Avoid spending like there's no tomorrow

The Morrison government’s fiscal policy response to the COVID19 crisis directed toward keeping business afloat to minimize short term unemployment has in principle been both necessary and timely.  However, questions arise about whether the fiscal response is too expansive, is the right form, and whether generous cash handouts should have been included. 

Comparing the COVID19 Crisis and the GFC

The last major out-of-cycle bout of fiscal activism was the Rudd government’s response to the Global Financial Crisis. What’s happening now therefore invites comparison with that earlier episode and historic Depressions. 

Although the GFC and COVID19 crisis can both be termed external shocks, they have been transmitted quite differently.  The 2008-10 GFC was an external financial shock similar to the Asian financial crisis of the late 1990s which impacted on the real sector of the Australian economy via financial sector meltdowns abroad. 

Back then, foreign banks, stock markets and commodity prices collapsed, as did the Australian dollar, which always acts as an automatic insulator for the Australian economy during external financial crisis by boosting the external competitiveness of exporting industries and of industries competing with imports.

The COVID19 crisis in contrast is an externally sourced health disaster which has prompted necessary preventative measures by governments that, in turn, have severely curtailed economic activity and driven up unemployment.  Stock markets have reacted accordingly by plummeting, and continue to gyrate daily according to investors’ perceptions of how long the health crisis and government restrictions on economic activity will last.

Keynesian Stimulus Spending

The English economist John Maynard Keynes most famously advocated fiscal stimulus in the form of increased spending on infrastructure (then called ‘public works’) during the Great Depression of the 1930s, a result of a stock market and banking system collapse.  However, the academic jury is still out on how effective it was.  Some argue that the uncertainty it created for business actually prolonged the Depression, at the same time as economies turned in on themselves and became highly protectionist.

The 2008-09 GFC fiscal response was ‘stimulus’ of the Keynesian kind. Yet there is copious academic evidence to suggest fiscal stimulus fails in open economies like Australia, especially over the medium to longer term, due to the inevitable macroeconomic costs it imposes. 

These costs arise through a stronger exchange rate if government spending is relatively higher than abroad.  The higher public debt adds to uncertainty and means retaining, or increasing, income and company taxes which stymies future investment and productivity.

Cash Handouts Were Ill Advised

To characterise the bulk of the federal government’s business-oriented fiscal response Keynesian and similar in nature to the Keynesian fiscal response to the GFC is misleading.  There is a big difference between Keynesian advocacy of direct government spending and cash handouts to boost aggregate demand in the economy, and business tax relief measures to counter a government mandated aggregate supply collapse.

The bulk of the fiscal packages announced to counter the economic impact of COVID19 are therefore not stimulus as such because they will not rouse economic activity, but will hopefully instead keep the economy on life support.   Hence terming these packages fiscal stimulus is a misnomer.

The one element that is in the nature of old style Keynesian stimulus is the cash handouts to pensioners and other welfare recipients.  Cash handouts to households are also a key element of the United States government’s response. 

Why governments have chosen this fiscal option is puzzling for several reasons.  First, it is at odds with government health restrictions, including stay at home advice and limits on provision of goods and services to essential services.  Pensioners of all people, for instance, should not be out shopping. 

Second, economic theory suggests that as these payments are one-off and hence temporary, they are more likely to be saved than spent, yet at significant cost to government saving.  If they are spent, it will add to imports, detracting from Australia’s GDP.

Avoid further fiscal stimulus

While a recession seems inevitable, a depression seems most unlikely.  Even so, an interesting and much neglected historical economic fact is that there was no fiscal stimulus response to the forgotten, albeit short-lived, depression in the United States in 1920-21, just after the Spanish flu pandemic and around a decade before the Great Depression.  At that time there was a close to one third fall in US industrial production, a near halving of the Dow Jones Industrial Index, a collapse in corporate profits and sudden rise in unemployment. 

Instead of fiscal stimulus, the administrations of Presidents Woodrow Wilson and Warren Harding responded by balancing the federal budget, while the Federal Reserve raised interest rates instead of lowering them.  Within eighteen months that depression was over.

Times and the structure of economies have changed markedly since then of course, a key difference being that economies are now more internationally integrated.  Yet it is worth remembering that there was no federal fiscal stimulus response to the 1997-98 Asian Crisis, which the economy weathered well.

Continuing to ramp up ‘stimulus’ elements in any future federal and state fiscal packages to encourage aggregate spending, as several economists have called for, runs the risk of severely hampering future economic performance, as happened post GFC.  

A “whatever it takes” fiscal mindset easily translates to “spend like there’s no tomorrow”.  But experience tells us there’s always a future cost when there’s a rush of red ink to policymakers’ heads.