A snippet on macro policy

Until fairly recently, macroeconomic policy (the management of unemployment, inflation and the exchange rate) was the central concern of economic policy. Since the early 1990s, and particularly under the Howard government, these concerns have shifted to the periphery.

The Hawke government abandoned targeting of the exchange rate with the floating of the dollar, but Keating in particular continued to regard the current account deficit as an important policy target, at least until the early 1990s. Excessive concern with the current account deficit was widely seen as one of the factors behind the policy miscalculations that produced the 1989-92 recession. The counterargument, put forward most prominently by John Pitchford, was that, in a deregulated market, the current account balance is ultimately determined by the corresponding set of borrowing and lending transactions, and that these should not be a concern of macroeconomic policy. This view is now fairly generally accepted. Even though the current account deficit is as large in relation to GDP as it was in the 1980s, only a minority of commentators[1] express concern about it.

More significantly, the government abandoned the idea of using fiscal policy to manage the economy, and ceased to take an active role in the determination of monetary policy, leaving this entirely to the Reserve Bank. Although the Reserve Bank, unlike other central banks did not take the view that it should be concerned solely with inflation, the resulting policy regime was one in which inflation targeting was the primary focus, and unemployment was, at most, a matter of secondary concern.
Finally, the government abandoned Labor’s target of an unemployment rate of 5 per cent, and declined to set an alternative target.

fn1. I’m a member of this minority

22 thoughts on “A snippet on macro policy

  1. Let me try to tag together some dimly-remembered macroeconomics.

    1. With flexible exchange rates the level of economic activity is determined by monetary policy and this operates through effects on exchange rates and exchange rate expectations.

    In fact ignoring exchange rate expectations fiscal policy has little effect on output level objectives. This was the finding of the old Mundell-Fleming type of macroeconomic model. With internationally mobile capital fiscal policy had its main stabilisation status under fixed exchange rates.

    So, if this is right, it is unsuprising fiscal policy isn’t used to ‘stabilise’. It is left to address social and distributional issues.

    2. The ‘consenting adults’ theory of the current account relies on rationality of capital markets. If markets are experiencing a real estate or speculative bubble then the surge in foreign borrowing, that might be reflected in a growing current account deficit, is not be so benign.

    But the latter possibility does not suggest you should target the current account. It suggests you examine what is causing the deficits.

  2. I am a member of that club JQ and I didn’t see you at the AGM in the telephone box!

  3. Hmm, I suspect being able to claim a 5% unemploymet rate (or something similarly low) *is* an aim of government policy. Of course, this is being achieved by redefining ‘unemployment’, rather than by reducing actual unemployment.

  4. John, I can’t imagine how a trip to the Holy Land could have caused you all of a sudden to begin ruminating on macroeconomic policy. (Shouldn’t you be checking out water-rationing mechanisms on a kibbutz or someting?) But since you brought it up, here are some thoughts.

    Two types of people are worried about the current account in Australia. One group see capital markets as hopelessly inefficient and bubble-prone, and think we could end up like Thailand. The other group believe that our welfare and tax system distort saving decisions, leading us collectively down the road to a debt trap. We could roughly characterise these positions as left and right. Pitchfordites are in the middle, or at another corner of the triangle, but I think the current orthodoxy more closely resembles the ‘right’ position. The policy establishment is worried about the current account, but they don’t talk about it because they don’t know what to do about it.

    The problem is one of too many targets and, because interventionist macro policy is unfashionable, not enough instruments.

    Conventional wisdom is that monetary policy determines the level of activity and aims to keep the unemployment rate at the NAIRU. (There is some recognition that the NAIRU can itself be gently lowered when the actual rate is low.) Meanwhile, the level of investment is deemed to be determined independently by rational private sector decisions. (Governments engage in some capital formation in areas of accepted market failure, but this is not considered a macroeconomic issue, and therefore not a matter of fiscal policy as strictly defined.)

