Parity and Stimulus

The ongoing appreciation of the Australian dollar could mute the impact of the current fiscal stimulus working its way through the system.

A recent paper released by the Centre for Economic Policy Research in London sheds light on the ongoing debate of whether fiscal stimulus being coordinated currently by the G20 nations would have a significant effect on the long run growth of their economies. The problem essentially has to do with estimating the size of the government multipliers of the nations involved.

As highlighted by its authors, on one side of the fence are the likes of Robert Barro who argues that the peace-time multiplier has essentially been zero. On the other side sit equally learned people like Christina Romer, Chair of the US Council of Economic Advisers, who uses a figure as high as 1.6. The difference between these two views is 3.7 million US jobs by 2010.

The paper in analysing the multiplier effect of government spending distinguishes between developed and developing nations, those with open and closed economies, those with fixed and flexible exchange rates and those with and without large external debts.

The findings which I quote below show a stark contrast:

In developing countries, the response of output to increases in government spending is smaller on impact and considerably less persistent than in high income countries.

The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.

The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long-run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.

In highly-indebted countries, the output response to increases in government spending is short-lived and much less persistent than in countries with a low debt to GDP ratio.

The picture this paints is quite clear. Since most advanced economies have successfully floated their currencies and have maintained relatively open economies, their ability to benefit from their spending will be limited in the long run. While it is true that in the short-run, fiscal stimulus does provide a “quick hit” to the system, the problem in the medium term is that as the stimulus diminishes (assuming it is temporary in nature), it creates a "fiscal drag" (the opposite of the multiplier effect). As per the US stimulus, this drag will detract from its GDP by as much as 2.5% in 2011.

China, an emerging economy which does not have external debts to speak of and which has a pre-determined exchange rate, will be able to benefit much more from its stimulus without threatening its exports. Australia on the other hand has seen its dollar approach parity with the greenback and may even see it reach $1.1, as the banner story of the Australian today declared, which would be an appreciation of about 70% from its lows this past year. This will lead to the stimulus leaking out of the country in the form of higher imports and weaker exports).

Unfortunately, the criteria laid out for spending, that it be targeted, temporary and timely may have been too difficult to adhere to. The cocktail of spending measures that resulted to address both short-run and long-run growth needs might have already been countered by monetary and exchange rate policy with the effects of a rising dollar soon to take hold.