Planning for surprising times

By Stephen Sedgwick

The Age
7 March 2009, p. 10

Policy makers and forecasters have been unpleasantly and powerfully surprised several times as the global financial crisis has unfolded. But downturns dont last forever and history suggests that policy makers can also be surprised on the upside.

For example, shifts in consumer, business or financial market sentiment can be difficult to predict but work powerfully to accentuate both the economic slide and the recovery. In dealing with the still evolving crisis we would be wise not to lock ourselves into policy positions that cannot be quickly reversed, if necessary, or which are inconsistent with longer term needs. This is true even though growth has turned negative.

There is no doubt that the US, and much of Europe and Japan are facing recession or worse. In some cases there is a real risk of deflation, an insidious condition that is difficult to counteract. World demand and the growth of world trade are faltering and access to credit has become constrained. Australia is heavily (and usually beneficially) reliant on world markets to buy and sell goods and services and for access to capital. Consequently Australias growth rate has slowed. But the household debt problems are not as deep-seated in Australia, and our financial system is fundamentally much stronger than that of many countries. Provided the worlds markets for goods, services and credit remain open for business Australia will most likely recover earlier and possibly faster than those countries whose circumstances define the nature of the crisis.

Australian authorities have rightly tried to restore credit flows, sustain domestic demand and moderate the rise in unemployment. Although the next few quarters will no doubt look and feel nasty, economic growth will recover in Australia, and when it does, the policy challenges that existed prior to the crisis will remain. Our population will still be aging and well need to maximize workforce participation. Inflation will have subsided but some forecasts suggest that it will fall less here than in other countries and may remain towards the top of the Reserve Banks target range. We will still have a large (probably larger, relative to GDP) current account deficit and therefore will need to remain an attractive haven for foreign capital and credit flows.

The government has taken commendable steps to restore credit to credit-worthy Australian borrowers. These include government guarantees (for a fee) for certain international interbank borrowings. These steps prevented collapse of the interbank market but they should be withdrawn as soon as possible. Progressively raising the governments guarantee fees to entice private players back into the market would be a good first step.

Regulatory changes are necessary in many countries to shore up the financial system to reduce the risks of a recurrence of a financial meltdown. But those changes need to be well designed. For example, one cause of the crisis is that the risks embedded in some novel and complex financial instruments were not properly understood. Since you cannot force Boards and managements to assess risk accurately and exercise good judgement by regulation, there is a risk that some will seek regulations that simply shift management accountability towards process compliance, as occurred after the Enron scandal. That would be a mistake, especially if it led to excessive risk aversion. Financial institutions exist to take risk. But they need to prudently and adequately capitalise in line with their actual risk profile.

On the fiscal front, the government has funded stimulus equivalent to about 2 per cent of GDP for two years. Commendably, almost the entire discretionary element has comprised one-off payments. A substantial fiscal package was justified initially to capture attention and positively affect confidence and behaviour, as one of the main risks is unwarranted pessimism. But the government does not totally control the timing of ultimate expenditure. Some people who initially saved their windfalls may later spend up once they feel their jobs are safe.

The Treasurer has foreshadowed more fiscal measures with a focus on infrastructure provision. And the governments response to the Pensions Review is expected shortly. Any new fiscal measures and tax/ transfer changes should be well chosen and have a modest fiscal impact. We are a capital-scarce country. We cant afford to waste it on white elephants, even in the name of short-term jobs creation. Moreover, reform of pensions and benefits still needs to be driven by the longer term needs of the economy: income support for the jobless and low paid, for example, needs to be consistent with maximising workforce participation, including participation by secondary wage earners.

In many respects monetary policy is easier to reverse than fiscal policy or tax and transfer arrangements. The RBA has dramatically cut interest rates and pumped liquidity into banks to ensure access to credit and to promote spending in rate-sensitive sectors such as housing. There are tentative signs that this stimulus (together with higher grants for first home owners) is beginning to work, with demand for housing rising, albeit from low levels. Indeed the RBA has noted that the monetary transmission mechanism is still effective in Australia, unlike in some other countries, because our banks are well regulated, well capitalised and not subject to as intense balance sheet pressures as counterparts abroad. This gives some hope that interest rates rises can help to manage the eventual upturn well.

But we would be wise not to become overly reliant on this. Interest-sensitive sectors, such as housing, are already fragile and there is little sense in creating unnecessary stress for householders and others newly encouraged back into the market. Confidence is likely to be fragile until the recovery is very well established, and it can turn viciously against recovery if a sufficiently negative surprise occurs.

Getting the timing right for this phase of monetary policy will be crucial. If the recovery is unexpectedly fast, early monetary tightening might be required. Since the job market usually lags, it is possible that unemployment will still be rising when the RBA has to make this call. It is to be hoped that by then monetary and fiscal policy will not be working against each other, which suggests that a cautious approach to fiscal policy is best at this stage.

Stephen Sedgwick is director of the Melbourne Institute of Applied Economic and Social Research at the University of Melbourne.