RBA spills the beans on Australia’s failed fiscal strategy

The Governor and other senior officials of the Reserve Bank of Australia (RBA) appeared before the House of Representatives Standing Committee on Economics yesterday (August 20, 2014), as part of the review by the Government of the 2013 RBA Annual Report. The Governor and the RBA Board are, ultimately, creatures of the political process, being appointed by the Government, which tells you that all the guff about central bank independence is just a smokescreen. Further, the insights that the RBA officials provided to the Economics Committee should leave no-one in doubt that the Federal government’s fiscal strategy is a failed vision for the prosperity of our nation.

The evidence that the Governor and his officials gave confirmed five points.

First, the Federal government has accepted that an unemployment rate of 6.25 per cent is acceptable.

Second, monetary policy can do little to change that.

Third, fiscal policy could reduce unemployment and provide for future long-term prosperity if it invested in human capital (education) and public infrastructure.

Fourth, the Government’s obsessive pursuit of lower fiscal deficits is deliberately undermining growth and causing the persistence in high unemployment.

Fifth, the completely chaotic Australian Senate, where a small minority party has the balance of power and is holding up significant cuts to fiscal policy proposed by the Federal government, is saving the economy from a even greater slowdown than is the case.

The – Hansard Transcript – of the Standing Committee’s questioning of the RBA officials is very interesting.

The RBA officials called as ‘witnesses’ to the hearing were Christopher Kent (Assistant Governor), Philip Lowe, Deputy Governor and Glenn Stevens, the Governor.

In the Governor’s opening statement he noted (among other things) that:

… it seems unlikely, I think, that households will revert to their behaviour of a decade ago when they were expanding their balance sheets quickly, saving much less of their income and increasing their consumption well ahead of growth and income.

This is a very important observation because it establishes that the period from 1996 to 2007 was atypical in our history. Why that is important is because it was the decade that the Federal government ran 10 out of 11 years of surpluses on the back of the private credit binge.

If the household behaviour was atypical and will not be revisited then it also means the surpluses were atypical and can only be revisited (or pursued) at great cost to economic growth.

Had the households not engaged in that binge, the economy would have ground to a halt in 1997 or so, given that the Government was pursuing fiscal austerity.

All Australians need to understand that continuous fiscal deficits are the normal outcome in Australia and surpluses are an aberration and cannot be sustained.

The Governor also told the Committee that:

… over the year ahead the growth of real GDP will be around two to three per cent. That is close to trend but probably a bit below trend in the near term … This outlook would mean, if it comes true, that it will be a while before we see sustained reductions in the rate of unemployment.

Two points to note. First, trend growth has been around 3.25 to 3.4 per cent. For example, between the March-quarter 2000 to the September-quarter 2008, before the crisis hit, average real GDP growth was 3.4 per cent. That is a long way from 2 per cent or even 3 per cent when we consider the impact on unemployment (more later below).

Second, the past trend growth rate is not necessarily a policy target to aim for. For example, even in the growth period leading up to the crisis, the Australian Bureau of Statistics (ABS) broad labour underutilisation rate was still well above 9 per cent (sum of unemployment and underemployment), which makes it obvious that given labour force growth and productivity growth, the real (trend) growth rate was insufficient to eat into the entrenched pool of wasted labour.

The following Table shows the average real GDP growth rates for Australia by decades since the 1960s. Once neo-liberalism took hold and fiscal cut backs become the overwhelming policy bias, the ‘trend’ fell sharply. The most recent ‘decade’ (2000s) includes the period up to the March-quarter 2014.

Period Average Real GDP growth rate
1960s 4.93
1970s 3.31
1980s 3.41
1990s 3.30
2000s 3.02

This discussion also runs directly into the growth versus environmental sustainability debate, which I must admit is somewhat of a misnomer. I do not agree that economic growth (measured by real output growth) has to be at odds with our need to safeguard the natural environment.

It all depends on the composition of the growth. As I have said previously, as populations expand, there has to be economic growth to ensure those who want to work can.

