Former Treasurer Wayne Swan is releasing some of his briefing notes from the GFC ahead of the launch of his upcoming memoir, The Good Fight. The first instalment from a meeting at the Prime Minister’s residence with the Prime Minister, Treasury Secretary and other senior officials on 4 August 2008 is remarkable for its acknowledgement of monetary offset. Indeed, the notes could just as easily have been written by Scott Sumner:
There are three broad considerations the Government would need to keep in mind in taking a decision to engage in discretionary [fiscal] action:
• The Reserve Bank through its control over interest rates, determines the overall level of aggregate demand in the economy, and the Bank would likely take account of any fiscal stimulus in its monetary decisions – that is, more spending would keep interest rates higher than otherwise…
The bottom line is that in the event of a shallow downturn, discretionary [fiscal] action may not achieve any noticeable outcomes in terms of growth and unemployment, but would leave rates higher, erode the [budget] surplus and put at risk the Government’s fiscal credibility.
These costs of course need to be weighed against the potential political costs of being seen to do nothing…
Needless to say, the ‘political costs’ argument won in the end, with the first discretionary fiscal stimulus announced in October 2008.
It is often argued that fiscal rules are unlikely to serve as an effective discipline on fiscal policy in the absence of political will. This is undoubtedly true, but fiscal rules can be seen as a mechanism through which the political will to tackle issues in relation to long-run fiscal sustainability can find more effective expression. If politicians are unwilling to put into law what they say they are committed to doing, then it is less likely that they will deliver on these commitments. The willingness to adopt fiscal rules can thus be seen as a test of the degree of political commitment.
Measures to strengthen Australia’s fiscal institutions should be a key recommendation of the Abbott government’s Commission of Audit.
This week’s abolition of the local federal debt limit is a welcome development, but only because a debt limit in absolute dollar terms is not a well specified fiscal rule and was never intended to serve as such. The US debt limit, from which Australia’s took its inspiration, was also never intended to be a binding constraint on government borrowing, although threatened to become one on the back of poor fiscal outturns.
The US debt ceiling was first put in place in the 1930s. Its purpose was to alleviate the US Treasury from having to seek Congressional authorisation for each individual debt issue. Instead, Treasury was given discretion to issue debt within the overall limit specified by Congress, but not in the expectation that it would serve as a binding constraint on government borrowing. Since 1960, the US debt limit has been amended by Congress 78 times. More recently, the US debt limit has been politicised and used a proxy fiscal rule, but is unfit for this purpose. Government borrowing is ultimately a product of government spending in excess of revenue and it is government spending that needs to be controlled.
A net debt limit specified as a share of GDP rather than in absolute dollar terms is a better specification and a useful addition to a suite of fiscal rules designed to impose fiscal discipline, as I have argued elsewhere.
A traditional objection to fiscal rules is that they might force a fiscal consolidation or prevent the operation of automatic stabilisers so that fiscal policy becomes pro- rather than counter-cyclical. However, as argued in my AFR op-ed Monday, this is only a problem in the absence of an independent monetary and exchange rate policy. An inflation targeting central bank and a floating exchange rate allows fiscal policy to focus on supply-side issues and long-run fiscal sustainability without being pre-occupied by aggregate demand management and macroeconomic stabilisation.
The 30th Anniversary of the Floating of the Australian Dollar
I have an op-ed in today’s AFR on the occasion of the 30th anniversary of the decision to float the Australian dollar. This year also marks the 20th anniversary of the adoption of implicit inflation targeting by the Reserve Bank, although a formal inflation target was not adopted until August 1996. As I note in the op-ed, the combination of these two macroeconomic institutions fundamentally changed the role of fiscal policy in the economy. Yet much of our macroeconomic policy debate remains stuck in the pre-float era. Full text below the fold (may differ somewhat from edited AFR text).
The Fraser Institute has released a collection of essays on Federalism and Fiscal Transfers, including my essay on Australia’s experience with horizontal fiscal equalisation. The efficiency and equity implications of horizontal fiscal equalisation in Australia are theoretically and empirically ambiguous, arguing against overly ambitious attempts at equalisation. The 2002 Garnaut-FitzGerald Review of Commonwealth-State Funding still remains the best reform proposal.
