A fly walks up the wall – so cut federal spending hard!

I wonder what people do on holidays. I am writing this from a little house overlooking the Pacific Ocean (at Blueys Beach) – picture “overleaf”. It is an ideal place to write especially as it is raining and not very warm. And with other possible distractions not available (waves) what else should a person do when in an ideal location to write but write. Impeccable logic I thought. So today apart from working on some academic papers that are due, I decided to reflect on an article that I read the other day in the conservative Australian Financial Review. It was one of those articles that always had to the same conclusion – cut federal spending hard. The logic applied was consistent with the conclusion that if a house fly walked up a wall – federal spending should be cut hard!

Here is a shot of my current location – as you can see a beautiful vista but no waves. So while I am waiting for the tide to turn I decided to write this blog. I decided that is what people do on holidays.

There was a lead article in the Australian Financial Review last Wednesday (November 16, 2011) which represented how the conservative media spins the facts. I cannot link to the article because it is behind a paywall although the Fairfax CEO hinted this week that the company might abandon paywalls given that they have driven readers away and reduced advertising revenue.

The National Daily – News Limited’s The Australian – is now operating with a paywall (although the first few months are free with registration) and their traffic has fallen significantly already. Once they force readers to pay for the view their custom will plunge. I don’t perceive that the Internet will support paywalls for daily newspapers.

Anyway, the AFR article was entitled – Gillard must cut, and cut hard and was written by Alan Mitchell (no relation). For readers abroad – Julia Gillard is the Australian Prime Minister.

The opening paragraph went like this:

The Reserve Bank of Australia has made it clear that it has no plans for the interest rate cut that Julia Gillard clearly wants unless economic circumstances change. The minutes of its November board meeting, released yesterday, leave no doubt that, in the absence of a new bout of economic weakness, the government would have to make very large cuts to its spending to justify a further reduction in interest rates in the near term.

Now it just happens that I had read the minutes of the RBA board meeting not long after they were released – probably about the same time that Alan Mitchell also read them. And my careful reading left me with no impression that the RBA was intending to hold interest rates at their current level unless the Federal Government made very large cuts to net public spending.

The link between the RBA minutes and Alan Mitchell’s ideological push for extensive public spending cuts was a fabrication of his construction. He provides no textual evidence to support his headline and contention.

This sort of fabrication often appears in the conservative press. We read that private spending has picked up – so large public spending cuts are needed. Or exports went up a little – hack public spending, Or a fly walked up the wall – even larger public spending cuts are needed … and so on.

You may want to make up your own mind. Earlier this week, the RBA published the Minutes of the Monetary Policy Meeting of the Reserve Bank Board for its November 1, 2011 meeting. At that meeting it cut the policy target rate by 0.25 per cent to 4.5 per cent.

The RBA Minutes say:

… Since the previous Board meeting, the economic data for the United States had been a little stronger than in earlier months, while the data for Europe had continued to soften. Consumer and business confidence generally remained quite low in most of the advanced economies …

Growth in Asia had remained solid, although it had moderated following the general tightening in macroeconomic policies over the past year, and there were also some early signs that the slowing in some of the advanced economies was having an impact in the region … growth in exports … have slowed, as had growth in investment …

Recent data for the United States, including for the labour market, had shown a more positive tone than was the case around mid year … business investment had grown strongly in the September quarter and by 9 per cent over the year, and growth in capital goods orders had remained strong. Notwithstanding the recent falls in consumer confidence to very low levels, the growth rate of household consumption spending had picked up a little in the quarter, with the saving rate falling. However, public expenditure was 2½ per cent lower over the year …

In the euro area, conditions remained very subdued, with consumer and business confidence having fallen in recent months … Growth appeared to have slowed in Germany and France, the two countries that had driven the European recovery since 2009 … Credit conditions appeared to be tightening, reflecting the problems in the European banking system, and members noted the very large fiscal adjustment facing many countries …

Reflecting developments in commodity markets, Australia’s terms of trade were likely to have peaked in the September quarter. The forecast for the terms of trade had been revised down, in line with the steep declines in iron ore prices …

So a generally cautious (downside biased) assessment of the international economic conditions.

