30 July 2020

New thinking is needed on macroeconomic policy levers

With the RBA at its own self-perceived monetary policy limits, Australia needs new thinking about how to manage the economic cycle. This could involve new policy tools for the RBA or serious consideration about setting up an independent fiscal authority.

As is well understood, the COVID-19 crisis has ended Australia’s world-beating 29-year long boom.

What is less well understood is that the exceptional aspect of Australia’s economic performance over the past 29 years was not the persistence or the strength of its growth. The key is that the economy had become more stable than ever before and, even more impressively, had been the most stable economy in the developed world.

Over the past 25 years, Australia has had the least volatile GDP growth of any of the OECD economies.

This is stunning. Particularly given that the economy has faced many large shocks over the past three decades, including the Asian Financial Crisis in the late 1990s, the 2008/09 Global Financial Crisis and the commodity prices ’super-cycle’ of the early 2000s. It is far from obvious that Australia, a highly open economy and large commodity exporter, should be the least volatile economy in the developed world.

To do this Australia has benefited from having a flexible economy, a floating currency and an independent central bank with a powerful policy tool.

In years gone by, the RBA had been able to increase its cash rate significantly to slow the economy and lower it sharply to support growth. The predominance of variable rate mortgages meant these moves had a particularly big effect on household cash flow and the housing market.

Now the cash rate is near zero and the RBA Governor has stated that negative interest rates are ’extraordinarily unlikely’. The central bank also has a near zero target for the three-year government bond yield, which it is maintaining by offering to buy government bonds as required.

The RBA’s monetary policy setting is at the central bank’s own self-perceived limits.

It is not that monetary policy settings cannot go further, it is that the benefits of even looser monetary policy are likely to be marginal, and come with large costs, while fiscal tools would be far more effective.

Although the currency can still be expected to operate as a significant economic shock absorber, the tools at the RBA’s disposal are far more limited than they have been in the past.

This will mean greater reliance on fiscal policy to manage the economic cycle.

Thankfully, fiscal policy has been used adeptly to support the economy in the face of the COVID-19 health crisis. As was the case during the Global Financial Crisis in 2008, in times of crisis, Australia sees strong fiscal and monetary policy coordination.

However, in normal times there is typically far less coordination. Over the past 30 years, the RBA’s monetary policy has played the main role in managing the cycle and its advantage has been that it is independent from the political cycle.

One option for dealing with this challenge is to give the RBA more tools to manage the cycle. After all, if the RBA’s mandate is as broad as improving the ’economic prosperity and welfare of the Australian people’, then its current tools are quite blunt instruments.

During the COVID-19 crisis the government has chosen to allow households to withdraw funds from their superannuation saving accounts. Varying households’ access to their superannuation could be a powerful tool for boosting or reducing household spending. For example, a varying proportion of a firm’s required contribution rate (currently 9.5%) could be made accessible to employees, thereby boosting or reducing their effective wage.  

However, if giving the RBA more tools is not palatable, another option could be to establish an independent fiscal authority which could be given these or other powers.

These powers could include a list of infrastructure projects which could be ramped up or slowed down to manage the economic cycle.

A key political objection to these proposals would be that fiscal policymakers are likely to be reluctant to give away policy tools, particularly ones that could be used to target spending to marginal electorates. Another criticism would be that these policy tools would see unelected officials making decisions about the allocation and distribution of resources in the economy that could be seen as more appropriately made by elected officials.

However, the same questions about distribution and allocation of resources could be raised about monetary policy. Lowering interest rates redistributes income from savers to debtors and lifts housing prices, rewarding property owners at the expense of potential home buyers.

These objections ought to be secondary to the key question of whether the national interest is best served by having an independent authority with powerful tools to manage the economic cycle. The answer seems clear. Without one the economic road ahead is likely get much bumpier.

This article appeared in The Australian Financial Review on 30 July 2020.