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The economic challenges

By Saul Eslake - posted Thursday, 28 February 2008


From a short-term perspective the biggest economic challenge facing the Rudd Government is that posed by the acceleration in inflation over the past six months, and the prospect that, on unchanged policies, inflation will remain above the top end of the Reserve Bank’s 2-3 per cent target band through until mid-2010.

They key phrase here is “on unchanged policies”, because the underlying message from the Reserve Bank is that confronted with such an outlook, policies will not remain unchanged. The Reserve Bank appears to be saying that if other influences - such as a slowdown in the global economy, a tightening in the availability (as distinct from the price) of credit, or appropriate changes in other instruments of economic policy - do not produce this “significant moderation in domestic demand”, then the Reserve Bank will seek to achieve it through further tightening(s) of monetary policy.

Once inflation gets entrenched above 3 per cent per annum, it tends to acquire a self-perpetuating momentum and can only be brought back down again at very high cost in terms of economic activity and employment.

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But, as a practical matter, a 2-3 per cent target has been agreed between the Reserve Bank and successive elected governments, and the Reserve Bank will do what it must in order to achieve it - raising interest rates further.

Inflation is not an elevated concern at present because the inflation rate has, for the moment, moved above 3 per cent per annum; it is an elevated concern because there is a significant risk that it will stay above that level for an extended period.

It’s true that monetary policy is a “blunt instrument”. Its impact falls disproportionately on those households with a mortgage - roughly 38 per cent of all households - and on those businesses with relatively high levels of debt. Those with no debt are, at least in the first instance, relatively untouched by rising interest rates - although they may well be affected in a number of different ways by the “second-round” effects of higher interest rates as those who are directly affected adjust their behaviour.

Because of the way in which the exchange rate of the Australian dollar is influenced by the spread between Australian interest rates and interest rates in other countries, tighter monetary policy also impacts relatively more severely on those sectors of the economy which depend on exports for a large proportion of their revenues and on those who compete with imports in the domestic market.

But it’s also true that monetary policy is the only instrument which the Reserve Bank has available to meet its inflation target.

Some might argue that the Bank should be using “other instruments” designed to limit the supply of credit rather than relying solely on adjusting the price of credit. But history strongly suggests that quantity-rationing is no less blunt an instrument than price-rationing, and more easily evaded in ways that ultimately expose borrowers to even greater risk. History also suggests that quantity-rationing has not been very effective in keeping inflation under control.

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It might also be argued - albeit only with the wisdom of hindsight - that the Reserve Bank has made some mistakes in handling the one instrument which it now has at its disposal. Such criticism can, however, only be along the lines that the Reserve Bank should have raised rates by more, and sooner, than it actually did.

The Bank should perhaps have been willing to raise rates by increments of more than a quarter of percentage point. In 1994, the Bank raised rates 2¾ percentage points in three months - and stopped what looked like a worrying rise in inflation in its tracks. Mindful, perhaps, of the greater risks stemming from the significant increase in levels of household indebtedness since then, the Bank has taken more than five years to raise rates by the same amount in the current cycle. The series of quarter-of-a-percentage-point increments has clearly lacked the “shock value” of the 1994 episode.

In making such criticisms, however, it should be acknowledged that the Reserve Bank cut rates by less at the beginning of this decade, and began raising them sooner, than any other major central bank in the developed world (with the exception of its counterpart in New Zealand).

It should also be acknowledged that no other central bank has faced as much criticism of nearly every decision to raise rates as has the Reserve Bank of Australia.

Finally, it should also be noted that no one else foresaw the magnitude or duration of the commodities boom to the point where, in the Bank’s assessment, “capacity constraints” are contributing as they are to inflationary pressures.

Nonetheless, because monetary policy does concentrate the burden of dealing with rising inflation on a minority of Australians, it is reasonable to ask whether other instruments of economic policy could not play a greater role in containing and reversing inflationary pressures.

I believe that the role played by fiscal policy in recent years has contributed to the inflationary pressures which have built up in the Australian economy, and thrown a greater burden on monetary policy than would otherwise have been necessary.

Fiscal policy has, by recycling part of the income thrown off by rising commodity prices from the business sector to the household sector, unnecessarily boosted domestic demand. After each of the last four Budgets nearly all of the upward revisions to estimates of revenue have been used to fund personal tax cuts and increases in personal benefit payments, leaving the projected Budget surpluses at about 1 per cent of GDP.

Shortly before the 2007 election I estimated that, since the 2003-04 Budget, so-called “parameter variations” had added some $457 billion to the resources available to the Government over the nine years to 2010-11; and that, of this amount, $435bn had been or would be spent or given away in tax cuts, and only $22bn “saved” in the form of Budget surpluses. And of this $435bn, at least $270bn had taken or would take the form of personal income tax cuts (including those the Labor Party has pledged).

My argument has always been that fiscal policy should have been doing more. It should have been exerting a restraining influence on domestic demand by allowing the so-called “automatic stabilisers” (the natural tendency for revenue to rise as a share of GDP as the business cycle continues and resource utilisation increases) to operate.

I’ve also argued that, because the corporate sector typically saves the equivalent of 3-4 per cent of GDP while the household sector, until very recently, dis-saved the equivalent of about ½ per cent of GDP, a policy of redistributing income from the corporate sector to the household sector through the budget must inevitably boost total aggregate demand - as it has done in recent years.

While it would have been politically naïve to imagine that all of this $457bn should or could have been “saved” in the form of bigger budget surpluses, I did say, and I still do, that a lot more of it should have been saved than actually was.

