Do We Need a Fiscal Stimulus?

As the Reserve Bank monetary policy statement might indicate, the answer to the headline question is that as economic growth weakens, we increasingly need some more government spending. The bigger problem is how to manage it.

Commentators were surprised by last week’s announcement by the Reserve Bank of the new level of the OCR (official cash rate) – the rate of interest which the RBNZ charges on overnight loans to commercial banks. The OCR sets the base interest rate for domestic borrowing and lending. The RBNZ lowered it by 0.5 percentage points from 1.5 percent p.a. to 1 percent p.a. A cut had been expected, but the usual reduction has been 0.25 percent at a time, so this cut was bigger than expected.

The unexpected caused some consternation as no doubt was intended. While the RBNZ was satisfied with the level of unemployment and thought the rate of inflation was a bit on the low side, it was concerned that economic growth seems to be weakening, most notably as a slower export growth. It attributes this to slower world demand for our exports (especially mentioning tourist services).

Certainly the world economy is not a happy place. Of course there is always somewhere some economies are performing badly, but at the moment there are two unusual critical issues.

First, there is Donald Trump’s trade war against China. We can paw over the detailed impacts but the one that dominates is the resulting higher uncertainty. This is not just the uncertainties that economic forecasters always face – data, lags, the rate of deceleration or acceleration, the interactions between the world’s economies.

More important is Trump’s behaviour. I do not want to get into the usual slanging match, but the reality is that we cannot predict what he will do – often he will reverse an earlier decision. This uncertainty adds not just to difficulties for the forecasters but also for businesses. Faced with erratic behaviour their natural reaction is to do nothing – and consequently to cut back investment, thereby reducing economic activity. This applies not just in the US but on the other side of the Pacific – both in China and in those nearby countries which are providing components for China’s exports.

Second, adding to this muddle, are British plans for Brexit. The universal conclusions among economists is that a ‘No Deal’ Brexit on 31 October will be a disaster for the UK. Now, as Boris Johnson, Nigel Farage and their acolytes have not understood, the British economy is not nearly as important to the world as the US and China are. (They also underestimate how important the world is to Britain.) But the European Union, even without Britain, is as important to the world economy as China and the US. It will not be as heavily impacted by Brexit as Britain, but the political energy devoted to dealing with it is distracting the EU from paying greater attention to its other economic and political problems.

So the context of macroeconomic policy today is that the world economy is more fragile than at any time since the Global Financial Crisis; nobody has much idea how it will play out (certainly not Trump or Johnson).

Mum used to quote an old saying from the Great Depression: when America sneezes, Europe catches a cold and New Zealand is in bed with pneumonia. Add that China suffers a chill and the same applies today. (Additionally, there is an informed view that China’s fabulous growth spurt is slowing down; that adds to the world’s woes.)

So doctor Orr at the RBNZ is trying to do something about New Zealand’s economic health. Hence the reduction in the OCR. You will notice that it was followed by a small drop in the exchange rate, which is no bad thing for a weakening export sector.

There is a problem. Economists’ cryptic term, always said ominously, is the ‘lower bound’. What is being referred to is that interest rates can fall only to a certain level – say for the OCR not below minus 0.5 percent p.a.. Below that individuals find it easier to hold their savings in cash; in effect a banknote is a zero interest deposit in the RBNZ (with a safety inconvenience compared to a standard deposit). So at the lower bound monetary policy operating through interest rates becomes ineffective. (There may be other monetary policy instruments but there is much unease about how they work in the long term.)

At this point the economy becomes very dependent upon the government’s fiscal stance – its revenue and spending. I am going to take a position a little different from the recent conventional wisdom which thinks fiscal policy does not have much effect. This view is being steadily overpowered by evidence and reality. (I have always thought the Austerians overemphasised the effectiveness of monetary policy, without much evidence for their claim. This debate belongs to another venue; the point here is that many commentators seem oblivious to the niceties of the defunct theories they are using.)

The alternative view to the Austerian one is that the government can lift the economy by increasing spending and (to a lesser extent) cutting taxes. This applies most strongly as interest rates near the lower bound. We are beginning to see calls for this, so let me briefly go through the argument.

First, the fiscal initiative would increase government debt contrary to the government’s fiscal prudence rules. My reaction is ‘so what’, and indeed the Minister of Finance has been giving the government a little more wiggle room.

Second, the fiscal initiative will work only if there are under-utilised resources in the economy. If there are none, the government initiative will blow out in additional imports or inflation (or both), which is not much use. The RBNZ and many other observers seem to think that the economy is drifting below its capacity, which means a fiscal stimulus may be appropriate.

Third, the efficient fiscal package is complicated. Some measures work better than others. In particular, government spending and income boosts at the bottom of the distribution tend to have a greater effect than income tax cuts at the top. This means that the fiscal stimulus of the Key-English Government after the Global Financial Crisis was not as effective as it could have been.

Fourth, the fiscal stimulus will increase government debt, as happened under the Key-English measures. To simplify, if the stimulus prioritises government investment (say, on infrastructure) the debt will be matched by increased capital assets, so there will not be a reduction in public net wealth, compromising the economy in the longer run. (Traffic jams you face or the lack of decent housing are examples of the failure.)

(As an aside I am disappointed that this analysis does not argue for more support to reduce poverty, something I would give greater priority to than this or previous governments. That is a consequence of the package being focused on keeping the economy strong. A redistribution package is not the best way to do this; other measures are necessary to enhance wellbeing.)

Fifth, combining the second and fourth points, the extra spending may not necessarily go to the areas of highest priority if production there is at full capacity. That may mean that the government cannot spend a lot more in regions where the construction and house building sectors are flat out, even if the need is greatest there. Additionally, the economic advice may be in conflict with the political imperatives of spending where the government will most increase its votes.

Sixth, the measures require a lot of forward planning to identify need and spare capacity in addition to the fact that the decision process takes time and there can be a significant delay between decision and implementation. I am not sure that the forward planning is already under way nor that there is even the capacity to do it effectively.

I am haunted by the Muldoon years. When he panicked, I saw officials desperately scrambling around for a fiscal package; very often their best advice was warped by political considerations. One could argue the same thing happened with the Key-English measures. Will we do better this time?

Some of this was discussed on ‘Nights’ with Bryan Crump on 13 August, 2019.