Thursday, February 5, 2009

A Stimulating Debate

Back in November, this space predicted that rising unemployment would become the source of headaches this year (given the declining skilled vacancies index, which incidentally have not bottomed out). At that point, it was not yet apparent whether the crisis in the financial sector would seep in to the real economy (translation: whether the fall in stock prices would translate into slowing growth and higher unemployment).

Some have argued that despite the medicine administered by the Reserve Bank of Australia and the Government in the second half of 2008, the rate rises during the first half of the previous year (when the rates in the US were headed the opposite direction) had alterred the public's perceptions of future prospects in a profound way.

These pundits argue that due to their "rational expectations" nothing that monetary or fiscal policy does now can "fool" them out of their present consumer funk. Here's one example from a former Clinton administration insider, who has turned anti-Obama stimulus advocate, Dick Morris.

The size of borrowing programs around the globe will most likely lead to higher interest rates in about three to four years. The sad thing about this is, when that time comes, the global economy might still be in a precarious state. Under that scenario, governments will be faced with three unsavory options: cut spending, maintain spending (through deficits), or raise taxes. Even if the global economy revives within this time, some serious crowding out will take place.

Considering the better than normal status of Australia in the developed world (we had a public surplus previously amounting to 2% of GDP in 2007), the arithmetic presently being applied has to do wtih maintaining a deficit to GDP ratio of less than 2-3% (a sustainable level) while keeping the economy out of recession. This is still possible in the current financial year (given the IMF projections), but looks increasingly difficult in the next. This is why the government is presently banking on its stimulus to spur spending and investment.

Wealth or income?

One important facet of the debate both here and America revolves around the size and timing of tax rebates to working families. Does a once-off large rebate stimulate the economy more than smaller, regular ones? Those that argue for one big lump sum believe that size and urgency does matter. Critics of it say that since it is not lasting, that much of this once-off payment would be tucked away and not circulated in the economy.

Behavioural economist Richard Thaler's work provides some guidance. In the mind of recipients, the question is settled, and it depends on the sort of “mental accounting” they perform. As lucidly explained here in the New Yorker by James Surowiecki, if the stimulus gets recognised as a form of wealth endowment, it will more likely be siphoned off as savings. If it is seen as additional income, recipients will have a greater propensity to spend the regular amounts.

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