We need a global fiscal push.

I’ve written many times before (at least here, here and here about the need for Australia’s government to pull the fiscal levers more to support the economy. The RBA has all but exhausted the monetary levers. Interest rates are nearing zero and risk creating an asset price bubble in the property market and/or the stock market. Even the Governor of the RBA Philip Lowe acknowledges that “it won’t generate medium term growth and just risks pushing up asset prices”. That’s why we need the government to fast-track more infrastructure investment, enact more training and skills development programs, undertake tax reforms in areas such as housing, and offer private sector investment incentives.

But it still won’t be enough.

Australia could do everything right. The government could go on the most well-targeted unprecedented spending spree in our history. Economic growth could push up over 3 per cent again. Unemployment could fall under the RBA’s 4.5 per cent target. Productivity could start accelerating. Wage growth too could once again have a three in front of it. Even inflation could return to the RBA’s 2-3 per cent target range.

But interest rates will still be too low.

Low interest rates are a global phenomenon. There are enormous amounts of savings sloshing around the global financial system looking for returns. Households and businesses are indeed borrowing it (every dollar of savings naturally represents a dollar of borrowing somewhere in the world – it has to) but it’s not productive investment. Too much of it is speculative. If it were productive, it would generate solid returns and would drive up interest rates. This isn’t happening. The private sector alone can’t find enough productive investments and governments aren’t bold enough to go on an infrastructure spree. Hence low interest rates and bubble-susceptible asset markets.

Australia can’t fight this trend alone. If global interest rates are low, ours will be too, even if our economy is running as well as possible.

This is the problem. During the good times, we want central bank interest rates to be at least 4 per cent. Before the GFC in Australia, they were 7.25 per cent! By some estimates today, good times would only deliver 2-3 per cent interest rates. The reason this is a problem is that during a downturn, it doesn’t leave the central bank much room to cut interest rates to stimulate the economy (unless they wanted to target a higher inflation rate – see my previous work here). This lack of ammunition would once again put the burden on the less efficient and less timely political process to boost the economy – something that independent central banks were supposed to largely mitigate.

This is why we need … A GLOBAL FISCAL PUSH. Trillions of dollars can be borrowed by national governments all over the world at near zero per cent interest rates. Some governments can borrow at LESS than zero. Even mortgage holders in Denmark are enjoying negative interest rates of -0.5 per cent – yes, their monthly bank statement literally includes an interest payment FROM THE BANK TO THE BORROWER! This is unprecedented and our grandchildren won’t believe it – so keep your bank statements as evidence.

I’m old enough to remember a time when it was unthinkable that we couldn’t convince governments to spend MORE and we may be seeing the tide turning. The European Central Bank is increasingly putting pressure on its national governments to spend up big. Even fiscally conservative governments like Germany and the Netherlands are reconsidering their balanced budget rules in light of the ridiculous cheapness of borrowing and the fact that the EU may already be in recession.

And there’s no shortage of projects that could be financed. In Australia, the pipeline of potential public transport projects is virtually endless. In Europe and the US, simply repairing and upgrading existing infrastructure would be a big boost. Given current interest rates, it beggars belief that governments can’t think of a worthwhile way to spend money.

This is one of the biggest moments in the global economy since the 1930s but we don’t need a world war to finish it. We just need governments to invest in their own backyards. It won’t just spur long term economic growth and bring interest rates back up to levels that would provide insurance against the next downturn. It could also show the world what happens when they work together, ushering in a new era of global cooperation that even a decade of insular nationalistic politics hasn’t yet destroyed.

Lowe pleads for government support as RBA running out of ammunition.

The RBA has done a complete 180 in just four months, from a tightening bias in February to passing the first of two consecutive cash rate cuts in June.
The RBA’s diminishing effectiveness means they are not expecting a full economic recovery until at least 2021.
RBA Governor Lowe is therefore doing everything he can to encourage further fiscal stimulus and structural reform from the government to more quickly absorb the economy’s spare capacity.

Back in February, the Governor of the RBA Philip Lowe said “the next move in interest rates is more likely to be up rather than down”. Since then, inflation has continued to disappoint on the downside and unemployment has crept up despite ongoing employment growth. The economy has continued to underperform with sluggish growth in household incomes and the cooling housing market depressing dwelling investment and tightening household budgets. Just as importantly too, the RBA reduced its estimate of the unemployment rate that is needed to drive up wage growth and inflation from 5 per cent to less than 4.5 per cent.

By June, this disappointing progress towards their own (suddenly more ambitious) targets forced the RBA’s hand. The cash rate was cut by 25 basis points – the first change in almost three years – then again in July to the current record low 1 per cent. The RBA is now waiting to see how these cuts – plus recent tax cuts, changes to lending regulations, the surprise election result and several international developments – play out across the economy before deciding upon further action.

What is particularly telling though is that the RBA is not forecasting wage growth, inflation and unemployment to reach target until at least 2021. Given how long they have already spent missing their targets, why wouldn’t the RBA try to accelerate this recovery?

Because the RBA knows it is running out of ammunition. It simply can’t (or won’t) accelerate the recovery any faster than this. At this point their ability to absorb the remaining slack in the economy is already diminishing. Governor Lowe himself, in his Opening Statement to the House of Representatives Standing Committee on Economics said “it is certainly true that, in the current environment … monetary policy is less effective than it used to be”.

At their current low levels, further cuts to interest rates are unlikely to be fully passed on to mortgage holders. Many lenders have already dropped the rates they pay on savers’ deposits (close) to zero so they won’t be able to offset many more cuts to their lending rates. Quantitative easing has been discussed as a means to reduce interest rates on longer term assets but generally only in response to a financial crisis or sudden exogenous shock to the macro-economy rather than merely a prolonged period of moderate sluggishness.

Another key channel through which a lowering of interest rates stimulates the economy – by pushing down the exchange rate and supporting exports – is also being undermined. Every major central bank in the world is expected to cut interest rates in the next six months. In addition to ourselves, the US, New Zealand, India and Thailand have already started – NZ by a market-shocking 0.5 per cent. The European Central Bank, the Bank of Japan, the People's Bank of China, the Bank of England and the Bank of Canada are expected to join soon. This means the exchange rate impact of any cuts to our own interest rates is being reversed by the same actions by other central banks – a phenomenon many are now dubbing a ‘currency war’. While cutting interest rates still has the benefit of shoring up access to affordable credit and boosting household disposable income even without the exchange rate channel, its stimulatory effect is diminished.

