We are approaching a period of fiscal dominance

The dissonance in mainstream economics and the political debate about policy settings is getting deeper and more public. We now have examples of central bankers ‘throwing their hands up in the air’ and nearly begging governments to abandon their obsession with fiscal surpluses, and, instead, use fiscal policy to stimulate waning economic growth. What I think is happening is that we are entering a period of fiscal dominance, which will represent a categorical rejection of the mainstream macroeconomics consensus that has dominated policy making since the 1980s – the neoliberal era. In turn, this shift will ratify the main precepts of Modern Monetary Theory (MMT). We are observing paradigm shift occurring as the dominant neoliberal paradigm fails at every turn. There is a long way to go though before the practitioners acknowledge that such a shift has occurred. But there is progress.

For many months, the RBA governor has been stating publicly that monetary policy is reaching its limits and fiscal policy should be relaxed.

On February 18, 2019, the Reuter’s article – Architect of BOJ stimulus calls for big fiscal spending backed by central bank, reported that the Bank of Japan’s former deputy governor Kikuo Iwata said that:

… there are few tools left to ease monetary policy further … Japan must lean on fiscal policy by ditching this year’s scheduled sales tax hike and committing to boost government spending permanently with money printed by the BOJ …

Inflation won’t hit 2 percent just with the BOJ continuing its current policy. The BOJ doesn’t need to change its policy much now. What needs to change is fiscal policy …

Fiscal and monetary policies need to work as one, so that more money is spent on fiscal measures and the total money going out to the economy increases as a result … That’s the only remaining policy option.

Very powerful words.

He said that relying on monetary policy would not work because “We need a mechanism where money flows out to the economy directly and permanently”.

Monetary policy works by altering the cost of borrowing, which is an indirect way of stimulating aggregate spending.

It is uncertain because while borrowers face lower costs, those who earn interest income have less purchasing power.

Further, when there is pessimism about future returns on capital investment and a heightened risk of unemployment, potential borrowers will not seek credit no matter how low the costs of funds goes.

On June 18, 2019, the ECB boss Mario Draghi gave a speech to the ECB Forum on Central Banking at Sintra – Twenty Years of the ECB’s monetary policy and said:

… fiscal policy should play its role. Over the last 10 years, the burden of macroeconomic adjustment has fallen disproportionately on monetary policy. We have even seen instances where fiscal policy has been pro-cyclical and countered the monetary stimulus.

If the unbalanced macroeconomic policy-mix in the euro area in part explains the slide into disinflation, so a better policy mix can help bring it to a close. Monetary policy can always achieve its objective alone, but especially in Europe where public sectors are large, it can do so faster and with fewer side effects if fiscal policies are aligned with it.

The ECB, of course, played their role in creating this unbalanced policy mix where fiscal policy was working against monetary policy.

Its QE program definitely funded fiscal deficits and saved Member States from insolvency which, in turn, saved the euro from collapse.

But at the same time, as part of the Troika, its insistence that nations engage in fiscal austerity as a pre-condition for receiving support via its bond buying program ensured that the two arms of policy were working against each other.

In a speech on July 2, 2019 – Sea change – delivered to the Local Government Association Annual Conference and Exhibition 2019, Bank of England governor told an audience:

… that monetary policy space could be more limited in some jurisdictions, increasing the desirability that fiscal policy supplement it if a downturn materialises.

The point is obvious – even central bankers are intoning a belief that the neoliberal obsession with fiscal surpluses is counterproductive and the next period has to see more fiscal stimulus from governments.

We had the interesting example last week of these tensions when the Reserve Bank of Australia governor (and his team) appeared before the House of Representatives’ Economics Committee for their annual presentation (grilling) associated with the RBA’s Annual Report release.

As noted, the RBA governor has repeatedly called on the Government to use fiscal policy to address the slowing economy.

This is in the context of a federal government intent on pursuing its mindless fiscal surplus obsession even though inflation is well below the RBA target and GDP growth is grinding to a halt.

Even recent comments from the RBA governor that the Government estimates of the NAIRU (around 5 per cent) are too high and there is significant non-inflationary space for fiscal expansion amounts to a rejection of the mainstream macroeconomics orthodoxy.

The RBA governor appeared before the House of Representatives Standing Committee on Economics last Friday (August 9, 2019) and in his – Opening Statement – he said that:

The growth forecast for this year has been revised down since we met six months ago …

It has become increasingly clear that the extended period of unusually slow growth in household incomes has been weighing on household spending …

a few factors that I would highlight as contributing to the low inflation outcome over the past year. These are: the slow growth in wages; the ongoing spare capacity in the economy …

the Board reduced the cash rate twice – at its June and July meetings – to a new low of 1 per cent …

The incoming data on wages, prices, GDP and unemployment all suggested that the Australian economy was some distance from running up against capacity constraints …

As I have discussed on other occasions, if further stimulus to demand growth is required to get us to full employment and closer to the economy’s capacity, monetary policy is not the country’s only option. Monetary policy certainly can help, and it is helping, but there are certain downsides from relying too much on monetary policy …

One option is for fiscal support, including through spending on infrastructure. Spending on infrastructure not only adds to demand in the economy but, done properly, it can boost the economy’s productivity …

If you read the whole transcript then you will appreciate this is central banker-speak (conservative ways of framing things) that is criticising government policy.

