Sunday, February 15, 2009

Crowding out and the Rudd stimulus package - still more economics 101

This post continues the discussion I began in More economics 101 - the economics of Malcolm Turnbull. Since then I have added The Rudd Stimulus Package - Andrew Laming's view to provide a Liberal Party view. This post focuses on the crowding out issue.

As with all these posts, I am trying to think my way through the issues. Feel free to disagree.

Economists use the term crowding out to describe the way in which one set of actions - an increase in Government spend, for example - can reduce other activities, thus crowding them out.

It may seem strange to talk about crowding out at a time the Australian economy has spare capacity. Yet it is an issue to my mind because of the way the package is being funded.

If the Government had funded expansion in the old-fashioned way by issuing Treasury bills thus expanding the money supply, then the increased spend would flow through into increased economic activity. The position is far less clear-cut when the extra spend is funded by increased borrowings from the market.

Increased Government spend pumps one dollar into the economy. The immediate effect is the same regardless of how that dollar is financed.

The Government then borrows one dollar from the market to fund its dollar spend. That dollar is no longer available to do other things. If there is a lot of liquidity around sitting idle as there is just at present, the effect may be small. However, these are very big borrowings.

One potential effect is an increase in market interest rates. Should this happen, then extra funds may be attracted to Australia, leading to appreciation of the currency. In turn, this would encourage imports, discourage exports, placing downward pressure on economic activity.

This is the type of effect that led Harry Clarke to write Pointless fiscal expansions that swamp us with debt but don't reduce unemployment, a post brought on-line in the wee hours of this morning.

However, there is another problem as well.

We presently have a thoroughly constipated financial system with banks still reluctant to lend to business. There is a lot of liquidity around, so Government borrowings may not of themselves shift real interest rates a great deal. Nevertheless, they could well further reduce the availability of loan finance for business.

Still keeping it in simple terms that I can understand, cash has to go somewhere. At present, there is a very high weighting in the market for risk, so available cash flows to the safest investments, reducing cash for perceived riskier investments, and that includes loans to business.

Government borrowings of the type Mr Rudd proposes increases the supply of high quality financial assets, potentially further reducing (crowding out) the cash available for loans to business.

In theory, this might lead to increased interest rates on business loans, widening the interest rate spread until funds are attracted. However, we already have credit rationing. So long as risk assessments remain as they are now, interest rates are unlikely to shift much in the short term.

We can already see some of these types of effects in the housing market place. For a number of reasons, housing is still seen in Australia as a relatively safe longer term investment.

This perception is not clear cut. There is downward pressure on property prices in the more expensive segments of the market place. However, at the lower end house prices have moved up, in part because of Government incentives. This is reflected in the statistics, with loan approvals for housing now increasing.

Banks are lending for housing because they still see it as a relatively safe investment offering a higher yield. Barring unexpected changes, they will continue to do so. So we have credit rationing for business, while housing lending expands.

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