This is why for several years now Governor Lowe has been putting increasing pressure on government to undertake infrastructure investment and microeconomic reform. Perhaps the earlier experience of the US and EU at the zero lower bound made Governor Lowe wary of Australia reaching this point several years ago. In an attempt to not overstep his jurisdiction, Governor Lowe may have been very explicit in his recent testimony in saying that he wasn’t making “recommendations” to the government, just providing “options”. But the implication and urgency was clear. And now that we can virtually see the whites of the zero lower bound’s eyes, many other economists have come to the RBA’s aid in also calling for additional fiscal stimulus. This would push the economy back towards target faster – and arguably more effectively – than the RBA acting alone.

After all, actions by the RBA to change interest rates only affect economy-wide spending indirectly. Fiscal stimulus on the other hand is itself an injection of spending – especially during a downturn when it is less likely to crowd out the private sector. Strategic investments also have the added benefit of boosting the economy’s long term productivity. Nor is there a lack of infrastructure in which to invest or reforms to undertake. While there is already a substantial pipeline of State infrastructure work underway in NSW, Victoria and Queensland, capacity constraints are far less binding in States like WA, SA and NT. Moreover there are regional and smaller projects that can be fast-tracked all over the country that avoid these constraints.

Governor Lowe also advocated structural and productivity reforms including training and skills development.

“A strong, dynamic business sector is the best way of creating jobs and growing the overall economy. We do better if Australia is viewed as a great place to expand, invest, innovate and employ people.”

Reforms to property taxation could also help workers relocate to areas of superior employment prospects. Reforms to industrial relations could bolster business incentives to invest in their productive capacity and expand their workforces. Lowe also pointed to an increase in the Newstart Allowance as a more effective short term boost than the planned tax cut for higher incomes.

The Federal Budget situation is also looking increasingly positive. On the back of the six largest monthly trade surpluses on record – all occurring this year – thanks to the mining export boom, the Government’s promised 2019/20 surplus may even be delivered a year early. By both international and absolute standards, Australia’s Federal Budget is in a great position to provide additional fiscal stimulus to absorb the slack of a struggling economy.

It also isn’t often that government borrowing costs are so low. At this point in time, all governments in Australia can borrow for 10 years at an interest rate under 2 per cent – some much lower still. Rarely does a government have the opportunity to do so much good, so cheaply.

It is also worth pointing out that the current environment of record low borrowing costs is a global phenomenon. Across the advanced world, an ageing population is increasing the desire to save rather than invest. Economic anxiety and previous accumulation of debts are causing individuals to consolidate their budget positions. In China too, with its relatively weak social safety net, individuals have to save and depend on the government to invest. This trend towards saving is holding down global interest rates and means that even after Australia’s economy returns to trend, opportunities will still remain for us to borrow cheaply to finance valuable public and private investments. The world is crying out for investment opportunities and there are no shortage of them, especially for a willing government.

While the market is expecting two further interest rate cuts in the next year, the diminishing effectiveness of the RBA’s shrinking stockpile of ammunition and the Government’s strong budget position strengthens the case for additional fiscal support.

Judith Sloan hits the fallacy trifecta!

Judith Sloan has really outdone herself.

In a recent article in The Australian[1]:

1.     She blames the RBA for the government’s failures.

For several years Judith has criticised the RBA for dropping interest rates down to 1.5 per cent back in the years to August 2016, saying it overheated the housing markets.

The RBA dropped interest rates during this period because the mining boom had ended and the real economy was sluggish. The risk of overheating the housing markets should have been addressed by regulators (through financial oversight) and government through planning for faster housing development to meet demand. Interest rates are a blunt tool to curb asset markets, would need to be raised significantly to do so, and would damage the real economy further in the process.

Any failures during this period were failures of government, not the RBA.

2.     She says the RBA should have raised interest rates in 2017/2018 when “the economy ran relatively well”.

Judith’s words were:

“Why the RBA chose to keep the cash rate so low for over two years as the economy ran relatively well is anyone’s guess. … If there were ever a time to raise the cash rate, it was during 2017 and 2018.”

You mean when inflation (you know, one of the RBA’s official KPIs) was barely touching the bottom of its target band?

You mean when the unemployment rate was far above where we estimated the rate of full employment was even back then and an average of 590,000 people were unnecessarily unemployed?

You mean when the housing market had started to turn down and where, in hindsight, the real economy could have done with some additional stimulus in preparation for the headwinds we now know were coming?

That’s when you think the RBA should have raised interest rates?

Judith even points out that the RBA has failed to meet its inflation target for a long time. How on earth does she see this as a reason to do anything but provide more stimulus, not less?

3.     She falls for the popular fallacy that by raising interest rates a few years ago, the RBA would have more ammunition today to combat the current slowdown or any potential future shock.

This is akin to telling a hiker struggling up a hill to put an extra 10kg of weight in his backpack just so he has something to drop in a few kilometres’ time. Weighing yourself down with unnecessary baggage now doesn’t make it better for you tomorrow. When the economy needs support, we should give it support, not wait for something worse to happen.

If the RBA runs out of ammunition, the government should do its damn job!

·       Further tax cuts could be implemented (not my preference at the moment).

·       Automatic stabilisers that (as the name suggests) automatically kick in when the economy slows could be expanded. A boost to Newstart for example, would provide more support to people who become unemployed during a downturn and avoid the tedious political process at a time when quick decisions are needed.

·       Certain infrastructure projects could be fast-tracked in areas that most need them.

·       Microeconomic reforms to stamp duty or industrial relations to boost productivity could be enacted.

Alternatively we could expand the RBA’s toolkit beyond just indirectly affecting economic activity through interest rates. ‘Helicopter money’ transferred directly from the RBA to households or government would work but would probably create a nasty case of moral hazard where the government expects to be bailed out repeatedly in the future. But their powers could include the ability to invest directly in infrastructure, as I’ve written before.

