Peter Swan

Many highly distinguished economists such as my friend Geoff Harcourt come from what is commonly known as the post-Keynesian school. This means they believe the theory of economics and fiscal policy applied to the nation bears little if any resemblance to the brand of economics that you and I as individuals are subject to.

Writing for The Conversation’s recent series on the language of economics, Geoff finds that when treasurers use phrases such as “you are using taxpayers’ money” they are confusing affairs of state with decisions that should be left to individual households.

But every treasurer should be aware each dollar of expenditure must come out of the pockets of taxpayers eventually, even if they borrow to finance the outlay in the short term. Exactly the same is true for you and me. We cannot borrow indefinitely to fund our consumption.

Geoff believes it is fallacious to “balance the budget over the cycle”. But if the government fails to do this, then undoubtedly the outcome is eventually the Greek and Spanish solution. This means more bailouts, massive rises in unemployment, a collapsed economy and departures of the able-bodied to work in economies such as Germany that have displayed better fiscal discipline.

Yes, if on average the economy were growing sufficiently fast, and the government borrowed during recessions and repaid the debt with a sufficient surplus in booms, then perhaps balancing the budget over the cycle could be relaxed slightly.

Of course, what we have seen is massive borrowing when the economy was doing quite well during the global financial crisis (GFC) due to China, and even more borrowing during the subsequent post-GFC period. Now there’s little chance of balancing the budget over any foreseeable period.

Geoff is closer to the mark when it comes to hypothecation – matching specific government expenditures with particular tax sources. For example, if police patrols are rewarded based on fines imposed on speeding motorists, they may become excessively zealous. Medical research funding is more properly determined by its social contribution – not based on a Medicare co-payment.

Countries with as good or better healthcare systems than ours, such as New Zealand and Singapore, rely far more on co-payments. The insurance aspect of Medicare requires subsidies to life-threatening and expensive medical intervention and not to regular GP visits.

Cynically, would the AMA have been more amenable to co-payments if all the revenue raised were to be paid to doctors rather than medical researchers?

Geoff points out that government expenditure has a significant impact on the efficiency and productivity of the nation. Not always beneficial, I might add. He indicates that this may be especially true of capital expenditures.

Geoff then goes on to make the remarkable claim that domestic borrowing to fund such deficits entails no real burden since both the taxpayers and the interest recipients are Australians. I agree, it is true they could in part overlap.

So the government borrows a dollar, perhaps to fund more welfare benefits. I, as the taxpayer, lend a dollar to the government instead of investing it in (say) advances in technical know-how to raise our future living standard. Activities other than welfare suffer in the Australian economy.

The government then raises the tax on me in order to pay the interest it owes me. I now work less hard because leisure and idleness remain untaxed. Taxes are then raised again in order to repay the principal as well as the interest on the loan I have made to the government. I consume more idleness and the Australian economy suffers yet again.

The burden is no different if foreign borrowing funds it. Geoff points out that repayment of principal and interest must come out of export earnings. These additional export earnings have to come at the cost of lower domestic consumption and investment, that is, lower non-welfare related activities. The tax burden is the same as in the case of domestic borrowings.

All borrowing, whether domestically or foreign, entails a tax burden with the burden increasing in the size of the deficit. Only if the borrowing is to fund long-lived public goods that I, and others, benefit from collectively is the borrowing justified. Most federal borrowing is to fund current expenditures and interest payments, not infrastructure.

Geoff concludes that “the end result has been the use of scare tactics over a wide range of issues, tactics which have no foundation in proper economic logic”. Yes, I agree scare tactics have been tried. Not very successfully so far because senators fail to see that in one way or another taxes have to be raised or outlays slashed to fund the repayment of principal and interest.

Are these tactics contrary to the laws of economics when applied to deficits? No. In fact, these laws are rigid and ultimately are little different from that faced by you and me as individuals.

Peter Swan is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Read Geoff Harcourt’s Why treasurers should go back to economics school

Richard Holden

Last Tuesday, the minutes of August’s Reserve Bank of Australia (RBA) board meeting were released. Market participants speculated about what they would say, currency and bond markets responded to what they did say about house prices and future interest rates, and the precise wording was dissected in great detail by the Australian press.

The words of central bankers such as Glenn Stevens attract a huge amount of attention. In the US, analysts have scrutinised even the body language of successive US Federal Reserve (Fed) chiefs.

