Shall we pull the fiscal or monetary lever?

For the first time in many months, nobody is talking about the RBA in a rates meeting week. Ironically, the silence accompanies a context which has made a shift in monetary polcy more likely than at many previous meetings this year. The global economy is unequivocally slowing, recession talk in Europe and the US is now mainstream, as is the fallout that includes slowing Chinese growth. In Australia, the labour market has clearly made a turn for the worse, leaving behind the important 5% level for the time being. House prices are sliding very consistently and not all that slowly either. The stock market has been smashed for two months and is down some 20-odd per cent and metals prices have been monstered (though not the bulks). As well, the inflation bogey has been put back in its box as the flood-related surge in first half prices passes, and the ABS offers a helpful hand by rejigging its CPI basket.

Interest rate markets haven’t missed the point. They are pricing the likelihood of rate cuts highly.

I guess the reason nobody wants to mention the war today is that the ugly sister of macoeconomic mangement, fiscal policy, is hogging the headlines via the Tax Summit. Though with the government shutting the outcomes down in advance, especially on the subject of whether or not the nation should aspire to run a Budget surplus next year, there is even greater reason to expect monetary easing to offset gathering economic weakness. It is this last reason that makes rate cuts inevitable, in my view.

Consider, last Friday there were two events that had reference to the position of the national Budget. The first, which dominated the headlines, was Treasuer Swan’s announcement that the final Budget deficit figures for the 2010/11 year was a deficit of $47.7 billion, some $2 billion better than expected. This has left us with a public debt to GDP ratio at 22% (according to the IMF).

The second, far more important, event was roundly ignored by the media. New Zealand was stripped of its AAA soveregin rating stripped by Fitch.

New Zealand’s public debt to GDP ratio is projected to be around 32% this year but, according to Fitch:

Public finances have traditionally been a rating strength for New Zealand relative to ‘AA’ rated peers but the deterioration experienced over the past three years has eroded that strength. The debt/GDP ratio of 46% in 2011, although below the ‘AAA’ median of 57%, is similar to the ‘AA’ median of 43% and the ratio of debt-to-revenues has risen in line with the ‘AA’ rating median to 122%. The general government revenue-to-GDP ratio has also become more volatile at 4.9% compared to the ‘AA’ rating median of 3.9%. Additionally, as non-residents hold more than half of New Zealand’s marketable government debt, the sovereign’s own funding conditions may not be isolated from any materialisation of risks in external finances, although Fitch stresses that the risk of such a downside scenario remains remote despite the downgrade.

I don’t know where Fitch’s higher public debt/GDP figure comes from. It is some 12% or so above the New Zealand Debt Management Office projections and those of the IMF. Anyways, the important point for today’s argument is that New Zealand has suffered a sovereign downgrade despite what appears to be a relatively decent public debt profile. And the reason why is clear:

The downgrade partly reflects Fitch’s view that the sustained shift in the domestic savings/investment ratio required to narrow the deficit sustainably is unlikely within the forecast period. New Zealand remains in the club of advanced economies with high household indebtedness – around 150% of household disposable income, similar to levels in Australia (157%) and the UK (159%), and above the US (116%). Unlike the UK and US, New Zealand has seen no meaningful reduction in this ratio since 2008. Fitch acknowledges that the government has implemented policies designed to facilitate a shift in savings, including raising KiwiSaver contribution rates, but the agency cautions that changing deep-seated behaviour is likely to be difficult.

While a sustained strengthening in household savings could address New Zealand’s external indebtedness, such a development – even if it emerged – could make for a period of weaker growth, unless accompanied by renewed structural reforms. Historical experience shows that private consumption growth in New Zealand has been well-correlated with house price moves. The economy’s five-year-average real GDP growth rate of 0.7% compares unfavourably with median average growth rates of 1.1% and 1.4% for ‘AA’ and ‘AAA’ range credits, respectively. Adding to risks over the medium-term outlook, official data indicates that the productivity performance of New Zealand’s economy weakened over the 2000s. Average incomes remain moderate by ‘AA’ standards and even further below the ‘AAA’ median.

So, the New Zealand sovereign is being downgraded owing as much to the economy’s overall dependence upon external financing to fund a structual current account deficit, housing dependency and indebtedness, as well as lack of competiveness.