The Minutes then examined “Domestic Economic Conditions” and it was here that one would expect to see some hint of Alan Mitchell’s conjecture if it was true.

The Minutes emphasised that the “main economic news in the month had been the release of the CPI data for the September quarter” which showed that inflation was falling in Australia and was now “running at a little below 2½ per cent, the midpoint of the medium-term target”.

The RBA concluded there was now “less inflationary pressure in the economy than had been expected earlier in the year”. The fact is that the RBA’s view that inflation was becoming a problem was not sustained by the data available a year ago and their decision to hike rates when labour underutilisation was above 12 per cent and there were no real wage pressures was not justified. They have a conservative bias towards raising rates which maintains unemployment higher than it should be.

Their version of full employment is an unemployment rate of 5 per cent. My version is an unemployment rate of around 2 per cent and zero underemployment. The RBA continually ignores in their commentarty the fact that Australia is endures high underemployment which acts in its own way (in addition to unemployment) to suppress wage pressures.

The RBA recognises that in relation to the domestic economy “conditions remained subdued in a number of sectors … [and] … there had been little net employment growth over the past six months. Other indicators also pointed to a softening in the labour market over the course of 2011, with the Bank’s liaison suggesting that firms were waiting to see evidence of stronger demand before hiring additional workers”.

While there was mixed evidence about the retail sector “consumer confidence remained below average” and the “housing market remained subdued” with prices droping and “(g)rowth in housing credit” lagging behind growth in “disposable income”.

Private sector activity (credit, construction) “remained subdued” while “conditions in the resources sector were very positive”.

Overall, the RBA has revised its forecast for domestic growth downwards “reflecting the weaker global outlook, the decline in confidence and asset prices since August, and a downward revision to the outlook for coal production” and “the unemployment rate was expected to increase a little” over the coming year.

The RBA revised its inflation forecasts down further and to remain squarely within its target bounds (2 to 3 per cent).

Importantly, the RBA admitted that it has been running a “slightly restrictive stance of monetary policy … over the past year”. The overwhelming narrative in Australia among the economists and financial press has been that our so-called “once-in-a-hundred-year” mining boom combined with the budget deficit left over after the fiscal stimulus intervention and the cyclical downturn in growth would drive inflation through the roof.

The RBA, like a pavlovian dog, reacted to that narrative and pushed interest rates up. There was no reason to do that. The slight uptick in inflation was all supply-side driven (natural disasters wiping out food production and energy prices rising) and no case could be made that aggregate demand was running ahead of capacity growth.

The data tells us that, at least, up until the second-quarter, the external sector was still a contractionary force on real GDP growth. While export incomes have risen courtesy of strong volumes and strong (but falling) commodity prices, import growth has risen faster. So our “mining boom” is driving growth in the rest of the world, not in Australia.

But the RBA (and the Federal Treasury) is obsessed with the notion that the NAIRU is around 5 per cent (they ignore underemployment) and that led to the rising interest rates.

The RBA Minutes then reflected on whether the Board should cut rates or leave them at their “slightly restrictive” level. They said:

A case could be made for leaving rates unchanged on the basis that, unless the world economy turned down in a serious way, the expansionary effects of the high terms of trade and the associated investment build-up would, in time, assert themselves more fully, even though recent conditions had been softer than expected. In that event, policy settings on the tight side of normal would be appropriate over the medium term.

So the RBA was still toying with the view that the mining boom would eventually overwhelm the Australian economy. As noted, up until now (given the most recent data released) the external sector is not contributing positively to growth. The sector is a net drain on growth.

With private spending still subdued and consumer confidence below average (by the RBA’s own reckoning) and the public sector withdrawing its fiscal support in blind pursuit of a budget surplus, there is no surprise that economic activity in Australia is below expectation (“softer than expected”).

But there is nothing in the RBA assessment that says that excessive public spending is making the case for the maintenance of current level of interest rates. Alan Mitchell just made that up.

The RBA Minutes then summarise the case for a rate cut (which they acted upon at that meeting):

The case for an easing in policy was that there had clearly been material changes to the recent course of, and outlook for, underlying inflation over recent months, while the downside risks for the global economy had increased.