It’s not surprising that what central bankers do is closely followed. After all, interest rates have a big effect on economic activity, a range of different markets and investment strategies.

But what is, at first glance, surprising, is that what central bankers say is perhaps as closely scrutinised as what they do. Of course, what they say is informative about what they might do in the future — but there’s more to it than that.

Perhaps the most striking feature about how central bankers communicate is that they are typically quite vague. This is so widespread and has become such an art form that it has been dubbed “Fedspeak”.

For example, former Fed chairman Alan Greenspan in 2005 told the US House Committee on Financial Services:

“Risk-takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. But long periods of relative stability often engender unrealistic expectations of it[s] permanence and, at times, may lead to financial excess and economic stress.”

Even the RBA’s comparatively plain-spoken Stevens said recently to the Australian House Standing Committee on Economics:

“At some point, if these responses start to gather pace, the sorts of forecasts we are setting out at the moment will very likely prove to be conservative. The frustrating thing is that no one can say when that will happen, or just what might be the proximate trigger.”

Why are central bankers so abstruse? Surely it would be better for them to communicate clearly. Actually, no.

Central banks have all sorts of information about the economy that investors and the general public do not. They use that information to inform future policy. So wouldn’t it be best if they could credibly communicate that information so the market could incorporate it into their decision-making as soon as possible?

Yes, but the key word here is “credible”. Imagine for a moment that a central bank could make a pronouncement that was both credible and precise. Being credible, markets would believe it. And being precise, markets would have no doubt what it meant about future policies.

But this very fact would give the central bank a reason to lie. Why? Because there is a trade-off between inflation and output (or unemployment). Different central bankers will have different appetites for how much unemployment they are willing to tolerate in order to keep inflation low.

So, as Nobel laureates Finn Kydland and Edward Prescott noted long ago, policy-makers (such as central banks) suffer from an inherent time-consistency problem. In this setting, all central bankers want to be seen to be “tough on inflation”, but then bankers with less tolerance for unemployment will still want to mimic bankers with more tolerance — so they can be believed to be tough and enjoy low inflation expectations.

But that’s a logical contradiction. So central banks cannot be credible and precise at the same time.

If you think this logic sounds complicated, airy-fairy and academic, then you are right. And wrong. It is exactly the reasoning laid out by a Harvard University economics professor in a paper in 1989 in the world’s leading economic journal, the American Economic Review. That Harvard professor, Jeremy C. Stein, later went on to become a governor of the Fed. So he’s seen theory and practice.

And his argument is perhaps more pertinent today than ever before – a time where central bankers are trying to balance multiple competing objectives with just one concrete policy instrument: short-term interest rates.

Poor Stevens is trying to juggle inflation, growth, unemployment, the exchange rate and housing prices all at the same time. He needs more than just the cash rate to do that. And to influence expectations at all he must balance the precision and credibility of his language.

What central bankers say communicates a lot more information than the interest rates they set. That’s why central bankers are so careful in their language, and masters of the art of Fedspeak.

Personally, I think Fedspeak sells the immutable economic logic behind it a little short. I prefer to think of it as “Greenspan’s uncertainty principle”. You can either know what he’s saying, or whether he really means it. But you can’t know both at the same time.

Richard Holden is a professor of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Geoff Harcourt

Although money and financial factors are integrated in complex ways in the workings of the economy, ultimately it is real resources – work forces (sizes and skills), capital goods and natural resources – that set the upper limit at any moment in time on the size of the community’s standard of living.

And yet that hasn’t stopped successive Australian federal treasurers, and their counterparts in other advanced capitalist economies, from increasingly using terms that reflect misunderstandings of the role of fiscal policy in economic policy.

When used by treasurers, phrases such as “we cannot afford it financially” or “where is the money to come from?” or “you are using taxpayers’ money”, confuse affairs of the state with what should be left to the workings of individual households.

Obsessed with the relationship of government expenditure and taxation, many treasurers suffer from deficit size fetishism, and fall victim to the “balancing the budget over the cycle” fallacy. Many also get caught up with hypothecation – matching specific government expenditures with particular tax sources.

Some confuse the significance of the national debt to income ratio for the present and future operations of the overall economy, especially the supposed link between them and the welfare of future generations relative to the welfare of the present generation. The “we’ll all be ruined” fear.