Even without the ability to lower interest rates further, there is no lack of ammunition – just a lack of will to use it.

The RBA has the right idea. Judith Sloan does not.

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[1] As well as in commentary over the last few years.

Government needs to pick up the slack BEFORE an emergency not after

There is increasing commentary recently about what it would look like if the RBA engaged in quantitative easing (QE) if it runs out of traditional interest rate ammunition.

I am pleased that the RBA is lowering interest rates, making it cheaper for people, households, businesses and governments to borrow. And yet, the talk of QE makes me nervous.

QE essentially involves the RBA entering the market and buying up financial assets. This acts to reduce further the interest rates on more assets across more maturities than could be achieved through the RBA’s usual open market operations with short term securities.

By reducing longer-term interest rates, the RBA will ideally suppress the exchange rate further and stimulate further borrowing and spending by individuals, households, businesses and governments.

Currently borrowers aren’t sufficiently tempted by record low short-term interest rates. Nor are we in the midst of a full-blown financial crisis. Instead it is entirely possible that the biggest obstacle facing them is not the availability of cheap credit but a lack of demand. Individuals aren’t confident about their future wage levels (demand for their labour). Businesses aren’t confident about future sales (demand for their products and services). Governments are also nervous about debt levels.

In such circumstances, ever-cheaper credit won’t necessarily stimulate the real economy. It will more likely over-inflate asset markets, including stocks and housing, as investors become ever more speculative in the face of cheap credit.

This is what makes me nervous. While I'm happy with what the RBA is currently doing, Australia needs a boost that is sustainable, not a speculative one with potentially dangerous fallout.

This is why governments need to step in with fiscal stimulus and structural reform before the RBA runs out of traditional interest rate ammunition. This can include:

-        Progressing with tax cuts and other financial supports for low and middle incomes

-       Bringing forward infrastructure spending, especially the smaller simpler projects that can be started sooner;

-    Reforms such as the replacement of stamp duty, the simplification of building approvals processes and planning frameworks, labour market reforms and incentives for small and medium sizes businesses.

-    APRA also needs to loosen its lending restrictions on banks from a 7 per cent borrower assessment rate to a simple 2.5 per cent buffer above the standard variable rate. This is the main obstacle to access to finance, not the RBA.

Unless governments can’t (or won’t) capitalise on record low interest rates unless the RBA uses QE to reduce them further, QE is likely to distort economic activity with questionable benefits.

Governments need to do this for Australia before the RBA brings out the emergency measures. There is no shortage of worthy recipients for stimulus and the potential consequences of failure are mounting.

The RBA is running out of ammunition and the government must pick up the slack.

The RBA has cut interest rates to a record low with further cuts likely this year.
This was a response to their own internal recalculation of the NAIRU that showed us to be even further from full employment than previously thought.
Add to this the possibility of a sudden actual real-world shock, and monetary policy is dangerously close to the lower bound of its effectiveness.
Government needs to take the hint and use fiscal stimulus and reform before the RBA runs out of ammunition and before wage and inflation expectations make a proper recovery even harder.


The RBA has cut interest rates to a new record low of 1.25 per cent. This was not a response to a sudden new market development. Rather, the RBA has recalculated its estimate of the ‘non-accelerating inflation rate of unemployment’ or NAIRU – the rate of unemployment consistent with low and stable inflation.

Previously the RBA believed the NAIRU was 5.25 per cent and an unemployment rate around 5 per cent would result in stronger inflation and wage growth.

Now they estimate the NAIRU to be around 4.5 per cent and that an unemployment rate even lower than that may be necessary to lift inflation back to within their target range, and improve wage growth for Australian workers.

The RBA consequently cut interest rates in the face of this new understanding and it should help support the economy. This added relief for mortgage holders could result in greater discretionary spending (retail, services, etc.) and additional debt being taken on for things like furniture and vehicle purchases. It should also cause a weakening of the Australian dollar that will improve export profitability and potentially divert some import spending to the employment of any currently-idle domestic resources.

The housing industry should also benefit directly from this. The RBA’s interest rate cuts combined with APRA’s potential reduction in lending ‘buffers’ should make new home purchases available to people who previously couldn’t access it. Greater borrowing capacity (and willingness) will support the home building and renovations industry.

Perhaps just as importantly, this new stimulatory environment is here to stay for an extended period. As recently as December last year, the RBA was forecasting that the next interest rate move was more likely to be upwards than downwards. Now, just six months later, the RBA has cut interest rates and there are probably more cuts coming. Downside risks are likely to continue into 2020 and beyond.

Moreover, the RBA may run out of interest rate ammunition before having returned the economy to the path towards full employment. Without a sudden positive international development or more ambitious fiscal response, this sets the scene for a somewhat impotent RBA, a prolonged period of economic underperformance and a low interest rate environment continuing for the foreseeable future. The government’s own wage and inflation forecasts – upon which much of their budget is based – could also be in jeopardy.

While low interest rates are, on the face of it, good for the housing industry, if they are a response to ongoing weakness in the broader economy and therefore, limited demand for housing, even the housing industry won’t be smiling.

Add to this the possibility of a sudden actual real-world shock, and monetary policy is dangerously close to the lower bound of its effectiveness. Estimates suggest that once the RBA reaches a cash rate of 0.5 per cent, further cuts won’t be stimulatory because the transmission mechanism would have been exhausted. Even quantitative easing has had mixed results around the world and may not be the economic panacea we would need.

Government needs to take the hint and use fiscal stimulus before the RBA runs out of ammunition and before wage and inflation expectations make a proper recovery even harder. Incoming tax cuts will be of great help and there is scope to bring forward some of the government's smaller and simpler infrastructure projects for immediate commencement. Federal infrastructure investment levels in general could also be even more ambitious – with appropriate costing and consideration for potential projects.