Take mining out of the picture and that is Australia.

Now, we don’t, of course, take mining out of the picture. But there is a very important lesson in the New Zealand experience that must colour the way the Australian government thinks about its fiscal position. That is, that the Budget is the key stone in the arch that supports Australia’s externally funded and rather unstable edifice of household debt. By that I mean the implicit guarantee that it provides the banks’ offshore borrowings, which Moody’s has declared contributes to a two notch ratings uplift to the banks.

Whilst the Tax Summit is full of admirable proposals for immediate spending and long term savings to cover the structural deficit that arrises from the aging population, nobody I can find is talking about the risk associated with an imminent slowdown in Chinese consumption of our bulk commodities. If China  does slow and the iron ore price falls for a sustained period, the damage to the Budget will be very significant. I can only estimate how big, but here’s some context to give you an idea, as I wrote some months ago:

After flat revenues between 2000 and 2003, the next four years saw Federal corporate tax revenue rocket from $37billion to $66billion. I have been unable to disaggregate mining but its a fair bet that that is where much of the growth came from.

…BHP and Rio alone grew their tax bills from a combined $2.2 billion in 2003 to $14.8 billion in 2008 (though not all of this was in Australia):

Iron ore makes up just shy of 50% of BHP’s profit and a much higher still proportion for Rio. The hit to the Budget will be very big when iron ore falls.

So, ask yourself, is it prudent for the Federal government to contemplate fiscal loosening in the midst of unparalleled terms of trade when the outcome of any sustained slowdown in Chinese demand will be a big hole in revenues just as pressure mounts of the banks external funding (as the pricing of Australian bank CDS currently suggests).

Fact is, the ratings agencies will not look kindly upon any sustained expansion of the Australia’s public debt/GDP ratio. And any downgrade would flow through automatically to bank funding costs, threatening a very unpleasant outcome.

In conclusion, for the time being, I do not expect the Federal government to loosen fiscal policy (nor should they). The RBA should and will loosen monetary policy first.

Not yet mind you. They need another month or two of crappy employment data.

Houses and Holes


  1. …nobody I can find is talking about the risk associated with an imminent slowdown in Chinese consumption of our bulk commodities…

    Slowdown in consumption or slowdown in the growth of consumption?

    …unparalleled terms of trade…

    Am wondering why we keep hearing about this when the external sector in total is a big fat negative. In other words while a component may be doing well it is the total sector that matters.

    • I do not think the “surplus obsession” as some have called it is completely political. As Wikileaks exposed recently, there were some very senior worries aimed at Australia’s credit rating during 2009. The lack of reference to the role of the Budget is a part of Invisopower! not reality (at least that’s my hope)…

  2. Judging by Craig Emerson’s comments, I think we’ll pull the immigration lever. Get population ponzi going again. Worked a treat in 2009. So long as the headline unemployment rate remains low enough, and companies keep making stuff up about needing more workers (they don’t), the government will be able to get away with it.

  3. While there is a lot of talk of finding the right levers to pull it is remarkable that we continue will crazy policies that limit new investment and job creation.

    See this link to story about Aldi having troubles finding land in our crowded ‘land of sweeping plains’ to build new stores.

    It is a shame that a company keen to invest in new retailing space, to be used to put some pressure on the existing duopoly, is finding it hard to get permission to build.

    Clearly, it is not just housing that is distorted by excessive planning regulation!

    All profits continue to be re-invested? – An interesting comment on the long range thinking involved.

    It is a shame that it is taking a reclusive German company to run the arguments and put some pressure on Woolies and Coles but I guess that is a lot better than nothing.

    • Having seen only one FIRB case with a EU investor myself, it’s amazing anything gets approved. After three years the company gave up when the FIRB claimed to have lost all the files on the development.

    • I have seen more than one development only go ahead because woolworths have been prepared to cough up large amounts of cash for infrastructure in the area.

      It is ridiculous what you have to do to build anything in this country.

  4. Why should the RBA wait?.A global recession/near recession is baked in the cake for next year and the rates- to- activity lag is 12 months plus.They should go now.

