Saturday, February 07, 2009

More economics 101 - the economics of Malcolm Turnbull

This post looks at the differing economic approaches of the Rudd Government and the opposition. I am not especially interested in the differing rhetoric of the two sides, just trying to understand the variations in the economics.

Mr Turnbull's web site carries his various statements. Again, I am not concerned with the detail, but with key concepts.

The Two Sides

Using the language of war, the Rudd Government has argued that the Australian Government must act now to protect Australia against global economic catastrophe. Having protected the banking system, measures are required now to provide short term stimulus while longer term investment measures start to come into effect. 

Mr Turnbull agrees that the economic outlook is grim.

Using another set of rhetoric, he suggests that the Rudd Government is behaving like the early Whitlam Government. After a long period in opposition, the Whitlam Government rushed through a series of measures, an over-spend that was to prove unsustainable.

According to Mr Turnbull, the stimulus packages have been ineffective and will leave Australia burdened with debt. There has been too much haste. Beyond the debt, spending now at the sale proposed must reduce the Government's capacity to respond to later developments.

The opposition proposes instead a much reduced stimulus package under which:

  • the tax cuts to come into effect from 1 July should be brought forward, backdated to 1 January.
  • The Commonwealth should pay a portion of the Superannuation Guarantee Levy on behalf of small employers (those with 20 or fewer staff) for the next two years.  This measure would directly improve the cash position of small firms, directly reduce the costs of employment, and so directly contribute to preserving jobs.
  • there would be smaller, targeted infrastructure spend with $3 billion committed to school upgrades by reinstating the Coalition's very successful Investing in our Schools Programme.

Two rather different approaches.

My Own Views

While my focus in this post is on the underlying economics, I should make my own views clear so that you understand where I am coming from.

There is some truth in Mr Turnbull's comparison with the Whitlam Government. It has seemed to me that that Mr Rudd is in a rush for other reasons. I have suggested that we should take a deep breath - less haste, more speed. I have also pointed to what I see as specific weaknesses in Mr Rudd's initiatives, weaknesses linked in part to current administrative and public policy systems that create delivery problems.

The international downturn has been faster and wider than I expected. The impact on domestic confidence has also been greater than expected, given the underlying strength of the Australian economy. For that reason, I have been inclined to support the Rudd measures.

I do not share Mr Turnbull's stated concerns about the deficit so long as we do not create a structural deficit. I am also less worried about Government debt.

Overall, my view has been that the downturn provides an opportunity to do new things, to catch up on past neglects, thus laying the basis not just for future growth, but also for long term improvements in our social and physical infrastructure. Part of my argument for less haste, more speed it to ensure that we get the best results.

Finally, I have argued that the various stimulus measures taken round the world will pull the world out of recession. As that happens, the Australian economy will boom again. However, I have also expressed the concern that the global stimulatory measures will overshoot, creating problems in the opposite direction to those we face as present.

The Economics - tax cuts vs government spending

Mr Turnbull's views and those expressed  by his colleagues such as Julie Bishop link to a global economic debate.

In economics, the term consumption function is used to describe the relationship between income and consumption.

As developed by Keynes, it includes two elements, a base or autonomous consumption that occurs independent of shifts in income, together with a  second or induced element that shifts with income. As income increases, some is spent, some saved. The term marginal propensity to consume is used to describe the amount spent out of every extra dollar in income.

The marginal propensity to consume links to another concept, the multiplier.

In spending a dollar, you give someone else that dollar. Part of that dollar is spent, part saved. The part spent is then further part spent and part saved. And so on in ever diminishing amounts.

Some of this money is spent on imports and hence lost to the process. The size of the multiplier - the final spend for every initial dollar of spend - depends on the marginal propensity to consume together with the marginal propensity to import.

The Rudd Government's first big stimulus package deliberately targeted some of those most likely to spend. The size of the effect depended on how much they did spend, then the subsequent multiplier effect.

For reasons I outlined in The Australian economic stimulus package - distributional and timing issues, there was always going to be some leakage. However, Mr Turnbull goes further than this.

Drawing on overseas work dating back to US economist Milton Friedman, he suggests that the marginal propensity to consume is determined not by immediate variations in income, but by expected permanent income.

This is quite important. The permanent income hypothesis suggests that a one-off stimulus of the Rudd type will simply be saved or used to pay off debt.

Further, to the degree that expectations about future income and the value of household assets (people have been spending all their immediate income because they expect the value of their assets to rise) are affected by by the downturn, the incentive to save will be increased.

So the argument now runs, there is no point in one-off stimulus packages. We are better off lowering taxes, since this affects permanent income.

We can now break our argument into two parts.

On the first, the multiplier, Mr Turnbull argues that the stimulus package failed because December retail sales were only $700 million more in seasonally adjusted terms than the month before. This led him to ask "What happened to the other $8.9 billion of the cash splash?"

The Liberal member for Bowman, Andrew Laming, went further. He suggested that a closer look at the figures suggested that was not much improvement on the previous December: "Around $300 million extra turned up in retail sales and that's tiny - around 5 per cent of the stimulus package actually ending up in the retail sector".

I don't think that one can make this type of categorical statement.

To begin with, the impact on spend is likely to have been spread, beginning in November and then extending through December into the new year.

The Australian Bureau of Statistics was forced to abandon its trend estimates for December becaTrend data retail sales November 08use the size of the retail bounce distorted trend estimates.

If we look at the previous trend estimated (graph) you will see that November showed a decline, resuming a downward trend. We cannot say what the December number would have been in the absence of the stimulus package. This is the real benchmark

Beyond this, we can (I think) say two things.

