rudd Government (advised it must be acknowledged by economists in the public service, the Reserve Bank and academia - though sadly probably not many in the latter) seems to have again got it pretty well right.

The return of “normalcy” requires above all that financial institutions be willing to lend money to any individual or business enterprise - including other financial institutions - when it is reasonably clear that the money will be used, be it for the purchase of a house or investment in machinery or equipment, or in “on-lending”, in a way that the borrower will repay the loan. This is not the case at the moment. The failure of the financial system to deliver in this respect is the most significant barrier to the resumption of some categories of economic activity.

For this to be achieved requires the “quarantining” of the so-called “toxic assets” held by some financial institutions in order that they, and other, financial institutions can resume “normal business” on the basis of prudent financial principles. This appears to be the proposal that the Australian prime minister will be taking to the forthcoming meeting of the G20. Its adoption by the world’s largest nations (and in particular those in which financial institutions have accumulated debts which have little prospect of being repaid in the short term) would be an important step in returning the functioning of the financial system to its “normal” role. This is as an important mechanism for allowing expenditure to be made on the basis of money borrowed - where there is a good prospect of the money being used in a way so that can be repaid.

Of course this general principle needs to be translated into a concrete proposal. One idea that has been canvassed is that financial institutions with “toxic assets” be required to hive these off, perhaps into a subsidiary of the bank which will have to deal with these assets separately to its “normal” operations. It may be that the plan involves some assistance by governments and some short-term concessions to debtors in regards to their financial obligations, perhaps in exchange for a “signing over” of rights to future capital gain, the proceeds of which will, in the longer run, help to fund the immediate assistance.
This is not the only possibility and it may not be the best. But it would help the reputation of economists if they could play a more positive role in making suggestions as to how this principle could be translated into practice.

Looking to the future, again, we might look hopefully to economists who have an understanding of the financial system for proposals in regards to the regulation of financial institutions. “Regulation” may in fact only need to be relatively light. It might not amount to much more than agreeing that governments should desist from influencing financial institutions to behave imprudently - as they were by US legislation under the title of “The American Dream” that forced US banks to lend to home buyers who had little or no prospect of repaying their loans.

Whatever the case here’s an issue to which the world might look hopefully to the economics profession to advise it on, and in respect of which economists may gain more kudos than they do arguing over the effectiveness of different mechanisms of providing an economic “stimulus”.

As to the “question du jour” - whether the Rudd Government’s actions so far have been an appropriate response to the current crisis - perhaps all that there’s any point in saying is: “all things considered, probably yes”.