Stimulus was always going to be problematic in an open economy

One of the major implications of the 1983 floating of the Australian dollar was that fiscal policy became less powerful than monetary policy. Any fiscal expansion (i.e. stimulus) would put pressure on domestic interest rates, attracting money into Australia (some of which is purchasing the bonds financing the stimulus), raising the Australian dollar and ultimately suppressing activity in trade-exposed sectors. This was obvious to a number of observers at the time of the Government’s stimulus packages in 2008-09, including Professor Warwick McKibbin, formerly of the RBA Board, who is quoted in the Australian this morning (Labor’s great financial crisis split with RBA):

…Professor McKibbin – who has argued that the scale of Labor’s stimulus had contributed to overheating the economy during its recovery from the GFC – said Australia’s performance during and since the crisis vindicated his position at the time.

“That’s why you want the Reserve Bank to be independent from both Treasury and government,” Professor McKibbin said. “It would have been good if the government had listened to my advice on fiscal policy at the time. We wouldn’t be facing what we do now, which is an exacerbation of the two-speed economy.

“Right now we should be running surpluses and extracting demand from the economy to reduce pressures on the non-mining sectors.”

McKibbin is spot on, though I can understand it would have required more than the usual sang froid among Treasury officials not to go along with the stimulus package, given that it truly did appear to many at the time that the world was on the brink of another depression.

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2 Responses to Stimulus was always going to be problematic in an open economy

  1. KS says:

    Thanks for that. Some of us have been banging on for well over a year that the stimulus may not be all such a wonderful thing for those of us in non-mining trade exposed regions. It has distortionary effects. Also always a problem with fiscal policy such as BER is the timing of implenentation and withdrawl. BER should have been just pulled earlier but suspect that would have been politically difficult.
    The strongest proponents of very large fiscal stimulus in the USA, such as Krugman, always have based their argument on the liquidity trap situation with interest rates at the zero bound when they should probably be even negative so that a very large stimulus doesn’t push up interest rates …… or the currency. At least that’s the way I’ve always understood the position.

  2. Gene Tunny says:

    Yes, I agree. The case for fiscal stimulus is clearest when there is a liquidity trap. Otherwise the usual concerns around crowding out of private investment and lagged, poorly timed impacts on the economy dominate.

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