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Economic water torture

April 28, 2010

The Australian economy is performing well. We had a small per-capita recession after the American & European banking crisis, but a solid financial system and good monetary policy (as well as some help from Chinese demand) have kept our economy stable. While some countries in Europe are now facing a government debt crisis, this won’t hurt Australia.

The real challenges that we face in the short-term are not caused by American banks or European government debt, but the consequences of our own bad government policies.

The stimulus package gave us a short term boost in the December 2008 and March 2009 quarters, but since then it has been a burden on the economy. In the long term, the cost will be higher taxes. But in the medium term, the consequences are lower net exports, higher cost of living and upward pressure on interest rates. While none of these effects are a killer issue for our economy, they are more like “economic water torture”, which slowly eats into wages and consumer welfare.

Another drop fell today, with data released showing that the cost of living has increased nearly 1% in the last three months (March 2010 quarter CPI growth = 0.9%).

The stimulus hurts net exports because it was partially financed by foreign borrowing. There is nothing wrong with foreign borrowing as a rule, but it needs to be remembered that changes in net foreign financial flows (capital account) must be offset by an equivalent change in net trade flows (current account). In short, the government drove up the capital account surplus and so (by definition) they drove up the current account deficit. This will directly hurt exporters and businesses that compete with imports, driving down profits and wages in those areas.

The impact on the cost of living and interest rates occur through a different transmission mechanism. Though, to some degree, these issues are offsetting. If the Reserve Bank of Australia (RBA) strictly targets inflation then the cost of living shouldn’t go up too much, but interest rates will rise more. In contrast, if the RBA is too timid in fighting inflation then interest rates won’t rise as much, but the cost of living will continue to rise. Or we could get a bit of both.

The irony is that the stimulus causes these costs only when it works. If the stimulus simply led to more savings (Ricardian equivalence), or replaced private spending (domestic crowding out), then the stimulus would provide no benefit and no consequence for inflation or interest rates. But if the stimulus did work, then it will have pumped more money into the economy. The medium term consequence of this is either more inflation (higher cost of living) or higher interest rates (as the RBA tries to prevent more inflation).

None of this is to say that the sky is falling. The Australian business sector is still strong and has a wonderful ability to navigate new challenges. And we should all remember that we’re in a rich, stable country. It’s just a shame that the Rudd government had to drag us down a few notches with their panicked stimulus policy and leave us with this economic water torture.

Categories: Economics
  1. TerjeP (say Taya)
    May 9, 2010 at 4:14 am

    The sky is falling it’s just falling slowly.

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