There is also scope for microeconomic reforms that improve productivity and efficiency across the economy. The replacement of stamp duty with a broader based land tax – or consumption tax like the GST – would be particularly beneficial for the struggling housing industry:

• It would facilitate downsizing for retirees, making larger homes available for new younger families;
• It would facilitate a more mobile and flexible workforce with people able to more easily relocate where jobs are available;
• It would provide State governments with a more stable source of revenue than stamp duties that tend to dry up just as the economy is in need of stimulus;
• It would help alleviate the intergenerational inequality that can emerge when one generation is lucky enough to be invested in the property market before a record-breaking boom.

Government has no excuse to sit on its hands. There is no shortage of productive investments and reforms to undertake, especially with borrowing costs so low – and falling.

While the story of independent central banks has been one of success for the last quarter century, monetary policy is not without its limits. It was never intended to entirely bail out the government from its responsibility for macroeconomic management. The coming years will test the government’s willingness and ability to pick up the economic slack that has emerged.

The Holy Quintet

5 Factors to Rescue the Australian Economy

In quick succession, five factors have come together that could officially end Australia’s economic downturn – the election, property tax policy, tax cuts, APRA and the RBA.
But true to form – and despite the expert consensus – I think the RBA will wait to see how things play out.

The RBA meets today for its June Monetary Policy meeting and virtually everyone is predicting an interest rate cut.

Except me. Just as it has for the last 33 months, I think the RBA will hold fire.

Not because I don’t think they should cut – I think they should have cut six months ago. The Australian economy has been slowing since mid-2018. House prices have been declining since late 2017 so the risk of overheating the housing market with lower interest rates has gone. Credit is tight. Inflation has undershot the RBA’s target range for years. Wage growth has underwhelmed despite strong employment growth and low unemployment rates. GDP growth rates for the last two quarters (and leading indicators for the March 2019 quarter) have also disappointed.

So why wouldn’t the RBA cut interest rates? Because in quite quick succession, four other factors have come together that could officially end Australia’s economic downturn:

1. The election. There is always uncertainty surrounding a Federal election. Activity in the property industry tends to slow down around this period as investors and owner-occupiers wait it out to see if there are any drastic tax or legislative changes that could affect their purchase decisions. With the outcome of the election now settled, this uncertainty is now over.
2. Negative gearing and capital gains tax. This election was also more relevant to the property industry than any usual election. Labor’s planned changes to negative gearing and capital gains tax would have put further downward pressure on demand for housing, house prices and construction activity. At a time when confidence is shaky and there are concerns about the prospect of a hard landing for the property market, any further (even small) shock to the sector could trigger a crisis of confidence and a steep downward spiral for not just the property market but also the broader economy. That would mean many more people unemployed and slower (even backwards) wage growth for those that retain their jobs. With Labor’s defeat and the conservative incumbents retaining power, these specific concerns are now off the board.
3. Fiscal stimulus. During the Federal Budget in April, significant fiscal stimulus was announced by the government. This included $7.5 billion in tax cuts for 2019/20 and similar in 2020/21, plus $100 billion in infrastructure spending over the coming decade. A significant portion of these tax cuts will also be given to the middle and lower end of the income spectrum where they are most likely to be spent (e.g. retail, services) and boost economic activity. Recent estimates have put the positive economic impact of these tax cuts as equivalent to a 0.5 per cent interest rate cut by the RBA, around the same as the Rudd Government’s ‘cash splash’ during the GFC. This is a timely stimulus given weak recent economic growth, inflation and wages.
4. APRA also made an announcement last week that could officially end the credit squeeze. Until now, APRA has required that banks assess potential mortgage-holders against an interest rate of 7 per cent. To be even more conservative, banks adopted a 7.25 per cent assessment benchmark. This was tightening the supply of credit drastically. Now APRA has indicated it will remove its 7 per cent rule in favour of banks adding just 2.5 per cent to the going mortgage rate. This could bring the assessment rate down by a full percentage point and should loosen the supply of credit and foster greater activity in the housing sector. There will also potentially be fewer defaults on previous sales that are soon to seek finance on land or dwellings that have subsequently lost some of their value in the face of falling prices.

This is a fortuitous confluence of factors that may continue Australia’s run towards 30 years of continuous recession-free economic growth and help us truly earn the title of ‘the lucky country’.

The RBA could make it five – the ‘Holy Quintet’. But for now, I wager that ‘Philip the Patient’ will remain just that.

Philip Lowe indicated last week that the RBA will “consider the case for lower interest rates” in June – hardly conclusive but the market took this as his strongest indication yet and is now 100 per cent sure that the first change of interest rates since August 2016 almost three years ago is going to happen today. Market expectations of two interest rate cuts this year have been reinforced and even brought forward. If correct, this would bring RBA interest rates to a new record low of just 1 per cent. This added relief for mortgage holders could result in greater discretionary spending (retail, services, etc.) and additional debt being taken on for home, renovation, or vehicle purchases. It should also cause a weakening of the Australian dollar that will improve export profitability and potentially divert some import spending to the employment of any currently-idle domestic resources.

But given the above four factors, I think the RBA will wait to see how they play out first. Maybe they want to leave some interest rate ammunition in reserve in case of a significant new domestic or international shock (not a strategy with which I agree, but still). Maybe they want to avoid encouraging heavily-indebted households to take on more debt (unlikely to happen in current circumstances, in my opinion). Maybe they genuinely believe a cut isn’t necessary and/or won’t help (again, I disagree). Nevertheless, I hope their patience is vindicated.

A lot is riding on it.

Housing supply is about more than affordability. It can also be a useful tool in macroeconomic management.

The housing market has to manage its own inflation rates just like the RBA does with the broader economy, especially because the housing market has less tools at its disposal on the downside.

There’s a reason the RBA is so committed to avoiding general deflation where prices are falling across the economy – deflation can be self-fulfilling.

If everyone sees prices falling, and expects them to keep falling, they are more likely to put off their big expenditures. Why buy now when it will probably be cheaper in the future? Households put off buying that new TV, fridge, couch or car. Businesses put off investing in that new warehouse, office, production equipment or staff. Even governments may delay major infrastructure works – which are often subject to cost-benefit analyses – if parts and labour are expected to be cheaper in the future.

The very act of all these parties putting off major expenditure is precisely what causes a self-fulfilling deflationary spiral. In the 1930s, it was called the Great Depression.