    The residual is consumption, and because budgets profoundly affect aggregate consumption, having a fiscal policy now means having a policy toward the level of national saving. If the authorities deem, as they do, that we are not saving enough, they can save more on our behalf by reducing household disposable income and thus reduce private consumption, or they can just cut public consumption.

    Incidentally, if we accept the independent determination of investment, a policy to increase saving cannot be other than a policy to improve the current account.

    In practice, a policy that seeks to increase saving without altering investment or output must employ a mechanism that somehow translates a reduction in consumption directly into a rise in net exports. But the impact of measures to curtail consumption across the board cannot possibly be limited entirely to traded goods: that is, there is no way that, say, a rise in net taxes will simply reduce imports and increase exports. There will also be reduction in the consumption of non-traded goods, and by definition therefore a reduction in the output of non-traded goods.

    The full-employment objective dictates that the resources so freed be switched to production of traded goods. Broadly speaking this implies moving workers out of services and into manufactures, mining and agriculture (or at least slowing the shift in the other direction). Such a structural change, if it is to take place, cannot occur without a significant depreciation of the real exchange rate, such as to make the latter industries relatively more profitable and cause investment to be redirected to them.

    This means we need a lower inflation rate or a devaluation of the nominal exchange rate. Under the ruling assumption about how the inflation rate is determined, you can’t slow it down without creating unemployment. That leaves the nominal exchange rate, which in the international casino economy, doesn’t seem overly amenable to fine tuning.

    In the days when Swan and Salter worked out this approach, there was a fixed exchange rate and a centralised wage fixing system to help manage the adjustment. The Hawke Government floated the dollar, but at least it still had a means to pursue wages policy, and could have managed the adjustment if the price level had been more stable in the first place. Now we have somehow stumbled upon price stability, but have lost the ability to manage a major relative price adjustment. All we have is the fantasy that if we keep deregulating everything the distortions will be ironed out, the deficit will shrink, and we won’t need any second-best solution.

    Well, that should kill off this thread.

  5. Fascinating and informative James, thanks! Of course, (pointing out the obvious) doing away with a centralized wage system didn’t help the macro control theory either.

    I’m wondering whether the implied equation
    Household debt accumulation (is proportional to)(=) foreign net deficit
    is a bit simplistic.

    I think the observations correct though – exports are driven by overseas demand – local supply is always catching up (except for innovations). Imports are driven by local demand which is a function of credit availability if you assume that wages(costs) are a function of export prices. The latter, however, is generally not true.

    The difficulty with an aggregate figure like the current account deficit is to avoid getting entrapped by it’s calvinist overtones and instead to see it as a reflection of underlying problems. However, it’s only useful insofar as it is a predictor of difficulties down the road when in fact it may just be a sign of well established problems. I’m asking the question though – I don’t have a well formed belief one way or another.

  6. I think it interesting though that during the Hawke/Keating years the media,including the economics writers used to paint tales of woe concerning the Current Account Deficit – Huge headlines would result.

    When the Liberal Govt was elected, the economic journalist community decided to look the other way and ignore the increasingly poor performance of the current Govt.

    …and they say they aren’t biased?

  7. Shaun, For many of the Hawke/Keating years we had high inflation, high unemployment and high interest rates. The current account was seen as a Banana Republic outcome.

    Currently Australia is one of the best-performing economies in the world with low inflation, low unemployment and strong economic growth. (I also think its got much better macroeconomic management). The current deficit, if anything, is a reflection of a long boom.

    Its hardly surprising that people take a different view of the current account deficit.

    And can you really talk about the ‘increasingly poor performance of the current government’ at least in relation to economic management?

  8. Kyan:

    The decline in household net saving since the mid-1980s is pretty striking, whichever way you look at it.


    Even if one accepts your argument that the Howard Government has managed the macroeconomy better than Hawke and Keating in some general sense, I still don’t see your point. The current account deficit averaged a little over four per cent of GDP in the last five years of each of the two regimes, much higher than in most OECD countries. If it was a problem then, why isn’t it a problem now? And since when are long booms characterised by current account deteriorations? The only way I can make sense of your ‘long boom’ remark is that you perceive the recent high growth rate as justifying an expectation of a future high growth rate, on the basis of which we may feel confident to borrow. But the current account will still need to turn around at some stage. When that happens, will you interpret it as evidence of an unhealthy economy?