The RBA Board concluded that a “more neutral setting would” would “be compatible with achieving sustainable growth and inflation consistent with the target over the period ahead” and so they considered “it was appropriate for there to be a modest easing in the stance of monetary policy”.

That discussion should put the claims made in the AFR article in a clearer light.

The AFR article claims that the RBA minutes:

… point out that the RBA’s newly downgraded forecasts still have the economy operating at about full employment, with growth at about its trend rate and inflation in the top half of the RBA’s 2-3 per cent target range in 2013.

You will not find any mention in the RBA minutes of “the economy operating at about full employment”. As noted they consider that “the unemployment rate was expected to increase a little, before drifting lower again”.

The RBA Minutes also say:

The revised staff forecasts pointed to the likelihood of overall GDP growth being close to trend over the next one to two years, and inflation being consistent with the 2-3 per cent target

Trend growth – even if achieved – does not necessarily correspond to “full employment”. In fact, at the peak of the last business cycle (February 2008) Australia was still enduring broad labour underutilisation rates of around 9 per cent. That is, there was still plenty of idle labour.

Further, the claim that the federal government should significantly cut spending now because some forecasts predicted stronger growth in 2013 misses the point that these forecasts (even if accurate) would have been conditioned on the current fiscal support being provided to the economy.

What would the RBA forecasts be if the government suddenly “cut hard”? The answer is obvious.

The AFR article notes that the RBA will not cut interest rates further unless there is a serious “deterioration in the economic outlook”. I probably agree with that assessment although I do not agree with the RBA’s logic. I consider rates should be much lower at present but that is a separate argument.

Then the fiscal link is introduced. The AFR article says:

In the absence of weaker growth, the Gillard government would have to makes its own space for further cuts in interest rates by tightening fiscal policy.

Which means what? The Federal government should cut net spending and therefore deliberately undermine economic growth which is already subdued and justifying what the inflation-obsessed central bank thinks is a near neutral monetary policy setting.

That is the only logic that holds. The RBA thinks it moved closer to a neutral setting in its November 1 decision and would move towards an “expansionary” setting (their logic) if economic growth declines further. So to give the RBA the “room” to cut further, the Federal government would have to undermine growth and deliberately create unemployment. That is the AFRs logic.

It should be rejected. The AFR’s position is consistent with the neo-liberal bias that monetary policy should be the sole counter-stabilisation policy tool used and it should be solely directed and keeping inflation in check. Accordingly, fiscal policy should not be “active” and should passively support the monetary policy setting irrespective of the rate of unemployment.

That policy bias is one of the reasons that advanced economies have failed to achieve full employment since the mid-1970s and is a principle reason the current crisis is dragging on with millions of workers sitting idle increasingly entering poverty.

The role of the fiscal policy is not deliberately create unemployment when it is clear that the economy is nowhere near full employment (in Australia, 12.5 per cent labour underutilisation continues)! The role of fiscal policy is to add to aggregate demand and ensure that economic activity is generating enough employment (hours and jobs) to match the desires of the workers once private spending and saving decisions are made.

Monetary policy should be consistent with that goal. Given how blunt monetary policy is as an instrument it should be used as a secondary counter-stabilising tool, with fiscal policy dominating.


I also note that in the world gold data just released that central banks are busily buying up gold. I thought governments had run out of money!

And … keep your eye on the French bond yields relative to the Bund! The crisis is heading right into the core of the EMU – all member states face insolvency risk by construction. They cannot survive this onslaught without extensive ECB support – forever! More next week on developments in Euroland.

Back to my holiday – which means that I have to finish two conference papers as my next task today.

Saturday Quiz

Back tomorrow.

That is enough for today!

This Post Has 9 Comments

  1. In case you missed it, Matt Franko at Mike Norman’s site posted a great video of Nigel Farage giving some Euro Commission member hell. It is worth watching.

  2. Nigel Farage’s ad hominem attacks, while creating guilty amusement, are in fact are rancidly impolite. His attacks on neoliberal, Eurocentrist ideology I agree with. He appears to be a defender of democracy but as he is an avowed libertarian I would distrust him entirely on that score. Libertarians are generally loonies and Farage’s denialism about global warming puts him firmly in that camp.

