Coronavirus: It’s Keynes’s fault – again we go into debt to ‘stimulate’ the economy

Both were what economists call external shocks; the first origin­ating in our largest foreign investment partner; the second in its largest trade partner, though mainly resulting from our lockdown response.

And both resulted in federal and state governments opening the public-spending spigot on the presumption this would mitigate the economy-wide impact of the shock along Keynesian lines, oblivious to its harmful long-term consequences. Like the fiscal response to the GFC, COVID-19 leaves an economically threatening legacy of high budget deficits and public debt — this time potentially doubling at federal level alone, to reach more than $1 trillion in a few years.

The notion that considerable government spending mitigates the macro-economic impact of a crisis is a Keynesian fallacy. Suddenly injecting government spend­ing is not akin to injecting liquidity and bank credit via emergency monetary easing because government spending has to be funded from somewhere — in our case, mostly from abroad. Unlike emergency monetary responses to increase liquidity and loosen credit availability, panic government spending binges — particularly of the cash-splash and welfare support kind — cannot be readily withdrawn, and have lasting macro-economic consequences.

Crude Keynesian macro-economics in its original form presumed the economy was closed to international influences, there was mass unemployment of unskilled labour and the banking system was broken. But Australia is an open economy with a fully functioning banking and financial system and skilled workforce, which means fiscal policy works differently to simple-minded Keynesianism taught in high schools. Few have appreciated what British economist and Keynes critic Hubert Henderson said decades ago: “Nothing has done more … to lead modern economics astray than the practice which Lord Keynes brought into fashion in the 1930s of reasoning on the hypothesis of a ‘closed economy’ …”

Budget deficits are mostly funded from abroad, meaning we do not “owe the debt to ourselves” but owe it mostly to foreigners. Bond issues to fund budget deficits in the tens of billions are enticing strong capital inflow from abroad that is strengthening the exchange rate and worsening our international competitiveness. In this way, the exchange rate is mimicking its behaviour in response to the Rudd government’s counter-productive fiscal response to the GFC when the exchange rate appreciated to historical highs (more than $US1.10) due to the fiscal “stimulus” then that induced foreign capital to buy government debt. That severely worsened Australia’s competitiveness, contributing to the euthanasia of parts of the manufacturing sector — exact­ly what any good university macro-economics textbook will tell you.

So, if the dollar soars in coming quarters, damaging the prospect of a quick economic recovery, remember to blame the COVID-19 fiscal overdose administered by federal and state governments. Another contributing factor to a climbing dollar is likely to be the US Federal Reserve flooding world money markets with US dollars, to assist competitiveness, again an international factor.

Announcing bonus cash payments and bolstering welfare payments with public debt already escalating rapidly due to revenue losses was like a household deciding to spend more each week at pricey restaurants while under pressure with incomes falling to meet the mortgage payments.

The international factor that would puncture the dollar’s rise is a downgrade of the federal government’s AAA credit rating, which would also flow through to the states. Now a strong possibility, this would add a risk premium to interest rates across the spectrum. With a trillion-dollar public debt, every additional basis point of any consequent interest risk premium would add $100m to the public debt interest bill, mostly paid to foreign bondholders.

Again, blame fiscal “stimulus”.

Federal public debt interest is a net drain on national income and at federal level alone could rise to over eight times the size of Australia’s foreign aid budget and three times the federal spend on higher education and many other federal government programs.

Australia’s pre-pandemic fiscal position was not as strong as it should have been because successive federal governments failed to rewind the growth in government expenditure in the wake of the GFC. The size of Australian government pre-pandemic was already above its optimal level.

Cutting government spending should take precedence over raising taxes. Reduced public spending, particularly on industry assistance and overlap in spending at federal-state levels, should be central to the recovery program.

This should be accompanied by tax reform (including to internationally uncompetitive company tax rates), business deregulation and industrial relations reform. Without this, our economy will remain in limp convalescence for decades.