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  • PD Jonson

Fixing over-borrowed economies

The world economy is 'in the red zone', 'navigating in dangerous waters', 'completely stuffed' and a variety of other colorful and depressing descriptions. As the opening sentence of my book Great Crises of Capitalism asserts, the world may still experience a depression as a result of the global crisis that exploded in 2007-08. Indeed the odds of this have risen appreciably since the book was completed in late 2010.

In many countries, debt of both governments and households is sufficiently large that they represent serious economic headwinds. When an aging population, shortage of new innovation to increase productivity and declining workplace participation are also at play, headwinds can amount to a gale. In the case of the United States, Robert Gordon (2016) judges that such headwinds will greatly limit growth of income per capita in coming years.

The opening descriptions of current risks are signs of deep frustration among world leaders. If they are honest they will recognize that they, or their predecessors, are responsible for the current mess. The sad fact is that it is far easier to wreck an economy than it is to fix it.

Traditional economic policy impotence

Here is a bold hypothesis. An economy, even one as complicated and many-layered as the global economy, has its own tides and timetables. Governments can steal (or borrow) from the future by spending more, but the future demands its payment which come in the form of debt that needs to be serviced. Indeed, if markets come to think debt is too large, the debt needs to be repaid or else borrowers need to default. Governments can provide temporary stimulus, but this will be very unlikely to much change the overall level of activity, taking one decade with another.

A similar theorem applies to monetary policy. Stimulus now will increase economic activity now but the cost comes in the form of inflation and the tightening of future monetary policy, both responses that slow future activity.

In the case of Australia, monetary policy as represented by a 1.5 % cash rate is consistent with low goods and services inflation. If this rate was raised, the already excessive exchange rate would very likely be raised, adding pressure on the trade exposed export industries.

If interest rates were cut, this would encourage house prices, already on the east coast cities far too high. It would also encourage additional borrowing and spending by households already deep in debt. Monetary policy appears gridlocked for now and the forseeable future.

The RBA may say its only requirement is stable [goods and services] inflation, but that is inconsistent with the Reserve Bank Act. Excessively high house prices or an exchange rate sufficiently high to inhibit exports of trade exposed industries are both outcomes inconsistent with the Reserve Bank Act.

The great monetary economist, Milton Friedman, said that 'monetary policy cannot serve two masters'. In the case of a small open economy like Australia's there are three apparent 'masters' for the central bank to attend to. The late 1980s saw a case where interest rates were cut in an attempt to restrain increases in the value of the Australian dollar. The right approach was to raise interest rates to prevent the development of a damaging boom that produced a major bust.

In recent experience, interest rate cuts (to support the economy and check rising exchange rate) helped stoke a strong housing boom that at the time of writing is showing signs of a necessary housing bust.

In my opinion, three objectives requires three policies. Restraining an exchange that is damaging national competitiveness should be handled by a tax on capital inflow. Tiny steps in this direction have been taken in banning overseas purchases of second-hand houses, but an overall tax on capital inflow would be far cleaner and easier to use. The exchange control department of the Reserve Bank, dismantled overnight when the Australian dollar was floated in 1983, needs to be restored to handle the problem of an exchange rate that make Australian industry uncompetitive.

So called 'Prudential policy' needs to be used to prevent the build up of asset prices, especially in Australia house prices. Such a policy has been attempted by the newly created Australia Prudential Regulatory Agency (APRA), created on July 1 1998 from the prudential arm of the Reserve Bank. APRA is famously regarded as lacking teeth and needs in my view to be restored to the central bank and given a more active role in resisting asset inflation.

And regulatory policy is cases of severe asset boom or bust needs to be supported by tightening (in a serious boom) or easing (in a severe bust). Recent policy in many nations has responded that way to the bust, but so far asset booms have generally run free.

With these changes, the enhanced central bank would have three powerful instruments to modify the overall economy ('monetary policy'), maintain external competitiveness ('exchange rate policy') and prudential policy ('asset inflation policy'). The board of the RBA would need greater expertise to handle the more complex tasks it would be charged with. But the existing Reserve Bank Charter embedded in legislation first formulated in 1959, would still be relevant, and its aims would more likely to be achieved.

Without the changes outlined here, the Charter will certainly not be achieved, except occasionally by chance.

Effects of insolvency

When nations or banks become insolvent, a bailout now may alleviate the adverse effect on economic activity but, by adding to debt of the government (or a financial institution that acquires the failed institution), future activity will be slowed. And bailouts create 'moral hazard', encouraging a repeat of the foolish behaviour that created the insolvency.

As already noted, household debt is a far bigger problem for Australia. When global interest rates rise, as now underway, a point will be reached when households become insolvent and there will be families in deep economic pressure. Banks who have lent to household will suffer a rise in bad and doubtful debts and bank solvency may come under question. The crash in house prices and insolvency in the 1890 showed just how bad such an outcome can be.

Active policy like fixing potholes

The case for ‘activist’ economic policy is the same as the case for fixing potholes in the road, removing a cause of accident that might end the journey, or at least cause sizeable damage to vehicles hitting the pothole.

The trouble is, economic potholes are frequently filled with wasteful spending that weakens incentives to work, to save and to innovate. Spending or tax relief that does not add to productivity, as is frequently the case when there is unexpected economic trouble, is like filling potholes in the road with loose sand and gravel, likely to do more harm than good, partly by reinforcing the modern delusion that ‘the government will provide’.

The people sometimes called 'bastard-Keynesians' have been in charge. Such people rush around looking for potholes to fill and (worse) to fund great projects they described as 'nation building' with no benefit cost or other rational test of value. Keynes himself was concerned with the once in a century case of deep and intractable depression, when no compassionate leader could sit pat without offering policies with some chance of success.

But, even in the case of deep depression, if households and businesses reject the attempts to alleviate the situation, 'Keynesian' policies will fail. This point was clearly recognised by our teachers at Melbourne University almost 50 years ago.

My bold ‘intertemporal policy impotence’ hypothesis has probably already been devised by some bright, mathematically inclined young economist at the University of Chicago, and if so I would welcome being sent a relevant reference. But, if it is supported after careful thought, it disposes once and for all of the bastard-Keynesian approach to economic stabilisation.

Implications of traditional policy impotence

There is a strong conclusion from the impotence of traditional fiscal and monetary policy. The only way to stimulate a modern economy with large debts is to embark on a policy reform to remove impediments from increases of productivity.

The key to potent economic policy is to raise productivity. Any decent economist will provide a list. Brave governments will pick a set of productivity enhancing policies that restore economic dynamism. Then people will be amazed at how soon budget deficits will be dealt with and debt burdens reduced by ongoing fiscal surpluses.

The need for fiscal austerity combined with policies to raise productivity is a universal policy setting that any over-indebted nation must adopt if its people are to prosper. This is the only way to fix economies. Traditional monetary and fiscal policies are now largely impotent and will very likely make things worse.


Milton Friedman (Ed), Studies in the Quantity Theory of Money. Chicago: University of Chicago Press 1956

Robert J. Gordon, The Rise and Fall of American Growth, Princeton University Press, 2016.

Peter D. Jonson, Great Crises of Capitalism, Connor Court,

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