Propping Up Demand

The importance of demand

The key objectives for any economy should be to achieve low unemployment and a stable rate of inflation. Obviously there other important objectives too, including the promotion of fairness and equality, but these are generally dependent on economic stability.

And, in fact, these are the key objectives of the Reserve Bank of Australia, as stated in its governing legislation, the Reserve Bank Act 1959 (sections 10(2) and 11(1)):

It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia.

The federal government would do well to also make these things the stated core objectives of its economic policy, and to state in the budget papers how various policy decisions support these objectives.

The realisation of these objectives depends on the demand side of the economy. In an economic downturn, demand slumps, which can lead to higher unemployment. In an economic upturn, demand increases, which can lead to high levels of inflation. Neither of these outcomes is a good thing.

Thankfully, we’re not entirely beholden to the economic cycle. We have two key tools at our disposal: fiscal policy and monetary policy.

Fiscal policy

In an economic downturn, the government can loosen its purse strings to fill the gap left by receding private sector demand. This can be achieved by spending more, reducing taxes, or both. This was the purpose of Rudd’s cash handouts, school building scheme, and home insulation subsidies. These schemes quickly injected money into the economy, propping up demand that multiplied throughout the economy and kept unemployment at bay.

In an economic boom, governments should pull back spending (or increase taxes) to moderate demand in the economy. This approach has the added benefit of the government banking money that could be used for stimulatory purposes in any future downturns. Conversely, keeping government spending at higher levels (or taxes at low levels) can help to inflate bubbles, driving up inflation and potentially worsening any coming downturns. The successive tax breaks introduced throughout the second half of the Howard Government is arguably an example of this.

Using fiscal policy levers to moderate the economic cycle is typically referred to as Keynesian economics, sometimes derisorily, as though John Maynard Keynes was some kind of crackpot and not one of the greatest and most respected economists of all time. The effectiveness of fiscal policy is well evidenced and, accordingly, arguments against this type of approach tend to be philosophic-ideological (that the government has no right to interfere in the economy) or secondary in nature (that fiscal policy creates distortions that eventually result in in unintended negative consequences).

Monetary policy

Monetary policy relates to the availability of money in the economy, which can be manipulated by adjusting interest rates or increasing or decreasing the amount of cash in circulation. The availability of cash, in turn, impacts on demand for goods and services.

In an economic slump, a nation’s central bank can either drop interest rates or inject more cash into circulation. Access to easy money reduces consumers’ desire to save, and increases the appetite for consumption and investment. Increased demand keeps unemployment at bay. This is why interest rates have been cut and cut and cut since the financial crash of 2008. It is also why the US Reserve pumped trillions of dollars into circulation in a program called Quantitative Easing.

When the economy is in a positive phase of the cycle, interest rates can be increased to moderate demand for goods and services that are shooting upwards in price, and to slow investment in speculative markets. In a housing bubble, for example, where real estate prices are rising above (what could be considered) true property values, higher interest rates can discourage investors from buying up and driving prices even higher.

Monetary policy is a particularly blunt instrument. Changes in interest rates, whether up or down, hit the entire economy. When there is an unsustainable bubble in one sector the economy (for example, real estate), increasing interest rates could ease that bubble but also bludgeon other parts of the economy that aren’t performing well. Short of some unusual measures that the RBA appears reluctant to implement (such as macroprudential reform), monetary policy levers have very general impact and, therefore, limited use. Fiscal policy, on the other hand, can be used to drive demand up or down in various sectors of the economy, through targeting spending and taxing, although there are typically flow-on effects to other sectors of the economy..

Current and future demand

So a stable economy is all about demand, and when rising or declining demand begins to adversely effect the economy, there are policy levers available to deal with it.

With the various bits and pieces of bad economic news this week, the question needs to be asked: what will be the source of future demand in our economy?

The ANZ-Roy Morgan measure of consumer sentiment has dropped 14 per cent in the past month. Likewise, the Westpac-Melbourne Institute measure has sentiment dropping 6.8 points in may. Consumer sentiment is an important indicator of consumption and, therefore, demand in the economy.

Meanwhile, wages are growing so slowly (2.6 per cent for past 12 months) that they are actually falling in real terms (see graph below). Declining wages means declining consumption, which means less demand for goods and services.

House prices, too, seem to have hit a wall. Speculation in increasing property values tends to drive further demand for real estate. Conversely, falling prices turn people off investing in real estate. So here we have another cause for concern over demand in our economy.

Of course, not all demand originates domestically. We also rely on demand from foreign investors and consumers.

One of our big exports is iron ore. And this seems to be dropping in price. Why is it dropping in price? It’s partly due to a surge in supply in the market. But, could Chinese demand for our iron ore be dropping? That seems to be the implication of the graph below.

Much of this news followed the release of the Federal Budget just over a week ago. If these indicators are genuine warning signs of a flagging economy, it will impact heavily on the budget figures. GDP will grow more slowly, revenues will dip and, ultimately, the budget bottom line will be hit.

But, the budget balance is largely irrelevant. The big question should be: how will the government prevent demand from falling off a cliff? Policy responses to hypothetical economic downturns are not typically covered in budget papers. But, with the bad economic news starting to pile up, some kind of shift in the government’s activities may soon be needed to address some of the softness in the economy.