Scott Sumner has a new paper published by the Mercatus Centre, Why the Fiscal Multiplier is Roughly Zero. The argument will be familiar to regular readers of his blog, but the paper serves as a nice summary of what has become known as the Sumner critique. As Scott would be the first to concede, this is not a new or unconventional idea, but somehow the economics profession lost sight of this basic insight into monetary-fiscal interactions during the global financial crisis.
The Sumner critique is particularly relevant to a small open economy like Australia, where the entire institutional framework for macroeconomic policy is arguably built around this insight. With a floating exchange rate and an inflation targeting monetary policy, the change in the budget balance as a share of GDP from one year to the next is a macroeconomic irrelevance by design. This allows fiscal policy to focus on microeconomic and supply-side issues.
In testimony before various parliamentary committees, former Treasury Secretary Ken Henry and RBA Governor Glenn Stevens explicitly acknowledged monetary offset in the context of the 2008-09 fiscal ‘stimulus’, but resorted to the argument that it was better to rely on a mix of macroeconomic instruments rather than monetary policy alone, citing alleged adverse side-effects from very low interest rates. In the US context, Sumner notes the real reason for such arguments: politically, the monetary authority cannot be seen to be explicitly undermining the efforts of the fiscal authority.
In Australia, it is often argued that the government should not cut government spending or return the budget to surplus because it would supposedly be contractionary for the economy. This not only ignores the role of fiscal policy within Australia’s macroeconomic policy framework. As Scott notes, the assumed underlying ‘estimates of fiscal multipliers become little more than forecasts of central bank incompetence.’
The Future Fund’s creator, former Treasurer Peter Costello, does not have much faith in the ability of sovereign wealth funds to promote fiscal responsibility:
Now I put aside $60 billion in the Future Fund. People say “oh well you could have put aside 70 or $80 billion or something like that.” But I make this point. If we’d put aside more they’d probably just have borrowed more.
Ashby Monk on how SWFs failed to prevent fiscal disaster in the EU:
The pension reserve funds were set up to try to use the ‘power of finance and compounding’ to take some short-term surpluses to meet long-term unfunded pension obligations. It’s a neat idea, which hasn’t played out as hoped. For example, Ireland used its fund to bailout Irish banks, Portugal has tapped its Fund to the tune of €6 billion to meet its fiscal obligations, and Spain has used its Reserve Fund to prop up its bond market. You get the idea.
The Western Australian Future Fund: A Solution in Search of a Problem
I have an op-ed in today’s West Australian making the case against the proposed Western Australian Future Fund. As I note in the article, the WA Future Fund nonetheless improves on the federal model by avoiding the establishment of an expensive new funds management operation that duplicates existing capabilities. The federal Future Fund incurred expenses of $444m in 2010-11.
I have an article at The Conversation referencing the Pagan-Gruen exchange at the Melbourne Institute’s Intergen+10 Workshop (you can listen to the exchange here). As I note in the article, whether the 2010 IGR growth assumptions were really the outcome of a political process is less important that the perception on the part of serious observers that they could be. This is something that needs to be addressed.
It is interesting to compare how the last IGR compiled under the Howard government in 2007 characterised Australia’s long-term debt position compared to the 2010 IGR. The 2007 IGR said that:
Demographic and other factors are projected to place significant pressure on government finances over the longer term and result in an unsustainable path for net debt towards the end of the projection period.
If Adobe Acrobat’s search function is right, the word ‘unsustainable’ never appears in the 2010 IGR. The 2007 IGR was a much more candid document in relation to the long-run fiscal outlook.
The government’s stated motivation for returning the budget to surplus next financial year is to give the Reserve Bank ‘maximum room to move’ on interest rates. Yet a fiscal contraction is no more effective in restraining the economy than a fiscal expansion is effective in stimulating it. In an open economy with a floating exchange rate and an inflation-targeting central bank, changes in fiscal policy do not have significant macroeconomic implications. That is why the reaction of financial markets to budget statements is so negligible. The Reserve Bank’s statements also make clear that fiscal policy is a very minor consideration in its decision-making.
During the financial crisis, the government tried to have it both ways, arguing that its fiscal stimulus saved us from recession, but had no implications for interest rates. The second part of the argument was correct, but not the first. If the first part had any truth, then monetary policy must have been much tighter during the financial crisis as a result of the government’s stimulus spending.
The government should have no concern over the macroeconomic implications of changes in the budget balance, so long as it is balancing its budget over time and conducting fiscal policy in a sustainable manner. This should free the government to focus on what fiscal policy can do effectively, namely, changing microeconomic incentives to work, save and invest.