  9. James. I think the current account deficit is partly a reflection of the booming Australian economy with high economic growth (a good thing) and partly I think a reflection of the real estate bubble (a bad thing since capital markets not valuing things well). If the latter subsides gradually without too much wealth trauma the economy should be fine. This can be achieved (as the Reserve Bank is doing) by gently increasing interest rates and talking-down the overvalued housing market.

    I just can’t see much relation between this type of deficit and that experienced under Hawke and Keating. The economy then was sluggish, Australia had high public sector debt, high inflation and high unemployment. The current account deficits then might not have been excessive but they certainly had different origins.

    Its not foreign borrowing per se that is a difficulty – it is foreign borrowing that doesn’t reflect sensible investment choices.

  10. re the debate about whether we see “increasingly poor performance of the current government”, what are the measures, either way? As John – rightly – points out, there is precious little left that governments actually do in relation to macro management. I suppose there is a negative indicator – at present they leave the Reserve Bank alone, as opposed to intervening in monetary policy, and the Reserve seems to be doing that job effectively! Up until the last budget I would have said that fiscal policy is now relevant to the macroeconomy primarily through the operation of automatic stabilisers (eg increased social welfare spending when the economy turns down automatically stimulates it): although I do worry that the huge spending burst announced in the budget, and the fact that the money is being spent so quickly, will potentially lead to a government induced boom-bust cycle over the coming year. I do find a problem with Harry’s contention that the government is a good economic manager but the housing bubble is a bad thing, given that over investment in housing is driven by government policy. It’s not an entirely irrational bubble – taxation incentives (especially re capital gains tax), subsidies for first home buyers, the exemption of the family home from assets tests for various forms of government assistance etc. are all designed around promotion of home ownership. Call me simplistic, but doesn’t the overwhelming weight of economic evidence suggest that where there are hefty government subsidies for one form of investment over another then as night follows day there will be more of the former than the latter?

  11. Stephen, Whatever you can say about negative gearing it is not a policy of the current government. Allowing for tax deductibility of capital costs of investment is pretty universal throughout the economy so I am not going to die with anguish on this one although you can (I don’t) argue against allowing losses in one area from being written off against positive income elsewhere. In the US and Canada borrowings for owner-occupied housing are tax deductible. I agree the first home owner’s grant is a dud policy — I assume the grant is pretty well capitalised into the price of property and doesn’t help new housebuyers much. But this grant does not account for the vast growth in prices that has occurred. I think it is partly an irrational bubble although obviously driven by low interest rates and a strong economy.

  12. Harry, we may be closer in views than you think. Negative gearing is not to my mind the problem (you’ll notice I did not mention it in my post). I have argued this in the past: the suggestion (not from you or indeed others in this thread, but I have seen it in the media elsewhere) that we should abolish negative gearing for housing investment is a distortion in the opposite direction – why should housing be penalised vs. eg share investments? But if we disallow all forms of negative gearing then there will be a real disincentive to investment, to the detriment of the economy.

    I do think that the 50% concession on capital gains for investments held for more than a year, introduced by the current government, is likely to have encouraged a big influx of speculators into the property market (and in to the share market, including via margin lending, which is booming). Other concessional treatments of housing are more long standing and can be traced back to Labor as well as Coalition governments I agree. Likewise I agree with you that grants for home buyers are quickly capitalised into the price of houses and therefore do little good. I accept that in Sydney and Melbourne there seem to have been irrational elements to the housing boom, but for many investors the incentives around house purchase in this country make it a rational choice (I am going against the trend in arguing this I know). I also share a view put some time ago by John that the “Howard put option” – the belief that the federal government cannot electorally afford to let house prices fall too much – may be influencing behaviour.

