Image: Australian Broadcasting Corporation

Nobel Prize winner Paul Krugman in an article states quite plainly that "Reform of the weaknesses... can wait a little while" and that the first priority is to "get credit flowing again and prop up spending".

Over the last 3 months, governments around the world have bailed out lending institutions, guaranteed deposits, and expanded the money supply.  The figures are astronomical.  Financial markets news service Bloomberg calculates that the total amount spent on the bailout in the USA is $7.76 trillion USD as at November 24^th. That amount could pay off half of all outstanding American residential mortgages, or provide $24,000 USD for every person living in the United States.

I have included a chart made in early November that compared the bailout at that stage in comparison to other large US government projects.  It clearly shows the extent of the first stage of policy response to the global financial crisis (GFC).

Image: Voltage Creative Blog

Hoping that its guarantees will not be called on, the Australian response has mirrored this shoring up of the financial system, albeit with less zeros. On the 12th October the government guaranteed $2 trillion in deposits and wholesale funding of financial institutions.  Under the Financial Claims Scheme, policyholders are now underwritten by the government in the case of the failure of a general insurer.

After the initial government bailouts of lenders in the UK and USA, Reserve banks around the world are now lowering short term interest rates, with RBA target cash rates now at 4.25% and the USA Federal Reserve targeting an incredibly low short term funds rate between zero and 0.25 %.  Beyond this, governments could also purchase long term treasuries to push down long term rates.

However there is a limit at which this provision of credit fails to improve an economy where borrowers just don't want to borrow.  Larry Elliot in the Guardian states that "There is talk of a classic Keynesian liquidity trap, when nominal interest rates fall close to zero and the authorities find it impossible to stimulate demand through lower borrowing costs."  British Economist Maynard Keynes famously described this problem with monetary policy as similar to 'pushing on a string'. 

Thus the next phase in government policy to assist the economy will have to involve a traditional 'Keynesian' expansion in government spending.  When an economy is contracting and has spare capacity, the government can boost the economy without causing inflation.

In his 1998 book, Restoring Japan's Economic Growth, Adam Posen found that Japan, during its 'lost decade' of stagnation during the 1990's, had success with fiscal policy when it was implemented.

The initial challenge is where to spend this money where it will enter the economy quickly and be spent to the best effect. Infrastructure has a higher multiplier than other forms of expenditure which means that for each dollar of spending results in a greater boost to economic activity.  Infrastructure spending can also address long term challenges such as climate change or water. 

Image: Moody's Economy.com

Earlier this month, faced with a government apparently reluctant to go into deficit and borrow from those in the economy who are too hesitant to invest, a group of Australian economists - Tony Cole, Saul Eslake, Allan Fels, Rod Glover, Nicholas Gruen, Ian Harper, Tony Harris, Mike Waller - wrote an open letter to the Prime Minister calling for aggressive stimulus of the economy, including spending on renewable energy infrastructure. 

While the Australian federal government may appear deficit 'shy', back in May they announced that they would provide legislative authority for an increase in future Commonwealth Government Securities issuance of up to $25 billion, which based on current estimates would enable the government to go into deficit.

Indeed the government has been spending rapidly, so far introducing $10.4 billion stimulus, the $6.2 Billion New Car plan, the $15.1 Billion in COAG spending on Health and Education infrastructure and training, and $2.5 Billion in new infrastructure spending announced on December 12. 

Infrastructure Australia, the government appointed advisory committee, has signed off on a priority list of projects to be funded from the $12.6 billion Building Australia Fund, so expect further announcements of government investment - possibly on urban transport infrastructure in the new year.