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Fiscal policy: the ideological war

By Fred Argy - posted Wednesday, 4 March 2009


On the other hand, egalitarian economists like Paul Samuelson, Joseph Stiglitz, Robert Solow and Paul Krugman want to use all relevant fiscal measures to minimise investment risk, ensure steadier income and avoid an increase in “core” unemployment - the unemployment rate consistent with non-accelerating inflation. This is also the view of some conservatives such as Martin Feldstein.

I find myself in the latter camp. Our argument is that:

  • supply side models are adequate models of the long run but they do not explain demand-side short-term economic fluctuations very well. Libertarian economic analysis is largely based on longer term models (e.g. 1955-2006 in the case of Makiw and earlier still by Barro), which allow for supply-side responses. This analysis does not apply to near-depressions. On the other hand, models which include wage and price rigidities, such as New Keynesian models, do have a greater ability to explain short-term fluctuations in a severe recession and can best address these macro-economic fluctuations; and
  • Turnbull’s strategy (to bring forward the earlier tax cuts of June 2009 and June 2010) will, as Peter Martin argues, do nothing to alter anyone’s view of their permanent income. Even if tax cuts could be converted to make them seem permanent, there is nothing to stop governments from choosing to hike tax receipts at a later date when the depression is over.
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The International Monetary Fund (IMF) is now urging its members to devise packages that “provide maximum fiscal boost to demand very soon”.

What is needed are timely, well targeted, easily reversible spending measures - such as bricks and mortar investments in “shovel ready” (no long lead times) infrastructure; temporary tax benefits for (genuinely) low-income persons to limit demands for wage increases; through the states, assistance for all specific industries or regions that will bear the brunt of job losses; and temporary tax benefits to encourage private sector investments and technology (such as reducing energy or water consumption).

The latest fiscal package does meet the “timely” criterion - they will have their greatest impact when the economy is most vulnerable. And they should prove temporary (with no permanent subtractions from revenues or expenditures beyond the first year or so). But, as Saul Eslake pointed out, they do not stack up well against the targeted criterion e.g. cash grants are not tightly targeted and it is not clear why every school in the country needs the opportunity to upgrade or acquire halls, laboratories, and libraries. The package could have been better targeted at investment, but the challenge was to ensure the measures were easy to reverse.

While there is no conclusive evidence of what happened after the Government introduced its first fiscal package, it has certainly impacted on retail sales, boosted housing sales, and led to a surprise jump in the number of women employed full time, suggesting that such packages can work.

All things considered, will the present $42b fiscal package meet all the necessary criteria? It can, in theory, “crowd out” private investment and net imports - but only if:

  • there is pressure on productive resources;
  • direct interest rate responses are likely to be very large, despite an accommodating monetary policy;
  • exchange rate movements are correspondingly large; and
  • there is significant forward looking consumption smoothing by private agents (Ricardian equivalence effects where people are smart enough to recognise that higher deficit spending will lead to higher taxes later).
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The first only applies when the economy is operating close to full employment. The second and third are crucial. The effectiveness of fiscal policy is only seriously damaged where (a) the smallest rise in investment and housing demand sharply pushes up rates of interest or (b) if the demand for real money is very insensitive to interest rate changes. But such extreme circumstances - and their effects on exchange rate movements, especially if other countries are doing the same thing - are unrealistic and unsupported by the evidence. As for Ricardian effects, past experience suggests that any effects tend to be long term and then only dampen less than half the initial impact.

So we can  reasonably argue that the fiscal package ought to work. A strong argument for such a package can be found in Economist’s View of February 15, although it does note the important distinction between borrowing domestically and borrowing from abroad.

Conclusions

In my opinion, Turnbull is wrong on both counts when it comes to his aversion to a big deficit and his preference for permanent income. But, for the first time, we have a political situation where libertarian and egalitarian economists are free to engage in a joust on big Keynesian ideas - small government versus big government.

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About the Author

Fred Argy, a former high level policy adviser to several Federal governments, has written extensively on the interaction between social and economic issues. His three most recent papers are Equality of Opportunity in Australia (Australia Institute Discussion Paper no. 85, 2006); Employment Policy and Values (Public Policy volume 1, no. 2, 2006); and Distribution Effects of Labour Deregulation (AGENDA, volume 14, no. 2, 2007). He is currently a Visiting Fellow, ANU.

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All articles by Fred Argy

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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