The first is that there was a very clear and large bounce. A 3.8% increase in seasonally adjusted terms is no small thing at a time of global downturn. The second is that if people did save or reduce debt, then that is not necessarily a bad thing at personal level in current circumstances.

The flow on multiplier effects are unclear and will certainly be lower than the traditional theory suggests. The only thing that we can say with a degree of certainty is that imports of consumer goods did not increase. This suggest that stocks were cleared, again no bad thing.

The second issue is the relative merits of a tax cut versus direct payments. At this point, Mr Turnbull is only suggesting that the tax cuts should have been brought forward. However, internationally the permanent income hypothesis is being used to support arguments for tax cuts as a stimulatory measure.

Bringing the tax cuts forward would, I think, have had very little short term impact on consumption because the actual cash impact would have been relatively small in the current financial year.

More broadly, I have a real problem about the use of permanent tax cuts as a fiscal stimulatory device because they then build a structural element into the deficit.

Government borrowing and the crowding out effect

In that lost world of the past, the Government would have funded a deficit by issuing securities to the Reserve Bank, thus expanding the money supply. Then, as economic conditions improved, the Government would have used the extra tax revenues to pay the Bank back.

Current orthodoxy does not allow this. Instead, the Rudd Government proposes to issue Government bonds to the market to fund the spend. This, Mr Turnbull, suggests will create a burden for the future.

At one level, this is true just as it would have been in the traditional approach. However, there are two quite separate issues involved.

First, the cost has to be set against the extra national income generated during the downturn. If the Government spends one borrowed dollar and gets a five dollar increase in national income, then it is in front because the extra tax revenues cover the cost.

Conversely, if the Government spends one dollar and gets, say, just one dollar back, then it is behind.

Secondly, returns from capital investment are spread over time. There is absolutely nothing wrong with borrowing longer term where this is linked to a longer term return.

The best world would be one where stimulation measures generate a profit in their own right from increased economic activity, leaving the long term income stream from capital investment as pure cream.

Despite the Government's rhetoric, it is not clear to me that that current stimulus packages will in fact generate both the immediate stimulus and the longer term return.

There is also an immediate problem in possible crowding out.

Note to reader: I am out of time. I will continue this post a little later.


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Anonymous said...

Dear Jim,

Just a note on your excellent analysis.

This is not a debate between a small Coalition and a large Government stimulus package. It is not about supporting a larger intervention if you are bearish about Australia and smaller if you are optimistic.

This debate is about whether $42 billion spend AS PROPOSED is appropriate in quality and quantity.

Once committed, the $42 billion becomes opportunity cost. That's why Mr Turnbulls's proposed scrutiny of the package in the Senate is so vital.

This debate is not about whether the world will recover from the recession. Of course it will. The real argument is whether the stimuli, as proposed represent cost-effective recession aversion.

Highest level analysis asks - how and when is each stimulus dollar of GDP deployed to pre-empt economic threats and have maximum impact maintaining jobs, and in turn, Australia's GDP growth.

Judge the package not on the social infrastructure it delivers or that people are "paying down home loans and that is no bad thing." This is akin to treating a skin cancer patient with a weight loss program.

We all want nation-building, but in a recession, a specific set of measures are prescribed to maintain economic activity (reduce the length and depth of recession), and to position the economy to achieve the most sustainable growth recovery (so that we are better placed than our competitor economies when we all enter the post-recession phase.

Readers will know of those elements: PREVENTION: high-multiplier expenditure, targeting the most vulnerable domestic sectors to job losses, and ADAPTION: where losses occur, reducing frictional unemployment through rapid retraining and redeployment into economic infrastructure - which reduces costs to business, builds confidence and prevents further job losses.

Finally, with the current fiscal fixation, don’t underestimate the ultimate power of monetary policy. Australia's comparatively higher interest rates allow significant room for stimulus which is not available to other economies, which will restore confidence and entrepreneurialism without sending Australia into generational debt.

As an aside...

Your excellent graph was part of my analysis of ABS retail sales for December. It is irrelevant that December was $700 million more than November. To understand the stimulus, four factors enter the calculations;

1. Temporal factors. Treasury now says they only expected 10% of the stimulus to enter the economy in December (they didnt say that back in December). Most (they hope will turn up in Q1 and Q2 this year).

2.Annual cycles: because every year, Australians spend remarkably close to 11.1% of their annual retail spend in December (as they did in 08, despite stimulus),

3. Year by year comparison: the degree to which December 08 increased from the 4 Decembers before it, relative to the annual growths in each of those years.

4. Monthly trends (your graph), because even with all the pessimism post-Lehmans, it shows that retail sales held up July-November. Too many people grasp at November's slip and infer trends. Remember the stimulus came before we even had the ABS November 08 figures.

My case that Dec 2008 WAS ALWAYS GOING TO BE SOLID. That position is supported by all four points above, together with the confidence of falling interest rates, particularly cheap fuel and the Christmas effect (where people spend irrationally at Christmas (even at tough times), then compensate, with a rational slump in the first three months of the following year(see Xmas 2007).

It is difficult to argue that the December stimulus saved/supported/created any jobs, because department stores and the household sector (big winners from the stimulus), can and did further discount to maintain sales volumes and retain staff.

In the end, massive discounting plus the stimulus - achieved sales volumes of $300 - 850 million above expectation.

I argue that such a result neither justifies the stimulus, nor assisted much in averting what lies ahead for Australia in 2009.

Andrew Laming

ps: It was the tax cuts announced in May 2007which "introduced a structural element into the deficit." Bringing those cuts forward is merely a one-off tax expenditure.

Jim Belshaw said...

Andrew, this was a very thoughtful comment that deserves a very full response. Because I am so time limited, it may be tomorrow or Wednesday.