RBA Governor Glenn Stevens gave an odd speech in Brisbane yesterday, in which he more-or-less suggested the federal Government should try to offset the demand shock from the end of the mining boom with expanded infrastructure investment, and that now is not the right time for fiscal tightening. The RBA apparently thinks it can’t reduce interest rates further to boost demand, given Sydney’s runaway housing market and also because, in its view, households have already borrowed enough and do not have capacity to go further into debt. So it is up to the Government to step in and boost demand, as business appears unwilling to invest. The Governor’s comments surprised financial markets, as you might expect, given the comments are inconsistent with the consensus view on the operation of monetary and fiscal policies in an open economy with a floating exchange rate, such as Australia’s.
As Tony Makin, among others, has argued vigorously in the past, fiscal policy is typically ineffective in an open economy with a floating exchange rate, and monetary policy is much more potent. According to the textbook model, this is because fiscal stimulus puts upward pressure on domestic interest rates and the exchange rate, crowding out exports (see New evidence stimulus worsened our competitiveness from Makin & Ratnasiri). This is widely recognised and is why macroeconomic stabilisation policy is seen as the role of the RBA. Prior to the floating of the Australian dollar in 1983, it was the Treasury’s responsibility, because, under a fixed exchange rate, it is fiscal policy that is effective, while monetary policy is ineffective.
Oddly, the RBA Governor has gone against this consensus and called for fiscal stimulus from the Federal Government through infrastructure spending. As the Governor himself may have hinted in his remarks, it is possibly too late to do so now, in the context of offsetting the shock from the end of the mining boom, given how long it would take to get projects designed, approved and built. And I don’t think it would be sensible anyway, due to the reason above, and also because it doesn’t seem wise to replace elevated levels of business investment, which were always likely and expected to be temporary, by high levels of government investment, particularly given some of the investment might be in projects of dubious merit. Further, as many commentators have noted, if the Federal Government doesn’t act to repair its Budget now, we run the risk of permanent deficits and, possibly, the loss of our AAA credit rating sometime in the future.
I would suggest Sydney’s overheated property market appears to be the reason for the RBA Governor’s odd remarks, and it is here that the RBA’s attention should be directed. Rather than giving odd and naive advice on fiscal policy, it should investigate the causes of the overheated Sydney market and advise on any regulatory or taxation policy changes that might be desirable.
Finally, I should note I attended the Governor’s speech yesterday as the Secretary of the Queensland branch of the Economic Society of Australia, which organised the lunch at which the Governor spoke. As a Management Committee member, I am very grateful that the Governor agreed to speak at our lunch, which was very well attended. Obviously, views expressed in this post are mine alone, and are not necessarily shared by my fellow Committee members.