Deficit size fetishism reflects the view that government expenditure and taxation are always bad, regardless of the absolute sizes and compositions of the two and the overall state of the economy – for example, the rate of unemployment, the rate of growth, the rate of inflation (or deflation, as Japan has experienced in recent decades). Both the sizes and compositions of government expenditure and taxation need to be assessed by other criteria.

The composition of taxation, the contributions to the whole of indirect, direct and other forms of taxation and their incidence on different groups in the community, ought to reflect equity (fairness) – for example, which groups can least or most afford to pay particular forms of tax and taxes overall.

The total tax take should reflect the impact required on overall levels of spending in the economy, these in turn determining the levels of output, income and employment both prevailing and what the government would like to see prevail.

The composition of government expenditure is made up, first, of current expenditures, the salaries of parliamentarians, public servants and government employees generally; transfer payments from taxpayers to recipients of social services such as unemployment benefits, old-age pensions and so on; and interest payments to domestic holders of government bonds.

Second, there is government (public) capital expenditures on social infrastructure, the creation of new railways, roads, hospitals, schools and so on. Ideally, the level and composition of capital expenditure should be determined by the perceived medium- to-long-term needs of the community for the services they ultimately will provide.

As these expenditures have a significant impact on the efficiency and productivity of the nation, there is no reason why they should not be financed, at least in part, by borrowing, even by borrowing from overseas.

The latter does entail a real burden because interest and principal repayments mean higher levels than otherwise of exports to service them would be required. Nevertheless, if the borrowings are used wisely, this burden may be met and the economy can still be better off than it otherwise would have been.

There is no equivalent burden associated with internal debt (owed to lenders within the country) for, as noted, this involves a transfer from taxes to interest payments. The impact on overall demand depends upon the differences in the consumption and saving behaviour between taxpayers, on the one hand, and interest receivers, on the other. They may, of course, overlap. Any fairness considerations associated with such transfers may be tackled through the composition of the structure of tax rates.

So government expenditure and taxation, especially taken in isolation, are not interesting numbers. Certainly not numbers to have a fetish about, even if you are not just an ordinary Joe (Hockey), or an earthbound (Wayne) Swan, or a surplus-lover (Peter) Costello that hands out tax cuts to friends.

The criterion of balancing the budget over the cycle (or, preferably, creating a surplus) is based on a fallacy that the economy is not growing, that it will remain at the same level of activity forever.

At least since the 1940s it has been known that if economies on average grow from cycle to cycle, it is possible always to have deficits (within reasonable limits) without annual deficits exploding; for specific rates of growth, the deficit approaches particular limiting values that are livable within a wide range of values.

One outcome of this discussion is that hypothecation is a fallacy – particular forms and amounts of taxes should not be attached to particular forms of expenditure.

Citizens should pay taxes according to their overall ability to pay and they should receive government payments according to their particular characteristics as citizens – unemployed, aged, disabled and so on. The total of these government expenditures will be financed from the total funds raised by taxation and borrowing.

“Treasurer speak” in recent decades reflects serious conceptual misunderstandings of how economies work and how the functions of the state should be integrated with the workings of the private sector. The end result has been the use of scare tactics over a wide range of issues, tactics that have no foundation in proper economic logic.

Geoff Harcourt is a visiting professorial fellow at UNSW Australia Business School. A version of this post appeared on The Conversation.

Nitika Garg

Both research and popular media tell us that emotions and eating are intrinsically related. How many times have we seen a character in a TV show reaching for the ice-cream tub when feeling particularly down or after a break-up?

What is it about sadness that leads to such behaviour?

Feelings of loss and helplessness spurred on by sadness are what drives the unhealthy behaviours, whether it’s overeating or overspending. Research has shown sad people consume significantly more fatty, tasty food products, such as chocolate or buttery popcorn, than those who are feeling happy. They are also willing to pay a higher price for ordinary products such as a bottle of water.

This tendency to compensate and reward by engaging in unhealthy albeit pleasurable behaviours in the short run, has serious consequences in the long run especially with rising concerns about obesity in most developed countries.

Unlike “retail therapy”, which involves a more conscious decision to engage in a behaviour seen as rewarding and mood-uplifting, these behaviours operate at a more non-conscious level.

Interestingly, much as sad individuals crave a reward, recent research found that merely engaging in rewarding, hedonic activities, such as eating fatty foods, is not sufficient to break the sadness-overconsumption link.

This is troublesome as it suggests that in spite of engaging in unhealthy behaviours to alleviate their mood, people still do not find respite. The research suggests this might lead to a vicious cycle where engaging in such behaviours further induces guilt and dampens mood.