  5. “.. including raising ( New Zealand Superannuation Scheme) KiwiSaver contribution rates…” Actually, the incumbent Government has cut, halved, the contribution levels. But Fitch , and now S&P, will be right about our propensity to return to ‘the bad old days’ of borrow-and-buy-property. Nothing in our MSM is designed to alter, even question, that ingrained behaviour.

  6. This article really resonated with me. No-one wants to consider a slowdown in China because the implications are just too bad to contemplate. This includes me. It will destroy my super fund. It will destroy the stock market – 50% of which is houses (banks) and holes (miners).
    This would be a ‘great’ opportunity for Australia to go down the gurgler (we have an excuse with rest of world sinking) and emerge re-balanced somewhat with a lower more competitive currency.

    • Diogenes the Cynic

      I had these worries and sold my resources and bank stocks, a year ago. A contact in Shanghai told me that 40% of apartments there are empty, no tenants. Many are not even fitted out, just empty concrete shells.

      If you cannot sleep at night then time to sell. When China slows, iron ore will come off markedly, profits at BHP and Rio will halve and their share prices probably go down by more than that. The second leg down is the Aussie economy which will force Aussie property prices down further putting huge pressure on our banks. Federal government fiscal deterioration is already baked in with their optimistic projections based on China futureboom! I am hoping that China has a nice slow moderation but my money is not betting on that outcome.

  7. If the RBA loosen their monetary policy too early there’s a risk that it will be perceived as the turning point for the housing market and rather than improving our private debt position we may leverage up again. As history tells cheap credit in Australia goes into housing rather than business investment and this game is equally played by the lenders and borrowers. Monetary policy is a very blunt tool and easily leads to unintended consequences while fiscal policy can be more targeted.

    • And the immigration lever has the fewest problems of all three. So long as motorists don’t mind a little more congestion, and the rest can handle a bit more standing up on public transport, it’s all good. More people, more consumers, more demand, happy CEO’s … it’s a big free lunch!

      • Hmmmmmmmmm immigration parked in Sydney and Melbourne adds significantly to our CAD, and therefor our external debt and the continued sell-off of all asets – nailed down or not!

        There are no free lunches and there is no painless way out.

        Again re inflation why is it that everyone refuses to look at what is in the pipeline from China??????
        We’ve got inflation coming down on us and plenty of it.

    • Mmmm…during the How/Cost era, all 3 levers were “balls to the wall”….

      (yes I know interest rates were higher, but the acceleration and context is what matters – its sends a signal to the market that “everything is awesome – so awesome, the RBA needs to cool!!!”)

      Unlike now – the signal is “if the RBA is cutting rates, this is not good news….might leave my TD in the bank a bit longer or hold back on hiring more staff”

  8. Before my economic Road to Damascus conversion to neo-chartalism, I intuitively saw the crash coming in 2006 or at least that’s when I changed my fixed term deposit.

    I agree that monetary policy will be loosened before fiscal policy will be.

    I’m indecisive on whether there will be a cut this month or not, probably because I started following TheKouk on twitter. I still maintain 2x25bps cuts in successive months or a 50bps cut in February and from there it depends on what the global conditions are.

    So ultimately I guess I’m saying if they don’t cut this month (which they probably should on weakening inflation data and last set of unemployment figures) they will cut in November.

  9. Why shouldn’t governments expand debt to GDP numbers, ie fiscal stimulus?

    Because the rating agencies say so? I can’t believe they lay the ground rules, surely their track record is pretty awful ( The downgrades to US Govt asctually reduced bond yields. Not sure rating agency thins is something governments should force themselves to be constrained by.

    • US yields fell because the downgrade coincided with slwoing global growth. The US government isn’t powerful enough to do as you suggest, so I don’t see how we are able to…

  10. Glad you asked.

    I have a third alternative, I stitched together in an essay format.

    The problems in the world

    Today, we live in an interconnected world. Everything we do relies on action and finance in other countries. Our jobs rely on both local and international demand, on local financing, the international banking system, resource production, regulation and a whole host of other variables. Any event in one country has been proven to have the potential to send profound ripple effects throughout the world. We witnessed this to our surprise in 2008 when a sudden and unexpected default very nearly crippled many nations. For the most part, the worst of it was said to have been avoided, but we have to wonder given more recent events if in fact we have seen the last of it. Millions around the world have been forced into poverty, thousands of institutions have ceased trading, regimes have been toppled and western nations look set to default. More and deeper waves of destruction appear ready to be unleashed on the world. For many this will not come as a surprise, but for the complacent, it could be as devastating as 2008 was elsewhere.