    * Note – “Loony” – Those who persistently deny extensive empirical evidence are loonies.

  3. Yeah, about those RBA forecasts … They were wrong ALL last year on inflation which is embarrassment enough given their resources. They have been egregiously wrong on GDP all of this year. Not content to right the ship, their latest forecasts implicitly assume about 1.2pc GDP growth for each of Q3and Q4. I really don’t know what planet they are on. And then 4pc GDP growth to Jun-12. Really?

    Mitchell talks to the RBA a lot, so his assumptions about full employment (which we clearly are not at), is probably coming from those private chats, which, while not incorporated in the easing statement, likely explains the paradigm the RBa is still working on. I’m sure they’ll ease again in a couple of weeks, but their missing the woods for the trees approach means they will always be behind the curve on these matters. Highly, highly disappointing. A ‘more neutral’ setting implies still existing tightness in the RBA’s assessment, which if you look at real cash rates (adjusted for the extra expense the banks have lobbed on top, meaning mortgage rates consistent with a far higher ash rate), they clearly are.

    Bill, I know you are resuming the ‘Euro service’ next week, but I am very interested in your views on the Bund, seeing as you brought it up. The last few years of reading your work (and ancillary blogs and research) have had me believe for some time that all roads lead to Germany. I can see how US bonds might therefore be well sought after at Germany’s expense -ie. The spread we really need to watch is the US/Bund one…..

  4. Hi Bill

    I agree with your (and Apj’s assessment re the RBA forecasts). Dismal. I did like the ‘all roads lead to Germany’ comment. I’d be interested in your thoughts on this too.
    Thanks for your consistent attention to the awful details of where we seem to be heading. Your work and insightful, hard-won insights are most appreciated.

    By the way, we know Bluey’s beach (but we holiday at Seal Rocks). I might have to put you on report and make you stay back after class though! From your earlier post, it sounded like you might have been coming up to this part of the world with your family. I know you work hard, BUT you need to go for walks and play board games and have fun, as well as write papers. A holiday is for loving family time, too. All work and no play…. Anyway, hope you have a lovely time.


  5. “He appears to be a defender of democracy but as he is an avowed libertarian I would distrust him entirely on that score”

    Democracy and classical liberalism, on balance, seem to work well in Liechenstein and Switzerland, the latter being the world’s only Democracy and whose people stayed million miles away from the Euro debacle once given a say on the issue of the Euro (and indeed the EU).

    I don’t think Mr Farage is impolite. Just tells it as it is. “Truth hurts”.

  6. «I don’t think Mr Farage is impolite. Just tells it as it is. “Truth hurts”.»

    I agree here. He just tells it as it is.

    Anyway, I may not agree with his economic views or what he thinks of global warming. He thinks I should have a say on those things myself and in my own parliament by people accountable to me, and that is enough. First my Parliament needs to control economic issues, then I can elect who I think it corresponds more to my economic views.

  7. People like Farage have no problem allowing a few unelected individuals to run monopolies and control 99% of a countries resources. It will be perfectly acceptable for Farage to dictate his own terms and conditions to his peons.

    A very devious and dangerous man. Do not give him face. You have been warned.

  8. If you ask the people of Switzerland you’ll find many will say The EU walks all over them in return for their trade agreement, Farage used to mainly use Norway as his shining example of not being in the EU, till he was forced to admit they have to obey the majority of EU rules as part of EFTA with no real say in them, now he mainly uses Switzerland which, while it has a different agreement, is not actually, in practice, that different to Norway in terms of its EU relationship. In the end you generally obey the rules of the countries you trade most with, whether you’re members of their ‘trading club’ or not.
    UKIP do quite a good job at pointing out the huge inadequacies of the EU but the non EU ‘grass is greener’ aspect of their approach isn’t based on reality.

  9. @Bob
    Both Switzerland and Norway are only subject to part of the EU regulations. No CAP, no CFP, no quotas of any kind, no interference in criminal law and justice, no interference in social law, etc.
    That seems good enough for me!

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