But growth based on the employment and output of musicians is fundamentally different to that based on heavy industry. With creative government policy and employment leadership, we can maintain strong output and employment growth at the same time as we acknowledge the finite nature of our environment and adopt risk averse strategies to natural resource use.

The Governor is correct though – the elevated unemployment (and underemployment) levels will persist as a result of the slack growth rates.

He also noted that:

What I mean is we need more of the sort of so-called ‘animal spirit’, or confidence if you like, that is needed to support … investment that adds to that stock of physical assets … many businesses remain intent on sustaining a flow of dividends and returning capital to shareholders and are somewhat less focused on implementing plans for growth. Any plans for growth that might be in the top drawer remain hostage to uncertainty about the future pace of demand.

Growth is driven by spending! You cannot have economic growth unless someone is spending. Which makes the remarks by Angela Merkel overnight in Munich appear ridiculous to say the least. The UK Guardian article (August 21, 2014) – Angela Merkel scolds Italy and France over the faltering eurozone recovery – tells us that Merkel claims that the “faltering growth was the direct result of the 18-member currency zone’s inability to punish those countries that ran high deficits in contravention of limits set by Brussels” What?

Yes, you read it correctly – she claimed that the higher deficits in France and Italy were undermining Germany’s export markets. How anyone can say these things and command credibility is an amazing part of this Groupthink story I have been developing.

If France and Italy had have followed Germany down the low deficit route then German exports would be in much worse shape than they are now and the domestic conditions in each of the countries would be also much worse.

The uncertainty in Australia is being driven by the incompetence of the Federal government. In the May Fiscal Statement (aka budget) they foreshadowed significant cuts in government spending and higher taxes, which were clearly going to slow growth.

The new Senate, however, has held up a number of the proposed cuts, and so it is unclear what the net position will be at the end of the fiscal year.

But until last week, the Government was justifying the cuts on the basis that Australia faced armageddon because of its fiscal deficit and public debt ratio (both small by international standards, but both irrelevant anyway).

The concerted political campaign to demonise deficits and talk up crisis is backfiring. First, they cannot get the cuts they want through the Senate and for every day that passes it is clear to those who might have believed the emergency narrative the sky remains high over our heads and the economy hasn’t fallen off the face of the earth.

In other words, the lies the Government peddled are being exposed by the delays and so they are in the process of altering the narrative.

Second, the uncertainty about all this is killing confidence and so investment remains subdued.

On the positive side, the higher deficit than planned is helping to support growth albeit at more modest rates than would be required to bring unemployment down.

When the Committee members started to question the Governor we learned much more.

He told the Committee that he thought:

… the outlook that I am trying to describe is kind of okay but it is not quite as good as I would like.

One journalist today has rightly noted that the corollary of output being “kind of okay” is that “It follows that unemployment around 6.25 per cent is also ‘kind of OK'” – see Michael Pascoe – The government is failing at the limits of monetary policy

It is clear that as the RBA considers that output is at an “okay” level, it will not be reducing interest rates any further. That is, in Michael Pascoe’s words, “monetary policy … [has] … reached its non-crisis limits”.

The only thing that can bring the unemployment rate down is fiscal expansion and the Federal government is currently doing its best to cut net government spending – exactly the opposite to what it should be doing.

It was noted by one of the Committee Members that the RBA considered that “unemployment rate is likely to remain elevated for a time and is not expected to decline in a sustained way until 2016”.

The Governor confirmed that assessment with the help of some statements from his off-sider Christopher Kent.

The nub is this.

The trend rate of real GDP growth doesn’t relate to the labour market in any direct way. The late Arthur Okun is famous (among other things) for estimating the relationship that links the percentage deviation in real GDP growth from potential to the percentage change in the unemployment rate – the so-called Okun’s Law.

The algebra underlying this law allows a rule of thumb to be derived which allows us to estimate the evolution of the unemployment rate based on real output forecasts.