    2008 and Australia

    In Australia, we were able to avoid the worst of it in 2008 for two major reasons. Well targeted local stimulus, and our largest trading partner’s massive stimulus. The local stimulus was able to provide a short term boost to compensate for our stall, but the real pull came later, from China.

    We can see that the effects of short term local stimulus wear off. If we look at the USA, their stimulus wore off rapidly. Some say it was badly targeted or that they have far worse fundamental problems. This could be correct, however other governments implemented huge stimulus policies too. Britain for example also stimulated, yet they did not recover nearly as quickly as Australia. It could also be that stimulus is like a shot of coffee. Something to keep you awake for just a little longer.

    Fundamentally, there is a key difference between our country and theirs. We produce export goods in high demand. This is where the real boost came from. China’s seemingly insatiable demand for our raw materials took up the slack at almost exactly the right time. Without their demand, would we have suffered the same fate as the US and UK?

    Either way, stimulus is an enormously expensive exercise. At the start of the 2008 crisis, the Australian government was in a net positive financial position. Today, nearly 5 years on, despite being hailed as a perfect example of Keynesian policy in action, Australia’s national debt is approaching two thirds of federal tax revenue. Not high by international standards, but uncomfortable nonetheless.

    Our Reserve bank was able to stimulate too. At the time the RBA’s cash rate was 7.25% which gave it one of the highest rates in the western world. There was a large amount of leeway for the rates to come down. Come down they did. Rapidly, while simultaneously the government was flooding any ‘shovel ready’ policy with cash. Today the picture is not quite so rosy. Still a lot better than internationally, but nevertheless, at 4.75%, there is a lot less room to move. Glen Stevens has stated that he would prefer rates to be higher for precisely this reason.

    The problems in Australia

    Misguided incentives
    Throughout the last decade, our governments have become dependent on some incentives that at face value appear to be good policy. Certainly politically, they are great policy, but they have left a legacy that makes flexibility in the face of uncertainty difficult.

    Probably the most well known such incentive is the First Home Owners Grant. Initially intended to offset the impact of the GST, it has been relied on far too much to foster growth, and to deliver state tax revenues. The FHOG has had several impacts. The most obvious is the ability for first home owners to bid up the price of property. This appears great for quite a while, but as we have seen in the USA, there is a huge potential for systematic collapse. During the stimulus of 2008, the FHOG was increased to entice more buyers. It worked. Many people took on mortgages at historically high prices.
    Our own Steve Keen has shown a remarkable correlation between GDP, house prices and debt. As debt goes up, the other two measures follow – with startling predictability. He shows that the rise or fall in the rate of financing proceeds house prices by approximately three months. The growth in debt has slowed recently.

    For a long time, this was a boon to the states. As each home is sold at a higher price, the council rates rise, and the state revenue from stamp duty rose. It could be said that the states, despite initially being state Labor governments under a federal Liberal government, were complicit in this programme. It was good for revenues, so if they had misgivings, they certainly never stated it.

    The situation now is becoming more apparent to the general population by the day. Steve Keen asserts that our prices will fall in a similar manner to other countries. They have started a minor slide, but more importantly, delinquencies are rising.

    A fatal decision

    The biggest contributor to this situation is something most people have overlooked. Indeed, it is easy to point solely at the FHOG as the cause of this problem, but we live in a country with checks and balances. If prices are rising too rapidly, we should expect this to show in the inflation figures, and thus be corrected automatically by the RBA’s interest rate policy. This once was the case, but in 1997 a change was made to the calculation of the CPI that removed mortgage interest from the figure. For 15 years now, we have been deliberately ignoring house price inflation where previously we did not. It is interesting to note that 1997 is the first year that the rate of house price appreciation moved sharply upwards.