Windfall revenue gains associated with the commodities boom, and with strong economic growth, should have been allocated to “buckets” or “pools” to be drawn down over subsequent years, as economic conditions allowed, to meet longer-term goals; goals such as:

  • meeting the fiscal costs associated with demographic change;
  • ameliorating the costs of the climate change which will inevitably occur, and cushioning the impact of the measures required to prevent further climate change;
  • education and skills formation;
  • reducing Indigenous disadvantage;
  • improving and extending economic and social infrastructure;
  • improving water security, and addressing salinity and soil degradation; and
  • providing for tax cuts at a stage of the economic cycle when some form of fiscal stimulus might actually be appropriate.

Imagine what a difference we could have contemplated making if half of the $457bn accruing over the nine years to 2010-11 had been dedicated in this way.

In reality, of course, much of this enormous sum has already been dedicated to personal income tax cuts and to spending decisions which have had the effect of boosting domestic demand, at a time when it was already being boosted by the commodities boom, the lagged effects of earlier easy monetary policy, and rising asset prices.

And much as I wish it were otherwise, I accept that it would be politically impossible to walk away from the pledge for $31bn of tax cuts promised by Labor during the election campaign. But since there is now almost certain to be another round of upward revisions to forward estimates of revenue in the forthcoming Budget cycle, I hope the new Government will learn from the experience of its predecessor rather than repeat it.

There is another important respect in which fiscal policy decisions have added to the burdens shouldered by monetary policy.

There’s no doubt in my mind that some specific decisions of the previous Government induced people to take on more debt than they might otherwise have done. I’m referring, in particular, to the 1999 decision to halve the rate of capital gains tax, and to last year’s decision to remove income from superannuation funds by people aged 60 and over from the tax system altogether.

I can’t think of any sound principle of economics or public finance which says that income from speculating should be taxed at a lower rate than income from working - especially when increasing the proportion of the population who are working is supposed to be a policy objective. Yet that is the result of the decision made by the Howard government, with the support of the then Opposition, in 1999. And, in conjunction with the continued availability of “negative gearing”, this contributed significantly to the ensuing property boom, bringing aspiring landlords into competition with would-be homebuyers for a limited stock of housing.

I think it is little short of astonishing that, having spent five years telling the Australian people (correctly) that the ageing of the population constituted the biggest medium-term fiscal challenge facing the nation, the Howard government would make that challenge significantly worse by in effect making it optional for anyone over the age of 60 to pay tax, making it easier for quite affluent people in that age bracket to claim taxpayer-funded concessions and benefits, and as a result of one particular aspect of that decision (allowing people to contribute up to $1 million to superannuation before June 30 last year), encouraging another round of borrowing to acquire assets.

These two decisions were part of a more general pattern under the Howard Government of using the income tax system to favour particular categories of income, particular types of expenditure, particular groups of taxpayers, and particular forms of economic organisation, over others.

I would urge the new Labor Government to look seriously anew at reform of the personal income tax system with a view to reversing this trend.

Another significant challenge facing the new Labor Government stems from the unravelling of the global credit market bubble which developed in the aftermath of the collapse of the 1990s equity market bubble, in an environment of unusually low interest rates; a flood of money from developing to advanced economies, the obverse of the usual flow of capital from rich countries to poor ones; and a wave of “financial engineering” which foisted complex investment products with poorly understood risk characteristics on a wide range of unsuspecting borrowers and investors.

It is already apparent that the deflating of this bubble is causing significant stresses in the global financial system, and may well push the United States and perhaps others into recession.

Australia is far from immune to the stresses in the global financial system, and although our business cycle is now more closely aligned with that of the developing world, there are downside risks for our economy associated with the possibility of a sharp downturn in the US.

These developments add an additional significant complication to the task of containing and reversing rising domestic inflationary pressures. The challenge then facing the Government could become one of containing and reversing a sharper downturn in domestic demand than the one which the Reserve Bank is now saying, in effect, that we “have to have”.

This is all the more reason for the Government to avoid adding to inflationary pressures through fiscal policy measures, and to conserve its fiscal firepower for when it might actually be genuinely required.

There are also of course longer-term economic challenges facing the Government which cannot be ignored.

Climate change represents Australia’s greatest medium- and long-term economic and environmental, challenge. I accept the scientific consensus regarding the likely course and consequences of global warming. Like many other economists, I have some reservations about some of the calculations in the Stern Report, but those reservations don’t lead me to doubt the importance of taking actions to reduce the carbon-intensity of economic activity. I accept that doing so may entail greater change for Australia than for many other advanced economies given the relatively high carbon intensity of our existing economic structure. And along with four other economists working in the financial markets, last year I publicly supported policy interventions directed towards that aim, such as a carbon emissions trading regime incorporating a numerical target for overall emission reductions.

Although it may come as a surprise to some, I would also nominate rising inequality as a challenge which the new Labor Government would do well to address. The evidence suggests that the distribution of income, after taking account of the impact of Australia’s tax and social security systems, has not altered significantly over the past decade, except perhaps at the very top end; but that there has been a significant increase in inequality in the distribution of wealth. Over time this will, if unaddressed, accentuate the existing inequalities in the distribution of economic opportunities.

The market-based economy facilitates the creation of wealth and economic opportunity but does a poor job of distributing it in a way that doesn’t offend most people’s notions of social justice. Striving for that balance is, perhaps, another great long-term challenge for a modern Labor Government.

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This is an edited version of a talk given to the New South Wales Fabian Society on February 20, 2008. The complete version is available here (PDF 45KB).



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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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