Finance, Technology and Macroeconomics

Budgetary policy is so last century!

By Zach Alexopoulos


For all the fuss over the Federal budget, it may come as a surprise to learn that budgets are not that important as an economic policy lever any more. It is not Peter Costello who is in charge of managing the business cycle, or even John Howard. It is Ian Macfarlane, the governor of the Reserve Bank. Monetary policy, manipulation of interest rates, has overtaken fiscal policy, the budget, as the major policy instrument used to smooth economic fluctuations. The extensive airtime given to the budget on this site for the last couple of weeks is more than justified from a social or political viewpoint, but less so economically.

The reason is this. Not many people outside the economists' clique know it, but in an open economy with a floating exchange rate, monetary policy is always the major economic policy lever available to the government, not fiscal policy. To understand why, we have to delve into the theory of what's known as open economy macroeconomics. If you want to skip the technical bits, you can jump to the paragraph beginning 'what the model is getting at is this' without (much) losing the flow of the argument.

To make the point, we wheel out what's known as the Mundell-Fleming model, which after four decades is still one of the most useful and insightful models in all of economics, and for which its co-originator Robert Mundell won the Nobel prize for economics in 1999. (Marcus Fleming did not share in the Nobel glory because he died in 1976 and the prize can't be awarded posthumously.) The model analyses the effects of monetary and fiscal policy in an open economy under different exchange rate regimes, and it works especially well for Australia. In fact, it has been remarked on several occasions that Mundell-Fleming could well have been designed for Australia – the original version of the model examines a small, open economy which is largely a price taker for exports and imports, ie it has little control over the prices it receives for exports and pays for imports. That is a close fit to Australia. The derivation of the model is straightforward but tedious. I'll spare you the maths, but if you want to see the complete model in all its glory, just pick up any advanced macroeconomics textbook. Rudiger Dornbusch's Open Economy Macroeconomics contains the clearest exposition.

A central insight of Mundell-Fleming is that countries face an 'impossible trinity'. It is not possible to simultaneously maintain all three of an open economy, an exchange rate fixed to another currency, and control over monetary policy. You can only have two of the three. In an open economy with fixed exchange rates, you lose monetary policy autonomy, because you have to follow the monetary policy of the economy whose currency you're pegged to. Under those circumstances, fiscal policy becomes the only effective instrument available to the government for stimulating and contracting the economy. This was indeed the case for many countries last century when fixed exchange rates were the norm.

But matters are different under floating exchange rates, where the value of the currency is determined on the foreign exchange market. Most importantly, monetary policy becomes effective, as countries give up a different leg of the trinity, the ability to fix their exchange rate. In contrast, expansionary fiscal policy (an increased deficit or smaller surplus) leads initially to higher output, as under fixed exchange rates, but that extra output is dissipated in higher interest rates and a resulting stronger exchange rate. The reverse will hold for contractionary fiscal policy (a reduced deficit or larger surplus). This relationship will hold perfectly if capital is free to shift to where it will earn the highest return, and thus migrates to countries where it believes interest rates will be increased by a fiscal stimulus, causing the exchange rate to appreciate (go up) and thus cancel out the stimulus. Again, the reverse will hold for contractionary policy. Theoretically, under perfect capital mobility, fiscal policy will be completely ineffective. Of course, capital is not completely mobile, and so fiscal policy does have some effectiveness, but not as much as monetary policy.

What the model is getting at is this. The essential difference between the two types of policy is that monetary policy directly moves money into and out of the system, whereas fiscal policy faces frictions which reduce its effectiveness. The latter will only be the major lever if the exchange rate is fixed. Under a floating exchange rate, monetary policy will be the major policy instrument available to governments, firstly because it becomes available as a policy lever in the first place, and secondly because it acts more directly and with less friction than fiscal policy.

Of course, fiscal policy still has its uses. Monetary policy is the major lever, not the only one. Fiscal policy does have an important role in stimulating an economy in recession, through running budget deficits to increase domestic spending. It is also useful as a 'sharp instrument', rather than the 'blunt instrument' of monetary policy. This means that fiscal policy is useful in making a difference to individual geographical areas or sectors which are having problems, rather than economy-wide.

And naturally we cannot overlook the social justice issues embedded in the budget. Government programs make a tremendous difference to people's lives. Justifiably, much attention is devoted to dissecting who gets what. It matters how much education or health or defence get, and how much the tax take affects household income. The budget is a source of extremely important micro-level assistance to a huge number of people.

But regardless of how important the budget is in other ways, it is important to remember that there is still a limit to its effectiveness as an instrument for managing the business cycle. Note the recent spectacle of economists arguing over how much the budget will affect the economy. You wouldn't see that sort of disagreement after an interest rate change. Two interest rate rises appear to have almost single-handedly pricked the housing bubble, whereas the budget will not lead to anything nearly as drastic. It may pump up the economy a bit much for this stage of the cycle, leading to higher interest rates down the track (on par with the prediction of Mundell-Fleming), but it probably won't hugely affect the economy's behaviour.

It is fair enough to devote attention to the budget to see what different groups get, or to examine the political fallout (especially in an election year). But don't think of it as the most important economic policy lever. Monetary policy plays that role in Australia, as it must in an open economy with a floating exchange rate. Unless you're in a country with fixed exchange rates, budgetary policy being the major economic policy instrument is really last century

posted by JD @ 1:19 PM