    What this means is that the RBA was working on arguably flawed data. It was unable to make decisions necessary to prevent what many call a bubble. It is easy to apply the logic that if this change was not made, prices would have been unlikely to rise so far so fast. Instead, interest rates would have mopped up the FHOG, limiting its effects.

    More importantly, this decision affects policy today. The Reserve bank is charged with goals to limit inflation and also maximise employment. The problem is, this change has severely changed the distribution of its power. It no longer applies pressure more or less evenly to all home owners. Instead, it applies disproportionately more pressure on people who bought more expensive houses. Usually this means the recent buyers. The first home owners. The hardest hit are the buyers who bought during or after 2008. Just think for a moment, about this made up but plausible comparison.

    Joe bought a house in 2001 for $200k. He has been paying it off for 11 years now. He has built up substantial equity in the home – partly though repayments and partly through price increases. It was valued in 2008 at $420k.
    Joe has resisted refinancing, so he has only $100K remaining on the loan. At 7%, he pays approximately $7k per year in interest.

    Jane bought a house in 2008 for $420k. She has been paying it off for 5 years now. She has a little equity built up, but the loan is relatively fresh, so it’s not a lot. She still owes 400k. At 7%, she is paying 28k in interest per year.

    Both are in the same street. Both earn the same. Both have similar houses. But if interest rates rise, Jane is going to suffer 4x more than John.

    This puts the RBA in a very difficult position in the current global climate. They are unable to raise rates because cascading defaults will occur as the ‘Jane’s’ of the world hit their absolute financial limits. They are also unable to target the ‘Johns’ of the world to even out the load. This is why monetary policy is not only a blunt tool, but now an unprecedented uneven tool. It is diffucult to engineer a soft landing and moderate inflation with this tool.

    Outcome = stagflation?

    One possible and incrasingly worrying outcome of the current global issues is that Australia could enter a period of stagflation. With the RBA possibly unwilling to raise rates and trigger defaults, but international pressures pushing up the CPI, it is quite possible that we could be stuck with increasing prices and increasing unemployment if the global situation deteriorates.

    This could occur for a few reasons. One is simple. Our dollar is floating, and can trade rapidly up and down. The major factors that have held it high have been relatively high interest rates bringing foreign investment and speculation, and commodity prices. It is possible that our dollar will be traded even lower than it is currently (96c) due to a global rush to liquidity denominated in their own currencies. It is also possible that worldwide food prices continue to rise, and importantly, oil prices.
    We currently see an emerging and alarming disconnect between the two major oil indexes. The West Texas Intermediate which mostly supplies the US market, and the Brent Crude which is generally exported have diverged by $20 a barrel.
    This could be a critical sign for oil dependent nations like Australia. We could be facing a lower dollar and stable oil prices. This would translate to a marked increase in prices at the pump. If oil does not drop as it did last time, we could be in for a repeat of the 70’s.

    It is hard to predict, but this outcome is possible. If the RBA drops rates, our dollar drops and inflation rises.
    If it raises rates, defaults could occur.

    A possible solution to monetary policy in the face of stagflation.
    In the scenario above, we saw how monetary policy cannot have the same effects as it used to when house prices were relatively stable over the longer term. Ideally there would be a second tool for the RBA. Ideally it would be a fiscal tool. Giving the RBA a fiscal tool is politically safer than the government applying fiscal policy. When governments raise taxes, it is a major problem no matter how minor the rise. There is one tool though, that might be politically acceptable, and acceptable to the population.
    Superannuation. If the Reserve bank was given limited control over the superannuation guarantee, it could apply a fiscal-like tool far more evenly than it can apply a monetary tool. It might just be possible for superannuation to be increased while interest rates were decreased. In the above scenario, this would put greater pressure on John, while reducing pressure on Jane.

    If a crunch occurs again, it is also likely that our banks will again hunt for high quality tier 1 capital.
    It is likely that a lot of the superannuation will be put into our banking system.

    So this tool could allow Australia to moderate inflation, encourage growth through lower interest rates, and also capitalise our banks – without the federal government creating any more politically undesirable debt backed stimulus.

  11. Nobody talking about rates has me in mind of “the desire that dare not speak its name”.

    As for which lever to pull, for crying out loud I wish the pollies would stop pulling levers and just get out of the way so the market can do its work.