  13. Harry:

    Sorry to harp on this, but you still haven’t explained why the boom explains our current account deficit. Is your ‘dimly remembered macroeconomics’ telling you that high growth rates are associated with external deficits because the growth implies abundant investment opportunities? I can’t find much support for this idea in data from 1990 onwards. The best performing OECD countries in terms of growth rates over this period are Ireland and Korea, and both have enjoyed, on average, positive current account balances. They also have the highest rates of investment growth. Only New Zealand has a bigger current deficit than Australia’s and it has one of the lowest growth rates. The next two worst CADs belong to Mexico and Turkey, and both of these have high investment growth rates, but their GDP growth rates have been lower than ours.

    I should say I have an open mind about all this. But I’m puzzled why the current government gets so much credit for macroeconomic management from people who are otherwise stern critics. Perhaps the critics feel they are more credible if, having at least one positive thing to say, they appear balanced.

  14. James, I am not a macroeconomist and don’t like pushing my instincts too far in this area. But I will anyway. Australia has run current account deficits for most of its history because it is investment opportunity rich and savings poor. In recent times these opportunities have expanded so the money has poured in to wisely finance sound investments in manufacturing, tourism and so on. In addition a housing boom and a surge in housing/unit construction and renovation has been financed by unwise foreign borrowing — unwise because it won’t yield a return that exceeds borrowing costs.

    Thus I dodge the issue of whether the deficit overall is good or bad — it has elements of both.

    The evidence on the correlation between deficits and high growth/ low domestic savings comes from Australia and of course the United States over much of the past 15 years. I assume Korea, like most of the East Asian NICs, has high savings rates. Ireland I don’t know about so can’t comment — an interesting case since it has enjoyed very high growth and a pronounced housing boom. In the nineteenth century Ireland exported lots of people and this generally was accompanied with capital exports.

    I don’t endorse any politician (if you were referring to my views in your final para) but Australia does have about the highest forecast economic growth in the developed world in 2005, forecast inflation of about 2.5% and unemployment of 5.5%. Our interest rates are a bit higher than most developed countries but sensible given the housing bubble. Our public sector surplus is 0.5% of GDP. Not too bad.

  15. Aren’t CAD figures published with a sectorial analysis that can tell whether the CAD is due to defense spending or new mining ventures or consumer electronics?

    Also the current boom especially in employment over the last 12 months is not explained by the increase in personal debt. It seems to me to be driven by optimism in the private sector management usually with reference to overseas markets but also I suspect that the internal economic effects of the ‘sea change’ shift may be being underestimated.

    I’d note in passing that my home town of Albany W.A. pop 27,000 has easily twice as many positions vacant today as it did two years ago. If there is a lot of growth in the service and housing sectors outside of the capital cities then it might not show up in many figures. (an easing in the city house market with potential home buyers electing to move out for instance, but still buying a house)

    The other factor that’s driving the current economic good times is external and otherwise known as China.

  16. the size of the CAD is not necessarily an issue – I seem to remember (and could probably find the stats if I digged) that the growth of the USA into an industrial power in the nineeenth century was financed largely by overseas money: the US ran one of the longest and largest CADs on record for most of the 1800s. what does matter is the composition, the reasons for changes – and also how well placed we are to deal with the risks involved. To address the last issue> at present the large CAD does mean that when the world economy takes a nosedive as a result of US policy settings we will be more exposed, and this is a cause for concern. I know my view of the world economy is disputable – let me go on record as predicting that the growing US public sector deficit, poor jobs growth and macro mismanagement by the Bush government will lead to a significant downturn in the US economy by the end of this year or at latest next year (Bush is presumably just hoping that it happens post November 2004). If I’m wrong, I hope you all point it out to me! I am not sure China will rescue the world, given it is still – although growing fast – a much smaller economy, and that there are concerns among central monetary authorities in China about how sustainable their growth is anyway. In the end, our reliance on external funding means that we may be harder hit by the international downturn than many others.