So, if engaging in compensatory behaviours is not an answer, then what is? Researchers have been looking for the answer.

Apart from the sense of loss, the theme that dominates sadness is that of helplessness or lack of control over the situation. And so researchers have begun to explore the issue of control.

An important way to gain a sense of control is via choice. When people make a choice, even a trivial, potentially meaningless one, they feel more in control.

New research implemented this idea and found that when sad individuals were given a choice between two common objects (a chocolate bar versus a ballpoint pen), regardless of what they chose (and most of them chose the chocolate bar), they were significantly less likely to engage in indulgent consumption.

This same effect was not obtained when sad individuals were simply given the chocolate bar as a gift (no choice). This established that rather than getting the chocolate bar, it was the manner in which it was obtained that mattered.

Should marketers of tasty and fatty food products start marketing these products as feel-good options that boost consumers’ mood? Although on the surface it might make sense, this is a short-sighted strategy.

It is possible for marketers to create strategies that improve consumption habits as well as profits. One such initiative was the 100 calorie (~400 Kj) packs that let consumers indulge but still stay in control.

In the same vein, research findings suggest it would make sense for product managers to market products that may be low-fat, low-energy versions of products as direct choices in contrast to the unhealthy choices the consumer may be drawn to, making the former more attractive.

Consumers can also learn from these findings and develop strategies for the way they shop, especially when they may not be feeling their best.

Rather than looking at purchases in isolation (such as, need to buy soft drink), they can teach themselves to build choices around such purchases (such as, need to buy something to drink – soft drink or juice) which would give them a greater sense of control and, in turn, help them move away from indulgent consumption.

The same idea can be used for impulse purchases where most of us usually give in to buying things that are pleasurable and hedonic in the immediate, but guilt-ridden and adverse (sometimes) in the longer run.

The real issue is not “to choose or not to choose”, but rather to have a real choice.

Nitika Garg is a senior lecturer in marketing at UNSW Australia Business School. A version of this post appeared on The Conversation

Gigi Foster

The Economics of Just About Everything is the latest contribution by ex-ANU economics professor Andrew Leigh MP to the bookshelf of the intellectually curious Australian. The book is a long-overdue Antipodean interpretation of the global wave that took off in 2005 with Freakonomics: a sharing with the smart layperson of “the economist’s lens” on diverse issues from across society.

Along the way, the reader learns that far from being a dismal science, economics is a compassionate yet pragmatic discipline that proposes particular ways of viewing situations in order to understand better where behaviour comes from, and hence how to change it to achieve better outcomes.

Re-branding economics is no mean feat, particularly in this country where arguably most non-economists operate under the delusion that economics is mainly concerned with money, not welfare.

Leigh confronts this misguided view with a raft of citations to research by economists, including himself and many other authors from Down Under and around the world, offering guidance on topics that carry significant implications for social welfare, individual welfare, or both.

Perhaps Leigh’s most uniquely Australian example relating to social welfare documents the effects of the different incentives facing the Second and Third Fleets sent to Australian shores in the late 1700s.

The same firm financed both voyages, but for the Second Fleet it was compensated based on the number of convict heads taken on board in England, whereas for the Third Fleet it was compensated based on the number of convict heads alighting in Australia. With the monetary incentives that previously supported over-crowding now shifted towards survival, the death rate plummeted.

While this example is riveting, such uplifting stories about how incentives can be used to increase aggregate welfare might not be enough to retain the attention of many self-interested readers for 187 pages plus references, and Leigh – as an economist after all – knows that.

Hence, he cleverly includes plenty of examples of how the reader can personally benefit from economic insights, organising his material thematically into creatively titled chapters such as Fit for Tomorrow, which highlights the implications for individual welfare of economic thinking on matters such as obesity (how do I lose weight?) and smoking (how do I quit?).

If you want to know how to behave in the dating market, see chapter one, For Love or Money; if you want to know how to plan your child’s birth so she/he has a leg up in the trials for national sports teams, see chapter three, Starting Lineup.

But true to what is arguably the main agenda of the economics discipline, Leigh also addresses some of the big social welfare questions of our time: how to reduce violence (examining recidivism, firearms access, and terrorism through an economist’s lens); how to understand the persistent gender gap in wages; how to help people in the developing world. He also confronts head-on economists’ famously inaccurate forecasting, using an apt quote from Treasury’s David Gruen: “Economic forecasters aren’t stupid; what we are trying to do is hard!”

