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Keep an eye on the underlying economic threat, not market ups and downs

Unless the US can address structural problems, there no end in sight to this financial crisis. AAP

Global share markets were faltering even before the decision by Standard & Poor’s to downgrade the US government’s debt. The slump in share markets over the past week reflects a weaker outlook for the world economy – even if markets have recovered somewhat over the past day.

The problems facing the US and other developed economies are structural rather than cyclical. Politicians throughout the developed world have expected too much from macro policy instruments that are necessarily limited in effectiveness.

At the same time, leaders have shirked responsibility for addressing underlying structural problems. In terms of monetary and fiscal policy, policymakers have thrown everything but the kitchen sink at the post-crisis US economy. The returns to monetary and fiscal stimulus have been modest.

This is not necessarily an argument against easier monetary and fiscal policy, but it does highlight the need for policymakers and the public to have realistic expectations about what macro policy can achieve.

Much reporting and commentary would have us believe that the world economy dances to the tune of central bankers and the spending decisions of politicians, but if anything it is the other way around. Monetary and fiscal policy react to economic shocks over which policymakers have little effective control.

The US Federal Reserve’s policy of quantitative easing has come in for criticism, but US Federal Reserve Chairman Ben Bernanke’s policy approach comes straight from the monetarist playbook. It is same policy prescription Milton Friedman recommended for Japan in the 1990s when it found itself in similar circumstances.

Both Friedman and Bernanke closely studied the Great Depression of the 1930s and internalised the lessons of that episode. The first lesson was that monetary policy should never become an “arbiter of security speculation or values”. US monetary policy caused the stock market crash of 1929 because central bankers thought they knew better than market participants the appropriate level for the stock market.

The second lesson was that monetary policy should be accommodative in an economic downturn. But that does not mean that monetary policy is a cure-all. Only real factors, such as employment growth, can sustain an economic recovery. The role of monetary policy is to support growth in nominal demand, but the heavy lifting has to come from the supply-side.

The only relevant test of the appropriateness of the stance of monetary policy is current and future inflation outcomes. The Bernanke Fed has avoided a protracted deflation, kept actual inflation low and financial market expectations are consistent with inflation remaining low in future. To expect any more from a central bank is to misunderstand what monetary policy can realistically achieve.

The US dollar exchange rate has declined, but this is the appropriate response for an economy suffering a negative shock, just as Australia’s stronger currency helps insulate its economy against the positive shock coming from its terms of trade.

The role of fiscal policy in the US and elsewhere has been far more problematic. Standard New Keynesian open economy macroeconomic models typically give little role to fiscal policy.

Fiscal policy is assumed to be ineffective because of crowding-out effects via interest rates, the exchange rate and net exports. These crowding-out effects may be diminished in the case of a concerted global fiscal expansion (the world as a whole is a closed economy), but will still affect those economies that make relatively greater use of fiscal policy instruments, such as the US.

A more serious problem with fiscal policy is that an unfunded fiscal expansion is equivalent to announcing a future tax increase in the absence of a credible commitment to cut future spending.

An unfunded fiscal expansion reduces future wealth and the private sector responds to this reduction in wealth in the same way it would respond to a plunge in the share market or house prices. For political economy reasons, the distribution of the increased future tax burden is uncertain and uncertainty is the great enemy of economic recovery.

This is why the long-run fiscal policy multiplier is negative, yielding the seemingly paradoxical result that a fiscal consolidation is positive for economic growth. Historical experience shows that the fiscal consolidations that work best in stimulating economic growth are those that cut spending rather than raise taxes.

It was the failure of US politicians to acknowledge the policy implications of long-run budget sustainability that decided the recent ratings action by Standard & Poor’s. Failing to raise the debt ceiling would not have led to debt default if US politicians had taken the necessary decisions to put the budget on a sustainable footing. Raising the debt ceiling kicks the problem down the road and creates the risk of a far more serious fiscal crisis in future.

A fiscally responsible US president would have joined with responsible members of Congress in refusing to sign a further increase in the debt ceiling.

The Obama administration could have used the unthinkable prospect of debt default to force spendthrift members of Congress to reduce government spending and stabilise expectations for the future path of net debt that are currently weighing on economic growth.

Congress and the Administration know that if they lead the US to default on its obligations, the American people will sweep them from office. For politicians, incentives don’t come much stronger than that.

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