When not to stimulate

There is now little doubt in anyone’s mindthat the New Zealand economy is in for another bumpy ride over the comingyear.   Given this realisation the burning question is:   How can governmentpolicy save the day?  

Many analysts believe that looser fiscalpolicy, brought about either by cutting taxes or increasing short-termgovernment spending, will help to buffer the economy during the upcoming toughtimes.   

However, an economist that suggests fiscalstimulus whenever economic activity declines is like a doctor that suggestsantibiotics whenever their patients feel sick.   Whether a fiscal stimulus is agood idea depends on the specifics of the crisis we currently face.

The economy has slowed for a number ofreasons:   the international price of what we sell overseas is falling, theprice of what we buy from overseas has risen, we have experienced a drought,household wealth has slumped, and the cost and availability of credit havedeteriorated in some sections of the economy.

In the face of this myriad of shocks, thereis the potential for the government to help steady the economy – especiallywhen the shocks to economic activity are only temporary.

The primary situations where expansionaryfiscal policy can be useful are when consumer and business confidence drops"irrationally", when prices in some markets cannot adjust, or when consumersand businesses are "credit constrained" – a term which implies that people whocould get credit in a normal situation can’t now.  

When these situations occur the economy maydeteriorate more markedly than is implied by fundamentals, and governmentaction has the ability to push economic activity back to its "natural" rate.

To some degree we are facing two of thesemenaces – consumer and business confidence has dropped like a stone, whileanecdotal evidence suggests that there are a number of normally profitablebusinesses that have lost access to credit.

However, the Reserve Bank has the abilityto deal with both of these short term issues by cutting the official cash rate– a duty they have taken on in earnest!   With the Bank responding to smooth the New Zealand economic cycle, there is little need for the government to getinvolved.

Furthermore, the use of monetary policy tobuffer the economy from these temporary shocks is superior to the use of fiscalpolicy.   Monetary policy can react much more quickly to changes in the economicsituation and, even with the popularity of fixed-rate mortgages and a damagedcredit market, monetary policy will help lift confidence and economic activity ina timelier manner.   Even more importantly, monetary policy is not subject toregulatory capture in the same way as fiscal policy – the Reserve Bank can’t bepressured into changing interest rates for any select interest group.

Some may say that the situation is worsethan I have put forward – even once the credit market has settled, interestrates and access to credit will still be more restrictive than in recenthistory.   Furthermore, even with a lower official cash rate, the possibility ofa six-quarter recession will still be on the cards.  

Even so, the distinct possibility of 18months of shrinking economic activity does not ensure that looser fiscal policyis a good idea.

Beyond the temporary drop in confidence andelevated uncertainty in the credit market there are permanent, structural,factors that have changed.  

The nations that have kindly loaned usmoney for so long will now want some back, in order to deal with their ownreductions in income.   Over time it appears that limits on the supply of oilwill keep the price of fuel elevated (even given recent declines in the price).  And finally, the realisation that we owe a substantial carbon liability to therest of the world implies that we will have to ship more of our country’sproduce overseas to pay for it.

Any increase in government spending (andhence borrowing) in order to prevent these permanent shocks will not be of anyuse – because the funds that are used will have to be paid back at some point, exacerbatingthe inevitable shift to a lower level of economic activity.

A policy that requires increasinggovernment spending in the face of a permanent negative shock to economicactivity is dangerous – as it implies increasing spending in the face of lowernational income.   To put this in perspective, such behaviour by the governmentwould be equivalent to a household increasing spending after they have receiveda pay cut!  

Just as a household has to take a pay cuton the chin and move on with a lower level of consumption, a nation thatreceives a permanent shock to its income must simply accept a lower level ofeconomic activity.

If monetary policy runs out of steam and webelieve that the shocks to economic growth are still only temporary then theremay be a special role for increased government spending.   However, until thattime there is not.

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