In the Hansard Transcript of proceedings – Standing Committee on Economics 09/08/2019 Reserve Bank of Australia annual report 2018 – we learned some interesting things.

The governor told the Committee that: “Because we have a floating exchange rate, that allows us to set the interest rate relative for the domestic considerations on output, employment and inflation”.

This is an important component of the MMT advocacy for floating currencies. Domestic policy targets can then be pursued by government.

The governor also noted that: “Many people borrowed too much in previous times and now they’re having to repair their balance sheets, so they want to save a bit more. There is a lot of desire to save, and, right at the moment, not many firms want to invest.”

So the contribution to growth from the private domestic sector is declining, which requires an external growth boost (not happening in Australia as a result of persistent external deficits) and/or a government stimulus (not happening because of the surplus obsession) – hence, growth is falling towards recession levels.

He said: “monetary policy is less effective than it used to be” – referring to the tendency of people to pay down debt faster when rates decline rather than borrow more.

He agreed with the proposition that: “Full employment being the new revised 4.5 per cent rate?” (that is, unemployment rate). He said that: “we probably need to get down to an unemployment rate of 41⁄2 per cent to have wage growth consistent with the inflation target.”

Australia’s unemployment rate is stuck around 5.2 per cent and the forward fiscal estimates have it remaining around 5 per cent for the foreseeable future given current policy settings.

In other words, the central bank now believes that government policy is deliberately stifling economic activity and keeping unemployment significantly higher than it could be before inflationary pressures arise.

As an aside, I disagree with the RBA’s assessment that 4.5 per cent is a full employment level. It can go much lower than that before inflationary pressures become an issue. But that is another argument and blog post.

Then the Andrew Leigh, a Labor Party member of the Committee and former professor of economics who has publicly claimed he thinks the likes of Krugman and Summers are representative of the “sensible social democratic mainstream” and thinks MMT is crazy interrogated the RBA governor.

He opened with this accusation:

… that in the time you’ve been governor the Reserve Bank has pretty much comprehensively failed to meet its inflation target?

The point he was making was that he claims interest rates have been too high for too long – and he continued that line of attack.

He said that the central bank “mistake” led to “20,000 Australians who were not in work as a result of that decision.”

The Governor’s response was about the need to maintain financial stability in an environment where households had built up record levels of debt and encouraging more borrowing in that environment carried “longer term risks, and ultimately we could be very sorry if they manifested”.

They only cut rates “Once the borrowing by the household sector slowed”.

Leigh also asked about “what unconventional monetary policy might look like as you head towards the zero lower bound?”

The RBA said they were hoping to avoid using monetary policy tools other than interest rate adjustment.

The Governor catalogued the developments abroad in thsis respect:

1. Negative interest rates (Switzerland, Euro area, Japan).

2. Forward guidance – we will not increase rates indefinitely.

3. Below market-rate loans to banks to encourage lending.

4. QE – with government bonds, corporate assets, equities (Japan) – to expand central bank balance sheet.

5. Caps on exchange rate appreciation (Switzerland).

He concluded that these measures had had “some successes in lowering government yields and improving the dislocation in credit market” but we don’t know the full impacts yet.

He acknowledged that the RBA could drive the “risk-free interest rate” down to “a very low level”. This means that the government can set the yields on any of its liabilities if it chooses rather than take the behest of the private bond markets.

That means that mainstream notions of financial crowding out are impossible if the government chooses to act in this way.

Interestingly, a government committee member (Andrew Laming) asked about reducing underemployment and enhancing skills.

To which the Governor replied:

I hear a lot of stories at the moment that firms are struggling to find workers with the necessary skills, and I think in the past decade there has been underinvestment in skills development by businesses, and maybe the VET system hasn’t been working as well as it could have been as well. I think this needs to be a priority not just to give people jobs right now but to build the productive capacity for the future, and I think, as a nation, businesses and probably government haven’t done enough there over the past decade.

Again, a dig at government policy, which has hollowed out the state training and skills development institutions (TAFE) with huge cuts to their budgets and forced them to compete with fly-by-night private training providers who have adopted a ‘take the money and run’ approach, often leaving students who have paid huge fees for training courses stranded when the providers declare bankruptcy after ensuring the funds they have received are safely squirrelled away from the bankruptcy processes.

Another Labor representative on the Committee (Ann Aly) then homed in on the fiscal policy issue.

The RBA governor replied:

… I would like to see stronger wage growth in the country … in principle, you can create extra demand in the economy through fiscal expansion, not just through population growth but by lower taxes or increased spending … If we find ourselves in the position where aggregate demand in the economy is very weak, we’re not making progress on our unemployment and interest rates are very, very low, I think the fiscal option would need to be on the table …

I still see potential to do more of that over time and help support demand growth in the economy, increase productive capacity and make people’s lives better, and we can do it at very low interest rates.