The government and opposition’s mistaken belief in a trade-off between fiscal and monetary policy is dangerous, because it leads to fiscal policy decisions that are more about window-dressing the budget balance and claiming credit for reductions in official interest rates that would have happened anyway, rather than improving incentives. For example, the mistaken belief that tax cuts stimulate demand and lead to higher interest rates can prevent sensible tax reform that has positive implications for the supply-side of the economy. Similarly, the fiscal stimulus of 2008-09 was bad primarily because it misallocated resources. Take away the macroeconomic rationale and the stimulus measures look indefensible on microeconomic grounds, even if the spending had been administered perfectly (which it was not).
A budget surplus target can be defended as a fiscal rule designed to impose additional discipline on government decision-making that might otherwise be absent. But there is no reason to subordinate fiscal policy to monetary policy and fiscal targets should not be pursued at the expense of the microeconomic incentives that are the ultimate source of both economic growth and long-term fiscal sustainability.
The applicability of arguments used in other countries, including Norway and the smaller Middle East oil producers, to quarantine the revenue windfalls of a mining boom in a sovereign wealth fund for use by future generations are questioned for Australia. Relative to these countries, in Australia mining revenues represent a smaller share of the economy and budget, and Australia has a much more diverse portfolio of different minerals and energy, and many with proven reserves exceeding 50 years at current extraction rates. There are other sources of volatility of government revenues and outlays with low correlations with mining government revenues. Future generations are expected to have higher per capita incomes than the current generation. Including mining revenues and outlays within the normal budget processes provides greater flexibility for using the mining boom revenue windfalls for a wider range of investment, tax reform and debt reduction strategies to support higher future incomes than a sovereign wealth fund.
A curious feature of this debate is the way in which the defenders of sovereign wealth funds have raised the possibility of secular stagnation in defending inter-generational wealth transfers via a SWF (Malcolm Turnbull also suggested this in a tweet). As I note in my Business Spectator piece, a SWF could at best smooth the implications of secular stagnation over time. If secular stagnation really is upon us, then it is even less likely the Future Fund will realise its targeted real rate of return of 5%.
A Sovereign Wealth Fund is Not the Same as Fiscal Responsibility
Treasury Secretary Martin Parkinson addressed the issue of a sovereign wealth fund in a speech to the Australia-Israel Chamber of Commerce. Parkinson said that ‘Treasury is often characterised as being opposed to an SWF – yet our comments are neither supportive nor critical.’ In fact, Treasury and the RBA are just as often characterised as supportive of a SWF when they have been studiously equivocal. Whether Australia chooses to make greater use of a SWF is ultimately a decision for politicians. It is appropriate for Treasury and the RBA to discuss the implications of this policy choice, but we should not expect them to come down explicitly in favour of one side of the argument.
Parkinson’s speech makes clear that greater use of a SWF is not the same thing as more responsible fiscal policy:
the creation of an SWF per se does nothing to address either Australia’s net debt position or, more broadly, the level of government or national savings over time.
If the Australian Government had financial liabilities of $10 billion and runs a $1 billion surplus, it can reduce gross liabilities to $9 billion, or it can maintain them at $10 billion and buy $1 billion of financial assets to be held in an SWF – in both cases, net financial liabilities are $9 billion.
The only way the creation of a Sovereign Wealth Fund delivers a faster improvement in net debt is if it is used to justify a tightening of fiscal policy that would not otherwise be achieved.
As such, if we are to have a sensible discussion about the merits of an SWF, the proponents of such Funds, whether at the national or sub-national level, need to be clearer about precisely what they have in mind. Absent tough fiscal decisions, an SWF does not constitute a contribution to future fiscal sustainability.
Robert Carling and I make this point in our CIS Policy Monograph, Future Funds or Future Eaters? If contributions to a SWF, like the budget surplus itself, are no more than a residual after the government is done spending and taxing, then there is no reason to believe that a SWF changes government behaviour. A SWF, like a budget surplus, is a consequence not a cause of fiscal policy decisions. The IMF found there was little impact on government spending in its study of countries making use of SWFs.
Unless a SWF is embedded in a broader framework of binding and enforceable fiscal policy rules, there is no reason to believe a SWF will induce greater fiscal responsibility. If a politician supports a SWF but does not support fiscal policy rules, you know they cannot be trusted with a SWF.