Take the following output accounting statement:

(1) Y = LP*(1-UR)LH

where Y is real GDP, LP is labour productivity in persons (that is, real output per unit of labour), H is the average number of hours worked per period, UR is the aggregate unemployment rate, and L is the labour force. So (1-UR) is the employment rate, by definition.

Equation (1) just tells us the obvious – that total output produced in a period is equal to total labour input [(1-UR)LH] times the amount of output each unit of labour input produces (LP).

Using some simple calculus you can convert Equation (1) into an approximate dynamic equation expressing percentage growth rates, which in turn, provides a simple benchmark to estimate, for given labour force and labour productivity growth rates, the increase in output required to achieve a desired unemployment rate.

Accordingly, with small letters indicating percentage growth rates and assuming that the average number of hours worked per period is more or less constant, we get:

(2) y = lp + (1 – ur) + lf

Re-arranging Equation (2) to express it in a way that allows us to achieve our aim (re-arranging just means taking and adding things to both sides of the equation):

(3) ur = 1 + lp + lf – y

Equation (3) provides the approximate rule of thumb – if the unemployment rate is to remain constant, the rate of real output growth must equal the rate of growth in the labour force plus the growth rate in labour productivity.

It is an approximate relationship because cyclical movements in labour productivity (changes in hoarding), changes in average hours worked, and changes in labour force participation rates can modify the relationships in the short-run. But it provides reasonable estimates of what happens when real output changes.

The sum of labour force and productivity growth rates is referred to as the required real GDP growth rate – required to keep the unemployment rate constant.

Remember that labour productivity growth (real GDP per person employed) reduces the need for labour for a given real GDP growth rate while labour force growth adds workers that have to be accommodated for by the real GDP growth (for a given productivity growth rate).

The RBA officials told the Economics Committee that:

… the labour force is growing at a reasonably rapid rate: at about 1.7 or 1.8 per cent per annum-that order of magnitude … [and on] … labour productivity … if you take out mining, we were running at over two per cent per annum up until about 2003 or 2004. Then we had some years where it was only one percent and the most recent estimates are 1.6 – that is to say that is better and that has been for a few years now-so it is looking like this is something real not just a statistical aberration.

The required real GDP growth rate then to keep the unemployment rate constant is then somewhere between, say 3.3 per cent per annum of 3.8 per cent.

If the assessment of the RBA that real output over the next year is between 2 and 3 per cent, which has been the recent performance, then you can see why the unemployment rate has been rising quite sharply over the last year or so and will continue to rise in the coming year unless something changes.

The rising unemployment rate reflects the fact that real output growth is not strong enough to both absorb the new entrants into the labour market and offset the employment losses arising from labour productivity growth.

You should also be able to appreciate why the appropriate fiscal strategy does not relate to the current ‘trend output’, which is below the required real GDP growth rate given labour force and productivity growth.

The Governor also reiterated his views about normal consumer behaviour:

I do not think we can expect to go back to the consumer leading aggregate demand in the way that they did in the period up to 2006. You have all heard my sermon on this before. That was a very unusual period: falling savings, rising borrowing, et cetera. That is all fine, but it is not going to happen again. And I do not think we should try to make it happen again. I think that would be quite risky. So the consumer will play a part-a reasonable part-but not the same part that they once did. That is a legacy of the situation that we have come to. So they would be my views about those dynamics.

The obvious elephant in the room is fiscal policy.

The Governor however, said to the Committee that he would “not give gratuitous advice on fiscal policy” but that:

… monetary policy is not the answer really for some of the most fundamental things

At that point, his offsider Phillip Lowe told the Committee that:

At the end of the day, monetary policy cannot be the engine of growth in the economy. We can help smooth out the fluctuations, but we cannot in the end drive the overall growth in the economy … I think if we need to invest more and more effectively in education, in human capital accumulation and in infrastructure. Risk taking, education and infrastructure are the things that are going to help us be a high-wage, high-productivity, high value-added economy. The details here are not things that the central bank is expert in, but it seems to me that they are the ingredients to be a successful economy in the next 20 years.

This should end the reliance and faith that advanced nations have on monetary policy. It is simply not the right tool to maintain strong growth in employment and output.

