Opinion & Commentary
Economic policy must re-earn our respect
Financial market pundits in Australia and abroad are thoroughly divided on the inflation outlook. Some see an excessive increase in inflation as the inevitable consequence of massive fiscal and monetary stimulus.
Others view the financial crisis as an inherently deflationary event that macroeconomic policy is powerless to overcome. This fundamental uncertainty about the inflation outlook implies that both monetary and fiscal credibility have been damaged by the policy responses to the global financial crisis.
Increased credibility was the motivation for reforms to monetary and fiscal institutions in many countries during the 1990s. Greater independence for central banks was coupled with the adoption of inflation targeting regimes designed to anchor long-run inflation expectations and give greater credibility to monetary policy.
Australia’s 1996 Statement on the Conduct of Monetary Policy was just one example of this world-wide trend. This increased commitment to price stability was reflected in improved inflation outcomes that further bolstered the credibility of central banks.
At the same time, many governments also committed themselves to fiscal policy frameworks designed to provide for long-term fiscal sustainability. Australia’s 1998 Charter of Budget Honesty was a modest but inadequate step in this direction. A return to budget surpluses in Australia from the mid-1990s onwards also contributed to the credibility of this framework. The adoption of these fiscal policy frameworks complemented those for monetary policy.
The policy responses to the financial crisis have now put these monetary and fiscal policy frameworks under severe strain. The world’s central banks have engaged in unprecedented monetary stimulus to counter what would otherwise have been a disinflationary or even deflationary economic contraction.
This was the appropriate policy response, but has inevitably raised questions about the timeliness of any future normalisation of policy.
Among the world’s central banks, the Reserve Bank of Australia has been at the forefront of this process, raising interest rates since October, but there is little sign of monetary policy tightening in most other economies.
There are particular concerns over whether the US Federal Reserve will be able to resist pressure to maintain an overly accommodative monetary policy stance.
The Fed’s unprecedented role in supporting the US financial system and accommodating fiscal stimulus is seen compromising its independence and commitment to price stability, while its independence is also under attack from Congress.
Fiscal concerns
These concerns over the direction of monetary policy are perhaps less significant than the concerns in relation to fiscal policy. Governments around the world have implemented unprecedented discretionary fiscal stimulus packages, compounding the cyclical deterioration in their budget positions due to reduced economic growth.
These stimulus packages are of doubtful effectiveness in supporting demand in the short-run, not least because they undermine the credibility of fiscal policy in the long-run.
A discretionary fiscal stimulus package is equivalent to a future tax increase in the absence of a credible plan to reduce future government spending. Yet no one would consider the announcement of a future tax increase as stimulatory for current economic activity.
Discretionary fiscal stimulus packages have further widened the long-term fiscal gaps that threaten to overwhelm the budgets of developed economies as a result of aging populations. Australia has a relatively favourable fiscal position compared to most economies, but even before the financial crisis, the Treasury warned in its inter-generational reports that current spending policies are unsustainable.
There is enormous uncertainty about how these long-term fiscal imbalances will be resolved, both in Australia and abroad. Governments could cut spending, raise taxes, default on their debts or try to inflate them away. Different courses of action will have radically different implications for future economic activity. This uncertainty will itself hinder recovery and future economic growth.
The manifest unsustainability of fiscal policy settings in many countries, not least the US, has also undermined the credibility of monetary policy, raising fears of inflationary debt monetisation, a precedent already set by the existing quantitative easing programs of some central banks.
Inflation expectations implied by US Treasuries have rebounded from their crisis lows and now point to long-term inflation outcomes just above the 2 per cent generally considered to be consistent with price stability. More ominously, record highs in the nominal US dollar gold price are widely seen as symptomatic of concerns about future inflation and the risk of sovereign debt default.
Instability in inflation expectations reflects a fundamental lack of conviction in the resolve of policymakers to take the necessary monetary and fiscal policy decisions. It remains to be seen whether policymakers can rebuild the credibility that was sacrificed during the crisis, particularly on the altar of fiscal stimulus.
Dr Stephen Kirchner is a Research Fellow at The Centre for Independent Studies.
