The dictum that “a little knowledge is a dangerous thing” rings very true in the run-up to the federal budget. Limited understanding of macroeconomics, in particular, has been evident from the mantra that the economy needs sizeable fiscal stimulus in the form of increased government spending to boost aggregate demand.
High school and first-year university students of economics everywhere learn that hiking government spending counters recessions and lowers unemployment, as originally proposed by John Maynard Keynes during The Great Depression of the 1930s. But prescribing this as the excuse for a big-spending budget is seriously flawed in current circumstances.
This recession is not remotely related to any previous recession Australia has experienced. Caused by government-imposed restrictions on private firms, it has first and foremost shrunk the aggregate supply, or production side, of the economy.
It has been as though the heavy boot of government has depressed a large, coiled spring. Lifting that boot by removing the restrictions would see an automatic rebound in economic activity, although given the pressure applied, especially in Victoria, the recoil would certainly fall short.
That does not mean, however, that governments should now step in and increase unproductive public spending to boost aggregate demand as this will raise other macroeconomic risks.
What economics undergraduate students learn in their second or third year after digesting Keynes — or at least should learn because all good intermediate macroeconomics textbooks cover it – is that economies like Australia are highly integrated with international goods, services and capital markets.
Contrary to what is taught at an introductory level, students then learn that any attempt to ‘stimulate’ aggregate demand with extra government spending only acts to induce capital inflow, appreciate the real exchange rate and harm internationally exposed sectors like hard–hit tourism. The net result is likely to be zero net impact on the economy and jobs.
This more complete and realistic macroeconomic theory is backed by strong empirical evidence, and very well explains the behaviour of the Australian economy after the GFC fiscal ‘stimulus’ when the Australian dollar reached over $1.10, crippling manufacturing. Further empirical studies show extra government spending can ultimately have a negative effect on the economy after two to four years.
A little knowledge of macroeconomics also means not appreciating the future risks of running up public debt. Public debt did not figure at all in Keynes’ simple theory. Nor did foreign borrowing.
Yet, in reality, it is mostly foreign entities that buy the bonds being issued copiously by the federal and state governments. The annual $15 odd billion, and rising, interest payments on that debt is ‘dead money’ that subtracts from national income. Australia’s public debt has been lower as a proportion of GDP than many European countries. But why is Australia always compared to these economies? They are far less reliant on foreign borrowing and their chronically weak performance is due in part to big government and high public debt.
Meanwhile, those bonds purchased by domestic entities soak up funds that could be used more productively by firms. While extremely low interest rates suggest no clear and present danger to the economy, the speed at which public debt has escalated suggests a clear and future risk.
A raft of empirical studies, including by IMF economists, show there is a robust negative relationship between growth in public debt as a proportion of GDP and subsequent economic growth. This suggests a significant potential national income loss into the future with the next generation being worse off for it.
Adding to that risk is the possibility of a credit rating downgrade that would push up public debt interest, and/or a 1994-like bond market crisis that saw global interest rates spike around two per cent. Such a crisis would occur should international investors sell off bonds en masse on realising bond holdings have reached saturation point.
To the extent central banks continue to monetise public debt by buying government bonds (effectively “printing money”), the future could well be even worse, with slower economic growth, high unemployment and high inflation. Under those conditions we would see a replay of the ‘stagflation’ of the 1970s.
These risks imply the main focus should continue to be on reviving the supply side via radical reform to industrial relations to increase workplace flexibility, further company tax cuts and generous investment allowances. Well-targeted temporary wage subsidies also qualify as supply-side measures, along with the recently announced changes affecting bankruptcy and bank lending.
Tony Makin is professor of economics at Griffith University, a former IMF economist, and an author of the Centre for Independent Studies papers Lower Company Tax to Resuscitate the Economy and A Fiscal Vaccine for COVID-19, and the book, The Limits of Fiscal Policy.
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