The longer-term prospects of a nation heavily depend on the quality of its workforce and the public instrastructure that the private sector can leverage off.


With dependency ratios rising, the future workforce will need to be more productive than the current workforce. That will require massive investment in education and skills development. It will require large reinventions of public infrastructure in transport, information technology and communications and renewable energy.

In each of these areas, the current Federal government is attempting to make significant cuts. Further, the reforms to the higher education system proposed are inconsistent with this vision. I will write separately about those reforms another day.

The bottom line is that the Federal government is in denial and attempting to impose some weird, time-warped conservatism on the world when it should be doubling the deficit to fill the gap left by the subdued private spending.

That public spending would not only improve our flagging educational system but could also spawn major infrastructure projects that would stimulate further private risk-taking.

That is enough for today!

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has 16 Comments

  1. If the household behaviour was atypical and will not be revisited then it also means the surpluses were atypical and can only be revisited (or pursued) at great cost to economic growth.

    C’mon Bill, that’s the sort of statement you show to be false in your Saturday Quizzes!

    Firstly atypical doesn’t mean irreplicable and sustained low interest rates could conceivably result in that outcome. Secondly there’s much more to the private domestic sector than just households, and lower interest rates could result in business led growth.

    Obviously just pursuing a surplus and doing nothing else would have a great cost to economic growth. But slashing interest rates and using fiscal policy to control inflation could easily result in surpluses within a few years.

  2. We have many fools for captains (among politicians and ceo’s). Society needs to get governments into the game of serving the broader (not merely the already wealthy) interests. This is true almost everywhere yet everyone sits and waits for someone else to lead the way as if market forces will guide us along a safe path.

    I absolutely agree that we need well educated populations moving forward, for many reasons, however; I think we need fewer people developing new technology than we need applying it. Some of the most productive contributers to many communities are small independent businesses with one or two owner operators.
    Most of these bits of glue holding sustainable communities together (while keeping themselves gainfully employed and contributing to demand) are not developing the latest technology or even using it, yet many of these have found critical niches in their local economies which would be far worse off without them and far better off with many more of them, and yet where I live, policy does little to nothing to encourage or help foster the smaller scale productive activity. These types of business are only considered credit worthy by private banks after they have already established themselves so few people can actually succeed as startups. A public bank helping this type of activity would probably be a good addition to decent fiscal policy.

  3. “Fifth,the completely chaotic Australian Senate” – that is something of an exaggeration. This is not the first time that the government of the day does not control the Senate. And this is not the first time that the Senate is using its powers to review and hold to account the actions of the government. Just exactly what the constitution says it should do.

    Sure,there are some odd bods in the Senate. Probably about the same proportion that there are in any other group,economists not excepted.

  4. J Christensen,we did have a public bank once upon a time. It was called the Commonwealth Bank of Australia. It’s still called that but it was sold off to the rentier class and is now just another one of the big 4, entirely focused on making ever more obscene profits by pumping up the real estate bubble and various other questionable financial strategies.

    In the not too distant future all the clever economists will be writing treatises on why this occurred and why it all ended in tears and not for the first time.
    Rinse and repeat.

  5. I was watching Q&A the other night when Clive the Clown was on, and he was the -only- panel member who questioned the need for a Budget surplus. And the PUP is the only party with an average Australian in the Senate. I’m starting to think I should have voted for him.

  6. Adian needs to stop smoking the neo-liberal pipe.

    The burden of debt on households is much greater now than it was in the past.

    Also, expected returns on investments in the property market have pretty much disappeared compared to what was happening in 2000/2001.

    Properties purchased for around $100k or so in 2000 were selling for over 200k by 2001/2. The chances of doubling ones money in the current property market are nowhere near what they were then.

    The same can be said for business investment as well. Expected returns / profits are what matters – no the nominal rate of interest.