Indeed, while it has been said that social scientists are prone to “physics envy”, wishing to be but not quite being the hard scientists of their fantasies, Leigh’s presentation is more in line with the claim that economics is harder than physics since economists have no laws to lean upon, but only best guesses.

And Leigh is unafraid to propose some of his own best guesses, such as that Australia would be better off if we paid prisons a bonus for every released prisoner who does not re-offend; and that the rest of the world would be better off if we Aussies concentrated our foreign aid efforts in activities where he argues we have a comparative advantage – namely, assistance in dry-land farming, natural resource management, and security provision in unstable states.

The book is terrific airplane reading, but it stops short at times from a full exploration of what is being revealed. For example, the fact that births dipped before, and peaked just after, expectant mothers became eligible for the baby bonus in mid-2004 implies that there were fewer earlier-term inductions and C-sections in that cohort of births, which in turn should have implications for the health outcomes of that cohort of babies; yet this is not pursued.

It is observed that Australia is comparatively good at keeping the peace in unstable places; but why is this, and how might we teach others to mimic our success?

Obesity is described mainly as a problem of eating too much of the wrong things, and partly as a problem of time-inconsistency. Yet becoming truly obese brings such a dramatic reduction in quality of life that it is hard to believe that most obese people really got to where they are through mindless present-biased munching, correctable via a properly designed array of little nudges: something more must be going on.

In sum, The Economics of Just About Everything manages to be at once a call to action for Australian policy-makers, a fascinating introduction to some of Australia’s most entertaining applied economic research, and a supreme source of cocktail-party banter.

Read it for what it can teach you about economics and ideas, and use it to help make your world a better place.

Gigi Foster is a senior lecturer in the school of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

Poke a Russian bear with a stick and he will retaliate. That’s the lesson facing Australian exporters today.

When Australia announced it would join the US and Europe in placing trade sanctions on Russia in response to Malaysia Airlines MH17 being shot down in Ukraine, it could do so realising there wasn’t much trade to talk about.

Australian-Russia trade is only worth A$1.8 billion – Russia is our 28th-largest export destination and 30th-largest import source. In fact, Russia’s main export destinations are – wait for it – The Netherlands, Turkey and the Ukraine.

It imports mostly from China (like everyone else), Germany and the US. Australia only accounts for 0.3% of Russian imports as Russia’s 44th-largest import source and we are Russia’s 99th-largest export destination (barely registering on the trade accounts).

But now Russia’s counter sanctions could hurt agricultural exports, particularly in wheat, dairy, beef and kangaroo meat (Russia is our main export market for kangaroo meat). In most cases Australian exporters will be able to sell items such as beef to Japan, Korea (thanks to the new FTAs) or Indonesia.

In any case, Russia had already reduced beef imports from Australia (due to alleged concern over growth hormones). These would be the only sectors adversely affected assuming no further Russian retaliation over energy or financial sector sanctions placed on them by the West.

So how will the trade sanctions play out? Russia’s actions could hurt Russia most of all. A government putting on tariffs or other forms of trade protection is a like a government shooting its own people during peace time. Or as the legendary Cambridge economist Joan Robinson used to say, trade bans are like “putting rocks in your own harbour”.

Putin might well be bringing food shortages back to Russia like the bad old days of the Soviet Union and tsarist regimes – something the poor Russian populace has been used to historically. For a democracy it would be unbearable, but at an 87% approval rating, Putin won’t worry about that.

As he told me at the APEC meeting in Sydney in 2007 when John Howard allowed then Opposition leader Kevin Rudd to speak: “How nice to allow your leader of the opposition to speak. I would do so also, except I don’t have one.”

So will trade sanctions work? In economic history the record is patchy. The evidence shows economic sanctions against South Africa were more “psychologically hurtful” to the apartheid regime than economically damaging, though there is evidence that disinvestment by major institutions such as Chase and Barclays had more of an impact than trade sanctions.

As in the case of Cuba and Southern Rhodesia (now Zimbabwe), trade sanctions did not have as much impact as restrictions to foreign investment. And, in any case, the economic distortions in the domestic economy (like South Africa’s apartheid labour market distortions) were as damaging as external sanctions.

Ironically, the collapse of the old Soviet Union was the key factor in enabling the white minority government to start negotiating with Nelson Mandela and the African National Congress, making South Africa a “special case” in terms of effectiveness of sanctions.