Ironically, it can start by actually allowing inflation to creep too high. If the price of everything accelerates too fast, households and businesses can reach a tipping point where things become (or are suddenly perceived to be) too expensive to afford or more expensive than they are worth (in the latter case, financial stocks, for example). This sudden withdrawal of demand can then cause prices not just to slow, but reverse to offset some of the preceding ‘unjustified’ price gains.

When the RBA sees inflationary pressures rising then, what do they do? They increase the supply of assets in the financial market, causing the price of these assets to decline and their interest rates to rise, thereby increasing the cost of borrowing throughout the economy, reducing the desire to borrow, slowing the economy and slowing down inflation. This avoids the sudden stop and risk of deflation that can come from inflation accelerating too fast.

If inflationary pressures are conversely too weak, the RBA withdraws the supply of assets from the financial market, increasing their price and decreasing interest rates, thereby stimulating the economy again and avoiding deflation.

 

This importance of avoiding deflation (and also excessive inflation) doesn’t just apply to the macro level though. It also applies to individual sectors, especially ones as significant as the housing industry where many people invest and perceive most of their wealth.

When house prices start accelerating rapidly, new land supply needs to be made available quickly, whether this is through swifter and simpler approvals processes, zoning and planning rules that allow increased infill and density in established suburbs, or investment in transport infrastructure to open up new well-located land for development. This would allow new houses to be brought to market faster, softening the pressures on house prices.

Right now we are witnessing the impacts of a failure to do this.

For most of the 21^st century, rapid overseas migration drove demand for housing through the roof, but new housing supply wasn’t readily available. We now know what happened next – house prices accelerated rapidly to the point where – in addition to forcing regulatory changes that deterred investors – many owner-occupiers suddenly decided they couldn’t afford to enter the housing market. This reversal of demand then caused house prices not just to slow, but decline. At the same time that this demand went into reverse, a sudden (delayed) influx of new housing supply finally came onto the market too, forcing house prices down even further.

Now we are in a deflationary phase in the housing market where many people are deliberately holding back, not necessarily because they still can’t afford to enter the market, but because they now expect prices to continue downwards.

Unlike the RBA though, the housing market doesn’t really possess a mechanism whereby it can withdraw supply of land from the market in order to support prices. We just have to wait until prices find their floor and recover. Unfortunately, by the time this happens, the housing downturn could have spread to the rest of the economy, making the job of the RBA and the government in supporting a recovery much harder.

This is why it is so important to ensure a supply of residential land that is flexible to increases in demand. Excessive price inflation can result is a sudden stop and big downturn, and there aren’t as many tools to turn this around once it has begun.

MMT bad faith.

MMT advocates don’t seem to appreciate the risks in giving politicians responsibility for managing inflation, and they engage in the same sort of supply-side voodoo as tax cut-obsessed Republicans.

It seems to me more and more that advocates of MMT (or Modern Monetary Theory) may not be debating in good faith.

To be sure, this doesn’t apply to all – in fact, the reason I learnt about MMT at all was because I stumbled upon a conversation on the topic on Twitter, and several individuals were kind enough to engage with me very much in good faith.

But there does appear to be a segment of this movement that is not interested in whether MMT can be implemented feasibly, which leads me to believe that they’re just looking for an excuse to drastically increase spending on their chosen pet projects, without caring how it is accommodated (note I didn’t say ‘afforded’ or ‘paid for’ given the fact that MMT states the limits of government spending aren’t what the government can afford, but what the economy’s real productive capacity can accommodate).

The first reason for my accusation is that very few MMT advocates seem to highlight the potential disaster of trusting politicians with responsibility over inflation, rather than a semi-independent central bank. MMT does indeed point out that fiscal policy (taxes) is the intended tool to control inflation (even if not to ‘pay for’ government spending) but very few worry that whenever politicians have been given that power, they’re not good at wielding it. Tax policy is simply too slow to react to inflationary pressures (or lack thereof). Sometimes politicians are simply too afraid of the voter reaction if they change taxes one way or the other.

I’ve suggested some sort of independent fiscal authority with control over the choice and implementation of infrastructure projects, and maybe a direct link to the printing press (if not indirectly through simply a share of the government budget). This would leave the determination of any output gap and the proper cost-benefit analysis of infrastructure projects out of the hands of politically-motivated individuals. But it’s not an idea I see discussed frequently.

So this is my first concern with many MMT-advocates – they don’t seem to appreciate the entire purpose of outsourcing monetary policy to the experts of an independent central bank in the first place.

My second concern, in the case of the ‘Green New Deal’ debate in the US, is the suggestion (explicitly not implicitly) that the additional spending on environmental protection will create entire new industries and economic activity, thereby absorbing all the extra spending without it translating into inflation.

Again, this is a risky proposition to trust politicians to ‘pick winners’. Governments have attempted this kind of industrial policy all over the world with very mixed success. Sure, South Korea’s auto manufacturing industry did well with government support, as did the US’s manufacturing industry in the 19th century. But there are just as many examples (if not more) of abject failure (see South America – and I’m not even talking about Venezuela’s fiasco, I’m talking about countries like Argentina throughout the 20th century).

This is the kind of supply-side voodoo Republicans employed to pass their tax cuts – that they’d generate enough economic activity to pay for themselves. They didn’t. They were just used mainly for executive bonuses and stock buybacks. They haven’t even generated much new real investment.

To be sure, there *are* lots of good projects the US could undertake – even just repairing their crumbling infrastructure – that could literally ‘pay for themselves’ through increased economic activity. But if MMT is to be the new status quo, we need a way to ensure that once the ‘low hanging fruit’ productive projects are exhausted, politicians don’t keep printing money to finance lesser projects that do, in fact, just result in inflation.

So this is my second concern – how easy it would be for a government to pick the wrong industries resulting in all that additional money translating not into new economic activity, but plain old inflation.

MMT is philosophically interesting and is indeed a clever way of looking at how the world works. And it arguably arose (or at least came to greater prominence) as a legitimate antidote to the ill-advised government austerity movements that followed the GFC. But unless its advocates talk more about how it is to be implemented, accusations of bad faith – along with comparisons to countries like Venezuela – will continue.