  17. Harry, you say the economy was sluggish under Hawke and Keating.

    Between March 1983 and March 1996, when they were in government, real GDP growth averaged 3.6 per cent year (2.3 % p.a. per capita).

    Under Howard, between March 1996 and March 2004, real GDP growth averaged 3.6 per cent year (2.3 % p.a. per capita).

    If it was sluggish under one, it’s been sluggish under the other.

    True, inflation has been lower under Howard, but that is thanks to exceptionally good management of monetary policy by the Reserve Bank. Howard and Costello do get the credit for giving the Reserve Bank the independence to conduct monetary policy as it sees fit.

    And speaking of inflation, correct me if I am wrong, but I recall you writing a full page article in the Financial Review towards the end of 1989 predicting that inflation was about to blow out of control, because of what was happening to the money supply.

    That wasn’t exactly prescient. Instead, we got a huge recession, inflation fell and has been down ever since.

  18. Uncle Milton I think I said high unemployment and high inflation under Hawke/Keating. And yes inflation and unemployment are much lower now. But your statistics do suprise me and are interesting. I would like to check this and whether the figures are distorted by recession incidences but given the long sustained period of growth Australia has enjoyed I am sure you are right.

    Stating the obvious: The AFR piece was wrong. It was based on flawed monetary aggregate measures and misuse of such aggregates. So mea culpa. But tacking this error onto your critique of another set of arguments I made proves only that I am not infallible.

    I had hoped we might keep this to ourselves.

  19. Harry, the figures are easily checked. The RBA web site has all the data. Since the Hawke/Keating years includes the tail end of one recession and all of another one, it’s all the more remarkable their average growth is the same as the Howard years, where it’s been pretty smooth going the whole way. On unemployment, the relatively low unemployment rate right now is a little misleading. Aggregate hours worked have grown more slowly under Howard than Hawke/Keating. We have low unemployment because the participation rate has dropped, and because there are a lot of people working a small number of hours, so they don’t count as unemployed.

    Still, the economy has done well. As I said, I think this is mainly due to the skillful use of monetary policy by the Reserve Bank, and the very opportune falls in the exchange rate which helped our exporters when the going would have been otherwise very tough, such as during the Asian crisis of 97 and 98. More recently, our terms of trade have been at record high levels, and we can thank the Chinese for that.

    None of this has got much to do with any brilliance by the Howard government. But at least they haven’t made any major blunders in macro economic policy, like panicking over the current account, or the exchange rate. This is quite something, though their tax policy has certainly worsened the housing bubble, and if that bursts in an ugly way then it could bring down the whole economy. But it probably won’t.

  20. Uncle Milton, Your comments on the comparative performance of the economy under Labor (March 83-March 96) and the Coalition (March 1996-March 2004) suggest that the significantly higher inflation and unemployment under Labor did not affect growth much.

    I was interested enough to check out your claims in the Reserve Bank data base and they are basically right:

    (i) Average GDP growth per capita under Labor was 2.14% (quarterly data expressed as annual rate) and 2.38% under the Coalition.
    (ii) Inflation rates were 5.6% under Labor and 2.5% under the Coalition.
    (iii) Unemployment rates averaged 8.5% under Labor and 7.01% under the Coalition.

    The big recent gain has been the recent strong reduction in unemployment to 5.6% with continuing low inflation. The participation rate increased a smidgeon under Labour but has remained about constant under the Coalition. Hours worked increased strongly under Labor and have continued to rise under the Coalition.

  21. Harry, the problem is that the participation rate for males has continued to fall steadily. Whereas the continued rise in female participation presumably reflects ongoing social change, the decline in male participation looks a lot like worsening hidden unemployment. This is persumably the basis for the Captain’s rather provocative claim (in Robert Manne’s book) that unemployment is the Howard Government’s worst policy failure.

    I know from some of your earlier comments on this blog that you think the growth in hours worked is bad, and I agree. This phenomenon, combined with the low participation rate, suggests an unhealthy distribution of work.

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