In a well-functioning economy sanctions can bite quickly, but as in South Africa (due to apartheid) and Myanmar (due to having a ludicrously large army for a country of its size) they can have mixed effects.

Russia has an oligopolistic, or we could say “oligarch-istic”, anti-competitive economy so the oligarchs will choose to absorb the sanctions or distort the effects. The West has tried to target Russian funds abroad (in the UAE and London’s Chelsea) as that’s where the Russian oligarchs keep their capital, but that’s going to be a difficult target.

The MH17 Russia–Ukraine crisis has a long way to go in terms of geopolitics, and trade is likely to be just one weapon of choice in the skirmish.

Tim Harcourt is the J.W. Nevile fellow in economics at UNSW Australia Business School and author of The Airport Economist. A version of this post appeared on The Conversation.

Glenn Otto

There is now keen interest in whether the US Federal Reserve will move to raise its near-zero interest rates following two recent pieces of conflicting economic data.

Data on real GDP for the second quarter of 2014 indicates the US economy is growing at an annualised rate of almost 4%. This figure represents a marked turnaround on the negative growth rate for the first quarter of 2014. The average annualised quarterly growth rate for real GDP since the end of the US recession in the second quarter of 2009 is only 2.2%. So the 4% figure represents an above-average outcome.

Some preliminary evidence that the stronger US growth will be maintained into the third quarter of the year can be found in the latest purchasing managers index (PMI) figures for July.

But despite the recent strong growth in real output, the consensus view remains that actual US output is still below its potential output, implying the continued existence of a negative output gap for the US economy (where the output gap is defined as actual output less potential output). The latest Congressional Budget Office estimates for potential output suggest a current output gap of about -4.5%.

Further evidence of a negative US output gap can be found in the unemployment rate, which stood at 6.2% for the month of June. The civilian unemployment rate reached a post-recession peak of 10% in October 2009 and has trended downwards since then.

At 6.2%, the unemployment rate is still about 1.8 percentage points above its pre-2008 recession low-point. The present rate also lies above the average rate of 5.3% which was achieved during the 2001 to 2008 expansion.

Both these outcomes raise questions as to whether the Fed will soon end its unconventional monetary stimulus program of quantitative easing (QE), and more significantly begin to increase its interest rate, more properly referred to as the Federal Funds (FF) rate, set just slightly above zero since the end of 2008.

QE is a policy whereby the US Fed purchases longer-term assets – mainly mortgage-backed securities and long-term US treasuries – with the ultimate objective of reducing long-term interest rates (if the Fed’s purchases bid-up the price of an asset it will reduce its yield).

QE began during the GFC and continues today. Recently, the Fed has begun to taper the size of its asset purchases and at its end-July meeting the Federal Open Market Committee (FOMC) reduced the value of monthly asset purchases from $US35 billion to $US25 billion.

The other key variable for the Fed’s monetary policy setting is US inflation. The Fed has a stated target rate for inflation of 2% per annum. Standard measures of US inflation are the personal consumption expenditures (PCE) index – which showed year-ended inflation for the month of June at 1.6%  – and the consumer price index (CPI), which showed year-ended inflation for the month of June at 2.1%.

These are headline figures and like most central banks the Fed uses measures of underlying or core inflation as an indicator for the general trend in inflation. One widely used measure of US core inflation is the PCE less food and energy, which increased by 1.5% during the year through to June.

Whatever measure is used, the inflation outcomes for the US since the end of the 2008 recession have generally been well below the Fed’s target rate of 2%. To date, there has been little pressure from inflation outcomes for the Fed to raise the FF rate.

The present unemployment rate and negative output gap are consistent with the view that resource utilisation in the US economy is still below some optimal/normal level. Provided that inflation and its forecasts do not move significantly above the Fed’s 2% target, this will tend to support a continued expansionary stance for monetary policy – with no immediate movement towards raising the FF rate.

A reading of the end-July FOMC statement suggests that if current trends in US growth and inflation continue, the Fed will move to end its QE program, but may then wait some time to begin raising the FF rate.

Furthermore the process of returning the FF rate to some normal level – a rate approximately equal to the sum of the real interest rate and 2% inflation – is likely to occur via a series of small steps. Present expectations suggest the first increase in the FF rate will be in 2015.

For the Australian economy, the initial effects of a rising FF rate are likely to be felt as downward pressure on the value of the Australian dollar.

