The just concluded G-20 meeting in Australia repeats many themes and patterns set at earlier G-20 meetings. Those at the Australian Treasury who planned this year’s G-20 economic policy strategy have shown little macroeconomic policy imagination. By adding to the supply-side structural reform plans identified in earlier G-20 meetings (but not fully implemented), and failing to identify the macroeconomic policies needed to boost consumption and aggregate demand, key advisers have displayed appalling judgement.
Some structural reforms can actually cause aggregate demand to fall and unemployment to increase. Supply-side policies are at their best if introduced when aggregate demand is high and resources are stretched, and when displaced resources can be quickly re-absorbed. If structural policies are introduced when aggregate demand is weak and declining then they could prove counter-productive in the short to medium terms, and large adjustment and retraining costs could fall on the budget.
Even assuming the most favourable outcomes, spread out over many years, one thousand supply-side microeconomic reforms will be simply unable to provide anywhere near the locomotive power needed to raise demand and economic growth sufficiently to address to continuing deterioration in world economic activity.
The Main Problem: Inadequate Demand or Inadequate Supply?
The G-20 Brisbane Summit Leaders Communique correctly notes, in passing in the first paragraph, that the global economy is being held back by a shortfall in demand. But, thereafter, the Communique is completely silent on how this most central overriding constraint can be addressed and overcome. This is a glaring omission for without doubt, after years of application, current macroeconomic policies have failed to raise global demand.
It is beyond doubt that two of the major economic blocks, Europe and Japan, are suffering from a deepening underlying deflationary tendency and high, and still rising, public debt burdens. The continuing crisis in these two substantial blocks creates major risks for all G-20 countries, and should, therefore, have been considered and addressed in some way by the G-20 leaders.
Many of us have, at one time or another, experienced demand-pull price inflation. That phenomenon occurs when aggregate demand is excessive relative to aggregate supply.
However, there seems to be little appreciation that when aggregate demand is deficient relative to aggregate supply the opposite occurs, and we observe demand-pull price deflation.
In Europe and Japan, if aggregate supply were deficient relative to demand we would, by now, be observing rapidly rising consumer prices. But that is not what we are seeing.
If aggregate demand were deficient relative to aggregate supply then consumer prices would be weakening: that is what we are seeing.
Sequencing is important. The first requirement today is to raise demand. Only when demand has greatly increased is it the desirable and sensible to increase supply potential and productivity. There is no point in raising supply potential if there is no demand.
Of course, to the extent that the G-20 strategy does lift aggregate supply ahead of demand then the current deflationary tendency will be exacerbated, and prices will weaken further. On that basis Europe and Japan will move further away from internal balance. There will be even less chance of countries reaching their inflation targets. Unemployment and debt burdens will increase. This is a dangerous situation.
Furthermore, supply is not constrained by high interest costs or high wage costs.
Arguably, therefore, for all these reasons, the G-20 should have focussed on lifting aggregate demand, not supply.
‘Half a league, Half a league,
Half a league onward,
All in the valley of Death
Rode the six hundred.’
Monetary and Fiscal Policies that have Failed
Since the global financial crisis we can identify serious macroeconomic policy mistakes:
- New bond financed budget deficits contributed to the strong rise in public debt;
- Fiscal austerity and wage cutting policies led to weakening internal demand, output and employment, and also contributed to rising public debt burdens;
- Internal devaluation policies in the Eurozone failed to operate effectively to correct internal competitiveness differences;
- Quantitative easing (QE) policies in recent years failed to stimulate business investment or increase consumer prices, but have led to asset price bubbles, the mispricing of risk and exchange rate conflicts. The costs of exiting from QE are unknown, but are likely be substantial indeed.
It is now increasingly essential that further macroeconomic policy errors be avoided, particularly in the Eurozone. Adoption by the European Central Bank of large-scale QE policies would represent a new fundamental macroeconomic policy error, wasting precious time and resources.
It is clear that, with interest rates at zero bound, interest rate policy has largely reached its limit. Aggregate demand cannot now be boosted by the use of interest rate policies. Fortunately, as we see below, there is more to monetary policy than just interest rates.
Monetary and Fiscal Policy Options are Not Exhausted
In almost all contemporary commentaries one sees reference to the belief that all fiscal and monetary policy options have been exhausted. This, then, becomes a central assumption underpinning the economic logic used to advise G-20 Leaders that they needed to focus on supply-side policies. That central assumption also underlies the G-20 belief that governments can provide no more stimulus, and that the private sector has to take-up the reins of financing and lifting world economic activity.
That central assumption, however, is completely false (see below). Consequently, the G-20 Leaders have been seriously misled by their advisers.
G-20 leaders should have been advised that high and rising public debt, the deflation tendency, economic stagnation and high unemployment could all simultaneously be addressed by adjusting and better coordinating the stance of monetary and fiscal policies.
While fiscal austerity has failed the same cannot be said about fiscal stimulus. And, with interest rates at zero bound, and interest rate policy at its limits, fiscal deficits are the only tool that governments can use to stimulate aggregate demand.
Rather than use new money (as with QE) to finance the commercial banks and investors/speculators, the new money should be used to finance new public spending (including on infrastructure) and tax cuts. This combination of monetary and fiscal policies would stimulate household spending and provide a direct boost to domestic demand without raising public debt. There are no Ricardian Equivalence effects. As GDP increases under this approach, then public debt burdens would contract.
The mistaken concentration by the G-20 on supply-side reforms has distracted attention from the need to boost aggregate demand.
The economics professions generally, central bankers, G-20 advisers, the IMF and the OECD have all turned a blind eye to a practical, relevant and highly effective monetary and fiscal policy combination that could reverse the slide toward recession and depression. Almost universally, advisers, including the now moribund Australian Treasury (they failed to even consider the scope for Overt Money Financing), cannot break away from an outdated taboo, as explained by Lord Adair Turner in his Cass Business School Lecture.
Stagnation, secular or otherwise, is not inevitable. It is an unfolding shock that must be addressed by governments. The cost of delay is enormous.
Rather than focussing solely on supply, and assuming that the private sector will somehow step into the breach, the G-20 Leaders should have assumed responsibility for demand management. They should have requested the IMF to bring forward an analysis of the macroeconomic policies needed to raise aggregate demand (without increasing public debt) and to counter the deflationary tendency.
The G-20 countries are in dire need of macroeconomic policy leadership. An opportunity has been lost at Brisbane.
There has been a miscalculation in Brisbane. Due to confusion among Leaders and advisers, and ignorance as to the perils ahead, the Charge mounted at Brisbane, aimed at the ‘supply’ front instead of the ‘demand’ front, may well lead to the same fate as the Charge of the Light Brigade, mounted up the wrong valley at Balaclava 160 years ago.
‘Was there a man dismay’d?
Not tho’ the soldier knew
Someone had blunder’d:
Theirs not to make reply,
Theirs not to reason why,
. . . . . .”