Public policy reforms will control our destiny

The RBA has decided for now to maintain the benchmark interest rates it pays on overnight funds (aka the ‘cash rate’) at the historic low of 2.25 per cent. However, the market is still expecting one—or two—cuts by the end of the year. Indeed there is much strong evidence that the Australian economy is underperforming: inflation is under target, unemployment is rising, wages are stubborn, export prices are plummeting.

Australia might be a big continental island but we are not isolated. In fact, most of the developed world is fighting against deflation, and some even in hazardous field of negative interest rates. For instance, the European Central Bank is trailing under the ‘zero-lower bound’ since last June; Denmark, Sweden and economically conservative Switzerland have also recently moved in that direction.

Basically, by setting negative interest rates, a central bank is charging commercial banks to hold their reserves. Economists have long claimed that it would not be possible: one could always simply hold cash instead and place it under the mattress. Yet that option is not feasible when the cash amount reaches billions of dollars.

One hoped-for solution would be to put the idle cash to good use. In theory, banks should channel these resources for companies to borrow and invest. But here is the catch: companies are reluctant to invest in a moribund global scenario – and indeed are even hoarding cash of their own. German firm cash holdings are equivalent to one-fifth of its annual gross domestic product (GDP); in South Korea and Japan, that number rises up above a third of their respective GDP; even in America, companies like Apple, Cisco, Google and Microsoft are sitting on $350 billion.

Another interim solution would be to lend the money to the public sector. After all, governments with climbing budget deficits are always keen to binge on cheap credit. However, it seems this strategy is backfiring for most investors at the moment, as major government bonds—including German ones as of this week—currently also display negative returns. But it is good to note that it has not stopped the issuance of about two trillion dollars across Europe alone in government bonds with negative yields in the past months.

Australia is not currently facing the imminent danger of deflation, nor in the need of the sour remedy of negative interest rates. Nonetheless, Australia’s monetary policy independence is undeniably constrained by global events mentioned above. In fact, to state the contrary is to operate under a similar delusion to ants who ride a tree trunk down winding river rapids but believe they are controlling its direction.

Not only there is not much room at present to decide on our cash rates, but also the very ability of cheaper money to lift employment and investments is undermined by subdued export markets and low-priced imports. Apart from asset price boosts fuelling fears of a looming bubble, the impact of the current domestic monetary policy is now closer to distracting blank shots than to the silver bullet of former years.

So if the effectiveness of monetary policy is currently undermined and the dire prospects of fiscal laxity are constrained by the state of the budget, what can be done?

The answer lies in effective public policy reforms. And there is no scarcity of scope for improvements: pensions, education, health, labour market—to name just a few. In order to grow out of our current economic paralysis, Australia needs to set in place the correct incentives for hard work and sensible risk-taking behaviour, instead of encouraging people to game the system through badly-targeted welfare handouts.

We might not have total control over our cash rate levels nor a free ticket to fiscal profligacy. Instead, to once again become the guides of our destinies, we must focus on what we do completely control: Forget mainstream monetary and fiscal policies, our way out rests on clever productivity-enhancing policies.

Dr Patrick Carvalho is a Research Fellow at the Centre for Independent Studies.