It’s good for taxes to be progressive. But it’s more important that they can’t be avoided.

There’s been a lot of talk recently (particularly out of the US) about increasing taxes on the wealthy – Elizabeth Warren has proposed a wealth tax of 2 per cent for assets over $50 million and 3 per cent for assets over $1 billion. Alexandria Ocasio Cortez (AOC) has proposed a top marginal income tax rate of 70 per cent for incomes over $10 million. Bernie Sanders wants to lower the threshold for the estate tax and make it more progressive.

On the face of it, there is a good argument for countries like the US collecting and redistributing more tax than they currently do. I've written before that there is a good inverse relationship between tax collection and inequality. Countries in the OECD with the highest tax revenue as a percentage of GDP (e.g. Norway, Denmark) tend to be the best at keeping inequality low while still maintaining some of the strongest free market economies. On the other hand, countries like the US with one of the lowest levels of tax revenue as a percentage of GDP and also one of the strongest free market economies have among the highest levels of inequality.

What is the best way to raise tax revenue though? Income taxes? Wealth taxes? Corporate taxes? Consumption taxes?

Warren, AOC and Sanders seem to think the first two. I think they're also considering a reversal of Trump’s corporate tax cuts. And it makes sense. Income and wealth taxes can be progressive, with the richest people paying higher rates. Consumption taxes disproportionately affect the poor who spend a higher proportion of their income on goods and services than the wealthy. The same applies to flat corporate tax rates and small vs. large businesses.

So I can understand why Warren, AOC and Sanders picked these taxes.

Unfortunately, income, wealth and corporate taxes are rife with avoidance. Wealthy individuals and companies have the means to use every form of accounting trickery to avoid actually paying these taxes. Shifting profits overseas to avoid corporate taxes. Minimising your official income with every imaginable deduction to avoid income taxes. Even wealth and property taxes can disproportionately affect the middle class because the wealthy tend to hold most of their wealth in shares rather than houses and therefore, avoid such taxes. It’s not easy to enforce these taxes.

This is why, according to a recent article by Bloomberg, the OECD countries that are able to raise the most tax revenue as a percentage of GDP are the ones with the *least* progressive tax systems – economies that rely proportionately more on consumption taxes (e.g. Denmark, Finland). The US on the other hand, has very little reliance on consumption taxes.

As mentioned above, consumption taxes disproportionately affect the poor, but are much harder for the rich to avoid. They also have the added advantage of not discouraging work (like income taxes can) or investment (like corporate taxes can).

Consequently, these countries are able to raise much more tax revenue, and then undertake much more income redistribution to offset the disproportionate impact on the poor – social welfare, infrastructure, education, health care, paid vacations, paid parental leave, child care, all provided by the State to greater extents than in the US.

This redistribution can also include much more targeted exemptions for specific items or activities society wants to encourage above others. This can include fruit and vegetables, health care and, in Australia, possibly new home building. Given the barriers that existed to new home building for much of the 21st century, the affordability crisis that developed, the sudden influx of supply (especially apartments) and the subsequent risk (though not expectation) of a deep and protracted correction, this is not something of which we’d like a repeat episode. Even if such sudden new taxes don’t discourage investment, extra incentives for new home building are still a good idea given our history.

The IMF too, in their latest assessment of the Australian economy, recommended a shift away from less efficient taxes like stamp duties to more efficient ones like consumption taxes (our GST) and land taxes.

This does not mean all taxes need to be consumption taxes but a greater reliance on them seems wise. If high tax collections are the best way to minimise inequality – thereby helping people into the Australian dream of home ownership – while retaining a strong free market, then the taxes that are most difficult to avoid are surely the preferred option over more progressive, but easier-to-avoid, taxes – even if it involves the extra step of greater redistribution.

Redistribution is not a dirty word after all – it’s literally the one and only job of government.

Interest rate speculation pushed into overdrive.

Australia’s economic fundamentals are still strong.
But the local housing downturn, the global trade war, increasing international borrowing costs, a slowing EU, structural issues in China, and general instability all threaten to derail both global and local economic momentum.
The risks are asymmetric to the downside – the RBA should pre-empt them by dropping interest rates this year. The costs of not doing so are potentially much larger.

 

Death, taxes and cash rate speculation – these are universal constants. But in recent months, speculation about the direction of the Reserve Bank of Australia’s (RBA) cash rate have pushed this speculation into overdrive (at least amongst us economists).

The RBA – for many months now – has very clearly been signaling that its next cash rate move will likely be upwards. Many players in the industry agree, speculating some time in 2020 for the next rise.

There are good reasons for this upwards cash rate broadcasting.

Australia is continuing its approach towards 30 years of uninterrupted economic growth. Growth recently returned to trend following the mining and resources fallout, supported by strong home building activity and public infrastructure spending. The labour force continues to strengthen too, with unemployment back down to 5.0 per cent.

We are also being supported by a buoyant global economy. The US is experiencing one of its longest economic recoveries on record. China continues to generate economic growth rates beyond the dreams of any developed country. And advanced economies have driven strong global economic growth in recent years.

It is in spite of – or perhaps *because* of – this strong performance that there is increasing nervousness about the future. A number of prominent pundits have broken from the herd and begun canvassing the idea that the next move could actually be a cut. These concerns mainly surround two perceived risks – a global shock and a major local housing correction.

The IMF has just revised down its forecasts for global growth in the next couple of years; the trade war between the US and China (and perhaps the EU too) threatens to derail global momentum; recent negative economic data out of both the EU and China have raised concerns; and ongoing insular, nationalistic and anti-globalisation sentiments surrounding not just Trump’s America, but also Brexit, the Italian budget situation, recent French riots, and many other regions, threaten in the short term to shock the economic outlook, and over the longer term unwind decades of wealth generation, poverty reduction and international cooperation and stability.

Closer to home, Australia has its own ‘Moloch and Mammon’ on the horizon. Since their respective 2017 peaks, dwelling prices in Sydney have declined by 11.1 per cent to December 2018, and by 7.2 per cent in Melbourne. Nationally, prices are down by 5.2 per cent. The November housing finance figures showed that the number of loans by banks for the construction of a new home fell by 2 per cent in the month of November to be 9 per cent lower than the previous year. The change in the housing cycle had a direct impact on the flow of new residential building work entering the pipeline and creates a risk that the change in housing wealth may cause households to reduce consumption expenditure.