Glenn Otto is an associate professor in the school of economics at UNSW Australia Business School. A version of this post appeared on The Conversation.

James Morley

The major Australian banks have recently cut fixed mortgage rates below 5%. They have done so without any prompting from the Reserve Bank of Australia (RBA), which may actually start raising the policy rate within the next six months, especially if inflation continues to run around the top end of its 2% to 3% target range.

Why, then, did the Australian banks cut their mortgage rates?

One possible reason lies in an obscure old macroeconomic theory of “secular stagnation”  which has been gaining credence recently throughout the financial industry worldwide.

In a speech at the International Monetary Fund last November, Larry Summers, Harvard economist and former US Treasury Secretary, resurrected this old theory, originally developed by another Harvard economist, Alvin Hansen, in the late 1930s.

When a consumption-led recovery in the midst of the Great Depression started to falter, Hansen was inspired by the then nascent Keynesian idea that the economy as a whole could persistently suffer from inadequate demand in the absence of a massive policy intervention.

US population growth had slowed dramatically during the Great Depression and Hansen believed this was a “secular” (that is, long-term, non-policy) source of decline in private investment in new capital infrastructure.

According to his very Keynesian theory, this weak investment brought consumption down with it and, like John Maynard Keynes, Hansen did not believe in the ability of wage and price adjustment to restore the economy to full employment in the face of inadequate demand. Instead, he believed that fiscal policy would have to take up the slack, which it did with the onset of World War II.

The baby boom after the war meant that the theory of secular stagnation was largely forgotten. But Summers sees similar forces at work in recent times and he considers secular stagnation as a leading explanation for why the US housing bubble in the 2000s didn’t result in an overheated economy at the time.

One might question the idea that the US economy didn’t overheat prior to the Global Financial Crisis. But real GDP growth and inflation were actually quite moderate by historical standards throughout the 2000s. Summers speculates that this was because economic growth would have been much slower in the absence of a bubble due to secular stagnation.

This story is somewhat related to former Federal Reserve chairman Ben Bernanke’s “global savings glut” hypothesis about why interest rates remained so low throughout the 2000s. In Bernanke’s view, there were too many savers, especially from Asia, chasing too few high-return and often risky investments. This “chase for yield” put downward pressure on interest rates and fuelled the US housing bubble.

So what is the prediction of secular stagnation for the future and why might it explain the Australian banks’ recent cuts in mortgage rates?

The basic prediction of the theory is that economies throughout the world will continue to stumble along with anaemic growth and no inflationary pressures for the foreseeable future. At best, there will be more moderate growth from time to time, but it will occur due to periodic financial bubbles triggered by a chase for yield and low interest rates.

Faced with slow economic growth and low inflation, central banks will contribute to these bubbles by lowering their policy rates or making large-scale asset purchases (aka quantitative easing) when rates hit the zero lower bound.

In cutting their mortgage rates, the Australian banks appear to have bought into the secular stagnation theory and are clearly betting on continued downward pressure on interest rates driven by a global chase for yield.
Can anything to be done about secular stagnation or, perhaps, is its relevance to the current economic situation overstated?

Similar to Hansen in the 1930s, Summers argues that public investment in infrastructure provides the best way to address inadequate demand. He notes that current low interest rates also mean that the cost of financing public infrastructure investment is unusually low.

Would this fiscal policy approach work? Japan is an obvious place to look at in terms of what might happen in the face of demographic-led stagnation. And the results are not particularly promising.

Japan has undertaken massive debt-financed infrastructure spending and this has not exactly produced a booming economy. Of course, unemployment has remained low and deflation, not inflation, has been the greater problem. So perhaps things would have been even worse in the absence of Japan’s massive fiscal interventions.

Meanwhile, it’s not really clear how relevant secular stagnation is for the rest of the world, including Australia. Indeed, in an odd way, the possibility of secular stagnation means that we should at least briefly celebrate when we see Australian inflation running at the top end of its target range.

This is not to say that the RBA should abandon or revise up its inflation target. But higher inflation is an indication that the secular stagnation hypothesis may be incorrect, while the RBA can always raise its policy rate to bring inflation down again in the future.

Of course, the Australian banks currently betting on low interest rates won’t be quite as happy if this scenario were to play out.

James Morley is a professor of economics and an associate dean at UNSW Australia Business School. A version of this post appeared on The Conversation.