Chapter 14 –Current Events
Fiscal and monetary policy in action in Australia
In September 2008, Lehman Brothers, the fourth largest investment bank in the United States, collapsed leaving a huge debt. As shown in the entry for Chapter 12 this triggered a global financial crisis which in turn had a massive negative effect on output in many countries. For example, car sales dropped by around 40% in the major economies, and world trade contracted by 25% in a quarter. We described in the entry for Chapter 11 the reaction of the United States administration. What action was taken in Australia?
Fiscal policy
This had three main elements.
First, at the end of 2008 $10 billion was given in cash handouts to families who were receiving welfare payments and to pensioners. To the extent that these were spent, for a significant proportion were used to pay off debt or were saved, consumer spending and hence aggregate demand rose.
Second, in February 2008, a $42 billion increase in government capital expenditure was announced. Because there were clearly an inadequate number of major investment projects ‘shovel ready’ about a quarter of the stimulus was allocated to schools by, put simply, building an extra library or gymnasium in most schools. This provided an immediate boost to the construction industry. Inevitably, given the speed with which the policy was implemented, there was some waste and duplication and the media had a field day highlighting this.
The large part of the $42 billion was spent on infrastructure – notably ports and transport. Because it takes considerable time to plan and design a new port, for example, this expenditure was spread over several years.
Third, in April 2009 each person who had paid tax in the previous financial year was sent a cheque for $900 at a total cost of $8 billion. This provided a further boost to consumer spending.
It was estimated that the total package amounted to 4.9% of GDP making it, proportionately, one of the largest stimulus packages in the world.
The effect on the budget balance was dramatic. In the first half of 2008 there was a budget surplus of $19 billion; in the first half of 2009 there was a budget deficit of $22 billion. The budget was forecast to remain in deficit for at least six years. The deficits will have to be met by borrowing and hence there will be a crowding out effect (see page 000). Interest rates will be higher than would otherwise have been the case which will have a negative effect on private sector expenditure. Fears were also expressed that the fiscal stimulus would continue even when the economy was approaching full employment again – illustrating the problem of timing (see page 000).
Bank guarantees
In many advanced countries there were financial collapses and some banks received large scale government support. Although this was not the case in Australia the government guaranteed all bank deposits of less than $1 million. This was designed to prevent any panic withdrawal of funds from the banks.
Monetary policy
The Reserve Bank pursued an aggressive monetary policy. In September 2008 the cash rate was 7.25%. In succeeding months the rate was reduced – in one case by an historically large cut of 1.00% – to reach 3% in April 2009. The banks did not pass on all of the cash rate reduction to borrowers. Nonetheless the interest rate charged on variable rate home loans fell by 3.8%. The interest rate on business loans fell by around 3%. These reductions increased consumer spending, as borrowers’ interest payments fell.
The outcome
There was therefore a very large fiscal and monetary stimulus in 2008/9. It seemed (in early 2010) as if this had led to Australia avoiding a recession, for almost alone among advanced economies GDP did not decline in 2008/9 (see Table 10a in the entry for Chapter 10). In fact by late 2009 the Reserve Bank was concerned that the resumption of growth was threatening to take the inflation rate above the target rate of 2-3% per annum. In three steps of 0.25% the cash rate was increased between October and December to 3.75%.