The continuing housing market downturn has thus far not resulted in a significant wealth effect on household consumption. The largest price declines have been at the top end of the price spectrum – households that are less sensitive to changes in wealth and therefore, less likely to significantly cut back on consumption. But this is not a forgone conclusion and while we have long been anticipating a housing downturn (five years of housing construction completed in just four years couldn’t be sustained indefinitely), and ongoing population growth will continue to absorb housing supply, there is still ongoing uncertainty about the downturn’s true length and depth.

Record household debt levels have not yet caused households to tighten their belts and there are few concerns from the RBA about debt serviceability with mortgage arrears remaining low. But wage growth has only just begun to tick upwards from is recent sluggishness and is definitely not guaranteed to continue that way. Combined with structural issues like ageing populations and low productivity growth, wage growth could continue to struggle, putting pressure of heavily-indebted household budgets and increasing their vulnerability to increasing borrowing costs.

Slower global growth will slow the pace of interest rate normalisation around the world but the combination of APRA’s tighter lending standards for investors and interest-only lending and the Royal Commission into the financial industry have acted to tighten local finance conditions not just for investors, but also owner-occupiers (even though APRA’s caps have since been removed). The time it takes to gain approval for a loan has blown out from around two weeks to over two months. And we saw just last week that NAB increased interest rates independently of the RBA and other commercial banks, citing these increasing costs of finance. When the impact of the findings from the Royal Commission become apparent, plus Labor’s proposed changes to negative gearing and capital gains tax, it could be the trigger to a steeper property market decline and the thus far-absent wealth effect on the broader economy.

Perhaps most important to Australia – as has been the case for the last 20 years – is the fate of China’s economy, our single greatest export market. There too, significant amounts of debt have been accumulating. China’s massive ‘pump-priming’ following the GFC averted a significant downturn. But it unfortunately also shifted huge amounts of resources away from potentially productive and innovative private sector uses back into government infrastructure and programs, unfortunately derailing their transition from an investment-led to a more sustainable consumption-led economy.

Recent slower economic growth and other worrying data out of our behemoth neighbor to the north poses the question – do they still have the will and the means to carry themselves through the next downturn? To be fair, people have been talking about Chinese imbalances and slowdowns for a couple of decades now, and China has continued to defy expectations. Even the GFC couldn’t knock them over. Policy makers and regulators have also been attempting to address some of these imbalances for a while now. But these predictions only need to be right once. And doesn’t the fact that these imbalances haven’t disappeared (and have actually got worse) add *more* weight to the argument for every year China keeps kicking the can down the road, not less?

Furthermore, the international trade war – even though escalation is still forecast to cost the global economy only in the low single digit percentages of GDP – could represent the trigger for some of China’s more significant imbalances to reveal themselves.

 

These are a lot of national and international factors that could turn against Australia in the near future. Hence the recent boom in RBA cash rate speculation.

Monetary policy is supposed to be proactive, not reactive. The US provides a good case study of this during the GFC. It was real-time feedback from financial institutions around the country rather than deterioration in official statistics that revealed the sudden liquidity emergency being faced and triggered the unprecedented response from Ben Bernanke and the Federal Reserve.

In Europe on the other hand, they did wait for longer and actually initially increased interest rates because they were more concerned about inflationary pressures than the financial crisis that had already begun. Consequently, the pain that followed was much greater than in the US.

Our own RBA Governor Philip Lowe – generally seen in the industry as a rather conservative figure – would arguably need a significant new development to occur to consider not just delaying any future increases, but actually dropping the cash rate from its current record low 1.5 per cent.

What then would need to happen for the RBA to reverse its long-broadcasted position that the next cash rate move will be upwards? A sudden deterioration in official economic indicators? Unemployment to jump up over 6 per cent? Inflation to fall below 1.5 per cent? Economic growth to turn negative? An influx of panic from their business liaison program?

There is a lot that could go wrong in the near future for Australia and the world.

Notwithstanding one (or more) of the above potential global shocks, I am only predicting a manageable slowdown in the Australian economy, rather than a drastic correction or recession. But I do think this will be a valid justification for the RBA to drop interest rates this year. They no longer have to concern themselves with overheating the property market. In fact, the combination of tighter credit conditions, the imminent impact of the Royal Commission’s findings and increasing global borrowing costs means it may be very irresponsible not to drop interest rates further. The risks are asymmetric – much larger to the downside than the upside. Why not drop rates?

The RBA may suffer a bit of embarrassment if they suddenly change their position. But policy makers need to be willing to consider rapid reversals of position if the worst should happen. By the time it shows up in the official data, it could be too late.

Modern Monetary Theory

MMT reinforces some valuable lessons, including that fears over government debt and deficits are often overblown – especially during major economic downturns.
But there are problems with this approach in terms of trusting government to not stoke inflation or crowd out the private sector in the face of the temptations of ever-expanding government.
These are big asks.

I can’t believe it, but Twitter actually taught me something new. It’s not just about fighting with strangers.

Recently I came across a ‘new’ idea in economics called ‘Modern Monetary Theory’ or MMT. As it turns out, it’s actually not particularly new. But it does offer some useful insights into the relationship between government debt, inflation and taxes.

Granted, I only really encountered the idea recently, so I’m sure I’ll be missing or overlooking certain aspects of it. But here is my understanding.

I suppose the main conclusion of MMT is that concerns about government debt and deficits are overblown. MMT asserts that for a country that has its own currency (e.g. Australia, US, UK, etc, but not countries like Greece), there is technically no limit to the amount of money a government can spend. Even if the rest of the world no longer wants to lend money to that government (or for some reason, they start charging a much higher interest rate on that country’s debt), the central bank can hold all the government’s debt – it’s their money, they create it, they can create and spend as much as they want.

Not only does this mean a government can always ensure their economy runs at full employment. Technically, it also means a government that has its own currency can never go broke.