  7. Bill, one of the reasons that Merkel is going down the road she is may be that those in the German elite who would lose out have been the biggest crooks. I once saw a fraud list and DB was near the top along with the usual US suspects. Italians I know in the UK have told me that they voted for Berlusconi because he was the most competent crook among the candidates. They were all crooks, but Berlusconi was the one they thought least likely to do something incredibly stupid. They didn’t care about his private life, though they didn’t know about the young girls. So, the upshot from this perspective is that Merkel is being forced down this road to protect the biggest losers, who, it seems, happen to be the elite German white collar fraudsters.

    In the US, the account managers of DB are suing the bank for forcing them to violate their due diligence to their customers, which is required by US law and is a prosecutable offense. US due diligence law requires the bank to put the interests of the customer before their own interests. Not for DB. This case is now before the NY district court. Hopefully, right will prevail. But in US courts, that can never be guaranteed.

  8. Alan, I don’t smoke, and I’ve not encountered any neoliberal advocating keeping interest rates low and using fiscal policy to control inflation. Indeed ISTR it was Bill who first suggested it!

    But unlike you I don’t unquestioningly accept everything Bill says. And his dismissal of the private sector’s ability to take on more debt seems to be the result of his political views rather than economic reality. And I don’t share his political views – though we’re on the same quadrant of the political compass, I’m much closer to the centre.

    Interest rates are being held inappropriately high partly to deter households from taking on more debt. But if cutting interest rates doesn’t result in them taking on more debt, so much the better – that shouldn’t be the policy objective anyway. The real point of cutting interest rates is to reduce the cost of investing in capital, so that long term business investments become more affordable. Lower interest rates mean returns don’t have to be so high to be profitable.

  9. Aidan, the general political spectrum has moved further right over the past thirty or so years. Where the center is has altered significantly from where it was and where many people think it is. People in the center now are fairly right-wing according to a number of analyses. Goldwater was thought by many at the time to be a dangerous looney. But compared to the present set of Republicans, when you listen to his speeches, he sounds moderate. The center has moved and the looneys are off the scale. There seem to be two political positions in the US. Moderate Republicanism, which is represented by the Democrats. And the kooks, which is represented by the Republican right. There are many moderate Republicans who reject the extremists in their own party, but where do they fit? Something similar, though not as extreme, is true for the UK. Who ya gonna vote for? is now an important question for which there is no easy answer. And economics is at the center. The problem is that few people really understand the choices available. And no wonder. They are bombarded by neoclassical claptrap almost every week, even if the discussion is about something non-economic. For example, in a discussion of welfare reform and the difficulty people are having to cope, the reporter will mention “the taxpayer” in some form, thereby leaving the impression that taxation pays for welfare. And this was just mentioned in passing. But it happens incredibly often and no one picks up on it.

  10. larry, that’s irrelevant because I’m not aiming for the centre – that’s just where I happen to be. And the centre of the general population spectrum wasn’t what I was referring to anyway; I was referring to the political compass linked to on the About page.

    And your example is a bad one because it’s not incorrect to say that taxation does pay for welfare. Just because there are some advantages of Bill’s preferred way of looking at it (government creating all the money it spends and destroying all the money it receives) doesn’t mean alternateve views are wrong. And insisting otherwise only hinders people’s acceptance of MMT and makes them likelier to ignore it when we point out something that is geinuinely wrong.

  11. Aidan, it seems to me that it is incorrect to say that taxes pay for government operations in a fiat currency system with a floating exchange rate. If you consider all the programs and agencies paid for by the US, including the so-called secret ones that we know of, the amount exceeds what the government receives in taxes, in general. If the government is unable to cover all its expenditure through taxation, which previously it had to do either directly or in some roundabout way, what sense does it make to contend that it pays for any of it?

    I was thinking about the About page as well. I was simply comparing, hypothetically, two possible outcomes at two different time periods.

  12. Addendum: Aidan, if two views are incompatible in some way, for example, they are contradictory, to take the most obvious case, then it is logically impossible for both to be true. Of course, they can both be false. Let me generalize. If Bill’s view is incompatible with certain other views and all these views are incompatible with each other, they can’t all be true. But, again, they can all be false. Normally, one wouldn’t advocate a view they considered to be false, except for some rhetorical purpose.

