Ross Garnaut’s “Reset” makes another valuable contribution to the debate on Australia’s future after COVID-19. But in examining the past, he misjudges macro-politics in explaining what he calls the “Dog Days” of 2013-2019. It was fiscal austerity, not monetary policy, that held back growth during this period.
Garnaut said monetary policy was too tight, missing the opportunity to reduce unemployment to US level.
“Other central banks have adapted more quickly to the further decline in the cost of capital by lowering interest rates that they control more than the Reserve Bank of Australia has cut Australian key rates. This caused the exchange value of the Australian dollar to be higher than it otherwise would have been. “
In the four years since the 2008 global financial crisis, Australian interest rates were significantly higher than those in the United States, as the country had been through the GFC well, without any financial stability issues. GDP continued to grow at a reasonable pace and inflation was in the upper range of 2-3 percent.
In 2013, commodity prices had fallen from their highs at the end of 2011. The real exchange rate followed the decline in commodity prices, losing about 20 percent from the peak. The overnight rate of the RBA was lowered quickly and significantly.
Admittedly, Australia’s policy rate was higher than that of the United States, reflecting their very different GFC experiences. Their financial sector has collapsed. Emergency measures were needed, in the form of a zero rate on federal funds and vigorous unconventional monetary policy to prevent a 1930s-style collapse. These crises were still needed in 2013 because the US recovery was weak, held back by the legacy of the GFC balance sheet.
Should Australia have adapted to these emergencies, in our non-urgent environment, to keep the exchange rate lower than market equilibrium?
From 2013 to 2019, the spread between Australian and US policy rates was on average less than a percentage point, which is not enough to have much of an effect on the exchange rate. If the goal was a lower exchange rate, it would have been more effective to lower the bond rate with our own QE. Foreign investors held three quarters of our bonds and were therefore more sensitive to bond differentials than to key rates.
Any competitive advantage resulting from a lower parity would therefore have placed our trading partners at a disadvantage. Hence the strong international pressure not to attempt this kind of “every man for himself” policy. America is ultra-sensitive to “currency manipulation”.
Garnaut’s beggar-thy-neighbor policy would have been difficult to justify in a growing economy, although not fast enough to reduce unemployment as much as we all would have liked.
COVID-19 has provided a different environment for unconventional monetary policy. This necessitated a huge increase in the budget deficit, with difficult financing needs. At the same time, banks have had to flatter current borrowers with forbearance from servicing loans. Lower borrowing costs for the government and the banks were the wise prescription. Under these circumstances, no one could accuse the RBA of “currency manipulation”.
In all of this discussion of growth rates, Garnaut overlooks the role of fiscal policy. Australia’s deficit was around 5 percent of GDP at the time the GFC was taking place. It made sense. But then, over the 2013-2019 period, the budget returned to near-balance. It was still in deficit over this period, but its impact on growth comes from the change in the budget balance, which was unequivocally reducing.
We can discuss the exact size of the budget multiplier, but since Olivier Blanchard’s proposal mea culpa Regarding the IMF’s underestimation of the multiplier in the post-GFC period, a multiplier of around 1.5 seems reasonable. Thus, on average over this period, fiscal austerity reduced growth by nearly 1% each year.
Garnaut seems to support this austerity. In his 2013 book, he specifies that “it’s the combination of tighter budgets and looser money that drives the dollar down.” Some would say that austerity was necessary to quickly reduce the deficit in order to “reload the fiscal gun”. But whatever your take on this debate, it’s hard to deny that austerity has undermined growth.
Meanwhile, monetary policy has been “up to the wall,” exerting a strong expansionary influence with dramatically low interest rates. These rates simultaneously caused a surge in asset prices, including housing and real estate debt. Fiscal policy, on the other hand, was pulling the reins a lot.
By praising America for doing better during this period, Garnaut misses Donald Trump’s reckless corporate tax cut in 2017. This strong fiscal stimulus has brought the unemployment rate in the United States down to 3.5 percent. It demonstrated the power of fiscal policy, but meant that the United States started the COVID-19 crisis with a budget deficit of 5% of GDP and rising public debt.
There is no need to follow this example – just aim for a reasonable balance between monetary policy and fiscal policy.
Stephane Grenville is a former Deputy Governor of the Reserve Bank of Australia and a non-resident member of the Lowy Institute