I know, I know, I had the same reaction – “hang on, a government can’t just print whatever money it wants, it’ll spark inflation!”

Correct. That’s why MMT advocates taxes – not as a means for the government to *afford* what it spends, but as a way of shrinking the private sector enough to *accommodate* that government expenditure without sparking inflation[1].

And this reveals what I think is the critical insight of MMT – a government’s budget is not limited to how much it *taxes*. It is limited to how much the economy can *handle*. This still means tax revenue and government spending will approximately coincide. Generally, every dollar the government spends, it has to tax from the private sector so as to not spark inflation. But not always precisely equal.

During a recession for example, the private sector has already retreated. Government spending will not crowd out the private sector – in fact, by supporting economic activity and private sector confidence, government spending in this case will actually crowd *in* the private sector.

And it can do this simply by borrowing money (either from people, businesses, other countries or just their own central bank printing press) – no additional taxes needed to be raised in the short term.

Now, once the economy is back on a solid footing, this extra money in the system can cause problems. Once the private sector recovers, that extra money may be too much for the economy to handle. So … the government has to gradually withdraw it from the system in taxes to keep inflation down.

So there will be a long run close correlation between government spending and taxes – but it doesn’t have to be exact. Which means any debt that happens to be accumulated during this process is, by definition, not a problem. If it doesn’t spark inflation, and it doesn’t crowd out the private sector, it is perfectly acceptable.

So essentially, MMT advocates allowing governments to print whatever money they want/need to finance their expenditures, as long as they correspondingly shrink the private sector with taxes in order to manage inflation. And any money they happen to borrow in order to achieve this – especially if it’s from their own central bank – is irrelevant. It’s their money.

There are useful insights here. First, it destroys the analogy of the government budget being like a household budget – that governments need to ‘live within their means’ like any household. Households are currency-users, not currency-creators, so for that reason alone, it’s not a valid analogy. A government ‘living within its means’ relates not to how much money it ‘earns’ in taxes, but how much the economy can handle (even though the two roughly coincide).

Second, it reinforces the traditional Keynesian idea of government stimulus during an economic downturn. Not only does this kind of stimulus help prevent the kind of human costs and hardships we saw during recent European austerity, and back in the Great Depression. It also gets the economy back on a solid footing sooner, allowing government tax revenues to recover sooner, thereby managing government debt levels sooner. So even if your only concern is debt, stimulus, not austerity, during a downturn is the way to go.

And MMT adds another piece to this argument – the government won’t go broke if it has its own currency. Again, this doesn’t apply to countries like Greece, but it does to countries like the US, who also got caught up in ill-advised austerity following the GFC. Even ignoring MMT, government debt is always manageable if the interest rate on that debt is lower than the country’s economic growth rate – which has almost consistently been the case for the US, especially over the longer term.

There’s also almost no concern of inflation during a major downturn – so the government can just print and spend for much longer than usual without sparking inflation because the private sector has already retreated. No additional taxes required (at least in the short term).

Now for my concerns …

In the end, MMT is advocating for giving government, rather than an independent central bank, greater control over the printing press.

And it’s not as though we haven’t seen what happens when we’ve done this in the past. Governments always have an incentive to print and spend more. And they’ve often not correspondingly increased taxes sufficiently to avoid massive inflation.

Trusting a government to frequently review tax policy – and change it – in response to inflationary fears, is a much bigger ask than for a central bank. Not just because of their incentives to drop taxes and increase spending, but because the administrative logistics of changing taxes are far more onerous than changing interest rates.

But even if we assume a government can adjust taxes effectively enough in response to their own spending and consequent inflationary pressures, there is still the problem of a continually-expanding government.

If a government always has the incentive to spend more, and manages to tax more to keep inflation down, this means the private sector has to keep getting smaller and smaller to accommodate a larger and larger government.

This raises at least a couple of concerns.

One, government is generally less efficient than the private sector. So a government that crowds out private activity will make the economy as a whole less innovative, less productive/efficient and more prone to crises.

Second, there is simply the matter of personal liberty – the right for an individual to choose how to best spend their own money for their own personal benefit, rather than trusting a government to know what is best *for* them and spend accordingly. This doesn’t override the entire need for government, but it does put a limit on how much we should expect or allow governments to do. Personal liberty should not be *entirely* sacrificed under the guise of the greater good.

So can MMT inform current policy in a way that avoids the above concerns?

In short, don’t give additional power to the government. An independent central bank-type entity should still be in charge of managing the economy, and enforcing at least some fiscal prudence on the government.

I’ve written before about the potential value of an independent fiscal body that picks the best infrastructure projects to undertake, and decides when to undertake them. This way, politicians don’t end up picking politically-convenient projects with limited economic value. And their construction is timed consistent with the business cycle.

And the central bank should remain in charge of interest rate policy and (if not some other independent body like Australia’s APRA) financial system stability.

This way, during a boom, the central bank can cool the economy with higher interest rates and the independent fiscal body can slow down the infrastructure activity.

And during a downturn, if the central bank’s interest rate policy can’t provide enough stimulus (i.e. interest rates are at zero and the economy is still sluggish, as was the case in the US and EU following the GFC), then the independent fiscal body can borrow up big (either from their own people and businesses, the rest of the world, or just from their own central bank) and speed up their infrastructure investment activity.

Any debt that is accrued should not be a concern, as long as it doesn’t over-stoke inflation and crowd out the private sector (which are virtually non-issues during a major downturn). Even if your only concern is debt (which as we’ve discussed for a country with its own currency, it shouldn’t be), stimulus during a downturn is better than austerity.

This action of using fiscal policy to complement monetary policy (rather than replace it, as MMT seems to advocate) can help manage economic downturns with far greater effect, without risking the long-term problems of an ever-expanding government.

It also doesn’t risk a central bank’s credibility being undermined by the threat of political incentives – which can make their job much harder to undertake.

So MMT does seem to have something to offer. But we mustn’t forget the lessons of history. Political incentives are not always consistent with economic realities.

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[1] There are other mechanisms, such as interest rates, credit rationing, etc. that could shrink the private sector instead of (or in conjunction with) taxes. But for now, we’ll just focus on taxes doing the job, which is what many MMTers recommend.