    If a description/theory of an empirically real system one is advocating conflicts with a description/theory advocated by someone else, then it seems inevitable, to me, that you would contend that the other person’s description/theory fails to represent reality because you think yours does. At least one of them, if not both, must be false as a matter of logic. The manner of presentation by an individual may well affect the emotional reaction of the other person, but this does not alter the logic of the situation.

  13. larry, the USA didn’t previously* have to cover all its expenditure through taxation in some roundabout way. All the options that exist now existed then, although the need to maintain a fixed exchange rate sometimes prevented them from being used.

    Though other revenue sources exist, taxation is the only revenue source capable of funding anywhere near 100% of expenditure on a sustained basis, and is absolutely essential whether or not the country is financially sovereign.

    * At least not in the last century. But if you go further back to when it was on a hard gold standard, its options were more limited.

  14. Addendum: it is quite common for complex phenomena to be crrectly described in completely different ways. For example, flight can be described by Bernoulli’s Principle or Newton’s Laws (or a few other ways) but the result is the same in each case. Claiming the disfavoured descriptors to be wrong is not only incorrect, but makes you less likely to be taken seriously when you point out a genuinely wrong assumption.

  15. Aidan, I took for granted that the descriptions/theories were empirically distinct, for example, that they made distinct predictions, that they were not equivalent. That the same phenomenon can be characterized in equivalent ways I assumed was obvious and, hence, I did not consider that situation as it is logically trivial. In fact, to contend that two theories are incompatible is to indicate that they are not equivalent. They are not two different, but compatible, characterizations of the same thing.

    I disagree with your view of taxation and the situation that existed from the end of Roosevelt’s first term until the end of the war. Before that period and to a certain extent after until 1971, we didn’t have all the options we currently have. Since 1971, taxation could not be said to have covered government expenditure. Historically, this has typically been the case. I accept that one can’t spend like there is no tomorrow. But no one is seriously suggesting this. Beardsley Ruml, in 1945/6, who was chairman of the Federal Reserve from 1941-1946, argued, cogently in my view, that taxes were not necessary for a government to remain solvent and meet its bills, that this view was “obsolete”. The US Constitution explicitly mandates that the government pay all its debts. That Congress may act contrary to this at times is another matter. It wasn’t just a fixed exchange rate that constrained government spending, it was its pegging of the currency to gold reserves that also did so, a kind of double whammy.

    Taxes serve other purposes — they legitimate the denominated currency and force its use, as fines, taxes, &c can be paid only in this currency; they direct or regulate private spending; in a better world than ours, they would accommodate equitable wealth redistribution. &c. What they don’t do is pay for anything. Taxes are necessary, but not for underwriting government expenditure.

    And we have more options now than we did then except for that special period in the thirties and the during the war. We no longer have the constraint of the gold standard, which was a kind of straitjacket. When Roosevelt took the US off the gold standard, it freed him to enact programs that might have been difficult otherwise. Yet, even though he had created a currency system not dissimilar to the one we have today, many capitalists and financiers of the time considered him fiscally dangerous if not insane. History, it seems to me, shows he was, if not completely right, certainly not completely wrong.

    It took the war, where he spent money he didn’t have, as it were, that is, engaged in deficit financing, taxation did not cover this expenditure, to see that deficit spending was not only possible but essential if he was to be able to enact his Second Bill of Rights, which he set out in January of 1944. The Bretton Woods agreement, enacted after the war, altered the situation again, and in the long term not for the better.

  16. larry, taking incorrect assumptions for granted is the main problem. The taxes do not pay for anything view does not enable any predictions to be made that are incompatible with the taxes pay for most things view. Nor does it even contradict the taxes ultimately pay for everything view, though the latter does have to get rather convoluted to accommodate reality.

    You are correct in saying that it was the constraint of the gold standard that was the problem, and a straitjacket is an apt description – it prevented the meatphorical arms from being used, but they were always there.

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