What to do next? Policy directions after the financial crisis


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
USD as at November 24th. That amount could pay off half
of all outstanding American residential mortgages, or provide $24,000 USD for
every person living in the United

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).

2008 US BailoutImage: 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. 

Japan Economic GrowthImage: 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
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
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
Building Australia Fund, so expect further announcements of
government investment – possibly on urban transport infrastructure in the new

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