Are we all Keynesians again?

The Australian government’s latest fiscal stimulus has at least stimulated a debate about the wisdom of this type of government intervention.  It is a good thing that the stimulus juggernaut has hit a political roadblock, in the federal opposition, because up to now its passage has been too easy.  There are plenty of stimulus sceptics and it is time they were heard.

Richard Nixon famously declared almost four decades ago, “We are all Keynesians now”, meaning that the use of tax and spending adjustments to smooth economic fluctuations was generally accepted.  The world subsequently learned – through experience and a major revision of economic thinking – that Keynesian policies could be ineffective or even harmful.  Governments around the world are now acting as if those lessons had never been learnt, but they remain valid today.

Researchers at the International Monetary Fund (IMF) very recently concluded after an extensive study that “…the effects of fiscal stimulus can be positive, albeit modest.”  It is ironic that such faint praise should come from the IMF, whose pronouncements are now being invoked by our government to bolster the case for intervention.

The Australian Treasury estimates released last week make it clear that the Commonwealth budget would have gone into deficit in 2009-10 even if the government had sat on its hands.  Nobody would have objected to such a deficit.  It is a result of the so-called automatic economic stabilizers – the drop in tax revenue and rise in government outlays that occur automatically as the economy weakens.

Rather, the issue is whether, to what extent and how the government should actively change tax and spending policies to push the budget further into deficit.  This is what it has done on a huge scale.  Policy changes announced since the May 2008 budget will cost $68 billion over four years.  The point is not that this will have no positive effect, but that any benefit will be too small to justify the costs and risks involved. 

The stimulus packages include over $20 billion in one-off payments in 2008-09 to boost household disposable income.  Evidence and theory suggest that such payments do little to boost household spending, particularly when confidence is fragile. 

That point is just part of a much wider case against the effectiveness of fiscal stimulus.  Deficit spending by government can be offset by private sector retrenchment if it is unsustainable and creates uncertainty and fear about future fiscal policies (read tax increases) needed to bring the budget back under control.   Ministers can say as often as they like that the deficits are temporary and that debt will remain low, but the turnaround in the budget outlook in the last few months has been of such staggering proportions that it is a blow to private sector confidence.  

Then there is the risk, amply demonstrated by last week’s package, that governments in a hurry to spend will resort to wasteful spending which not only fails to give much of a short-term boost but does nothing to strengthen the fundamentals for long-term growth.  The latest package is full of politically fashionable spending on school buildings and energy efficient homes, but contains very little for economic infrastructure that would strengthen the supply side of the economy.

There are also timing problems.  The timing of a stimulus is only as good as the economic forecasts on which it is based – and economic forecasting has a poor track record, particularly at a time of volatility.  Due to lags, the government’s stimulus will have its peak impact during 2010, by which time a strong recovery may well be under way.  

The multi-country IMF study referred to above found that the bang for the stimulus buck is small: typically ten cents in extra GDP per dollar of stimulus at the time of impact, and no more than fifty cents even after three years.  Some other commentators think the effect is even weaker.  The notion that the pay-off to fiscal stimulus can be enlarged and fine-tuned through careful targeting sounds like a proposition from the Soviet handbook of economic planning, and will be about as successful.

None of this means that governments are powerless to help turn economies around.  The actions taken and still to be taken by the US authorities to restore the financial system to health are critical to the global situation.  Monetary policy everywhere has a key role.  It has already been eased very substantially and the effects will be felt with a long lag.  And the automatic fiscal stabilizers are at work.

In addition, Australia was one of a few countries whose budgets were strong enough to sustain a modest but credible loosening of the purse strings through fiscal measures that would have strengthened the economic fundamentals for the long-term as well as giving a short-term fillip.  Taxes could have been cut so as to improve incentives for individuals and businesses to work and invest.  But such opportunities have been foregone.

Robert Carling is a senior fellow at The Centre for Independent Studies, his paper Are We All Keynesians Again? was released by CIS in February.