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.

New Expectations in Monetary Policy

The ridiculous entries in Lolfed.com and reactions it receives (from Paul Krugman no less) demonstrate the decline in confidence that Americans have come to regard both the US Fed Chairman Ben Bernanke and Treasury Sec. Hank Paulson with. So much so that the unexpected announcement by the Obama transition team of the appointment of a new treasury chief in the person of current NY Reserve President Timothy Geithner was all that was needed to generate a much needed lift late Friday after a near disastrous week on Wall Street.

Here in Australia, the monetary and fiscal authorities have been keen to do a similar two step as the Americans with the same limited effect. Back in May of this year, the RBA was put under scrutiny over its decision to raise interest rates. Having shown its audacity in doing so during the election season that toppled the Howard government, it was given the imprimatur by Treasurer Wayne Swan who in declaring a war against inflation since taking office set the tone for monetary and fiscal policy to be on coordinated footing.

It didn't matter that Joseph Stiglitz, a Nobel Prize winning economist had been appearing on local TV regarding the Australian situation on inflation and the policy on inflation targeting which he predicted would be abandoned within five years because of its inefficacy to deal with the importation of inflation through petrol and food prices.

The defense that it was the commodities driven terms of trade boom generating price inflation notwithstanding, the oracle of Stiglitz has been proven true in less than six months with the higher than anticipated RBA cut of 100 basis points and further cuts in the offing, despite inflation exceeding the upper band of the 2 to 3 percent range. Why is it then that macroeconomic policy makers often fail to get their settings right?

Could it be that they are still operating under a misguided view of the world that sees agents as purely rational? To what extent do adaptive rather than rational expectations play a role in resolving the problem?