Relatedly, he was asked by the Greens representative (Adam Bandt) about full employment and underemployment and responded:

I am confident that if the unemployment rate gets down to 41⁄2 per cent we will see less underemployment. The two things move together. I think that if we can get the unemployment rate down to 41⁄2 per cent we will see less underemployment as well.

The unemployment rate is currently 5.2 per cent.

The underemployment rate is currently 8.3 per cent – on average the 1,112.3 thousand underemployed workers want to work 2 extra days a week.

So on the central bank’s reckoning, Australia is a long way from full employment.

There were two aspects to this:

1. Government wage guidelines (around 2 to 2.5 per cent per annum increase maximum) have created “wage norms” in the private sector that have led to undesirably low wages growth.

The RBA thinks that with productivity growth a 3.5 per cent annual wages growth rate would be a “reasonable medium-term aspiration”.

2. Fiscal policy is too tight (restrictive) – stifling overall spending.

The RBA agreed that increasing the unemployment benefit would “lift aggregate demand” but the government refuses because it will impede their surplus ambitions.

The debate turned to whether it “would be better to have a small surplus and not borrow to fund infrastructure or to have a small deficit because of meeting the interest costs of borrowing for productive infrastructure?”

The Governor’s reply demonstrated that while he was critical of the government purusing that surplus obsession at a time when monetary policy had nearly exhausted its reasonable options and growth was slowing, he still held onto the mainstream fiscal myths.

He said:

It’s important that the recurrent budget is in good shape, because having a strong recurrent budget allows you options if things turn bad. We saw that in the financial crisis. Having run disciplined fiscal policy, the country had options that it wouldn’t otherwise have had. It’s important that we keep disciplined fiscal policy.

Which is clearly a false statement.

Two points:

1. The pursuit of fiscal surpluses before the GFC didn’t give the government any extra capacity to introduce a stimulus to address the challenges of the GFC.

2. What the fiscal surpluses did was squeeze the liquidity positions of the private domestic sector and growth (and the surpluses) were then only possible because that sector increased its indebtedness to record levels.

That meant that the dangers of collapse arising from the crisis were magnified and that now, growth is faltering because the private domestic sector is trying to reduce its debt levels through spending constraint.

So the so-called “disciplined fiscal policy” not only led to the conditions that spawned the crisis but are now making it harder to transit beyond it.

And that is a common element on a global scale.

Another Liberal Committee member (Marise Payne) also focused in on the fiscal policy issue by asking “what more could the government be doing to address that unemployment, particularly underemployment.”

The RBA governor said:

I don’t want to provide the government with advice on what it could be doing, but at least conceptually, if aggregate demand growth is not strong enough, fiscal stimulus could be one way of overcoming that. I’m not calling for the government necessarily to do that, but just conceptually that’s what you could do.

This was an interesting statement.

Quite clearly, the RBA governor has previously stated the government wasn’t doing enough on the fiscal front.

As Michael Pascoe noted (July 12, 2019) – RBA governor Philip Lowe’s hugely embarrassing Frydenberg photo-op:

For five years Philip Lowe has been asking the government to do more to ensure Australia’s economic future, warning time and again that we can’t rely on interest rates to foster sustainable growth.

Then, apparently, he was called in by the Treasurer (Frydenberg) for a “painful two-hour meeting” where he was ‘forced’ to say that the “Australian economy is growing” and “the fundamentals are strong”.

He also said that the Government was supporting growth.

As Michael Pascoe concluded it was a “a remarkable achievement for Mr Frydenberg to have Dr Lowe say something as palpably silly.”

Independence of the RBA? Not when the government appoints the governor and uses him as a political tool to advance their own agenda.

Later we had the ridiculous charade where Ann Aly asked about fiscal expansion and the Governor replied:

Can I just clarify something: I have not called on the government to do fiscal expansion. It would be inappropriate for me to do that. I don’t advise the government. What I’ve sought to do is lay out some options.

Aly: “Yes, additional fiscal support”.

Lowe: “It’s up to the government to choose from the options. People ask me about what the options are, and I lay them out, and people can ignore that if they want to.”

It is painful to read.

Of course he has repeatedly stated that the Government is not doing enough on the fiscal policy front to support growth and bring down unemployment below the current rates.

But he also plays the game that the RBA and the Treasury are somehow ‘independent’.

Conclusion

All these recent interventions by central bank governors (and I have only cited a few of many) indicate that the dissonance in mainstream economics and the political debate about policy settings is getting deeper and more public.

Governments are being pressured to abandon their obsession with fiscal surpluses, and, instead, use fiscal policy to stimulate waning economic growth.

This tells me that we are entering a period of fiscal dominance, which will represent a categorical rejection of the mainstream macroeconomics consensus that has dominated policy making since the 1980s – the neoliberal era.

More and more people will start to achieve an understanding of the main precepts of Modern Monetary Theory (MMT) as a result because our framework is the only macroeconomics that has been advocating this shift.

Resistance continues from the mainstream but the pressures are mounting.

I see it in terms of the invitations I am receiving to visit new places and give MMT-oriented workshops. In November – Japan, in December Pakistan, to name upcoming adventures.

That is enough for today!

(c) Copyright 2019 William Mitchell. All Rights Reserved.