Question

Please briefly discuss the impact of bushfire on the Australian economy and give suggestions to the Treasury and RBA regarding the fiscal and monetary policies and analyze how these policies could help Australia stimulate the economy in the short and long run. (1000 words)

Answer 1

I discuss the Australian Government's policy response to the crisis and in particular, the thinking behind some of the specific policy responses, I would like to briefly sketch out the structure of the Australian economy and describe how it was travelling before the global recession hit.

Australia's annual GDP is worth about $1 trillion US at current market exchange rates (somewhat less at PPP exchange rates), and Australia's economy is the 14th largest in the world based on market exchange rates (the 18th largest based on PPP GDP).

There are around 11.4 million people in the labour force and similar to other advanced economies, the predominant activity is services. In fact, more than 65 per cent of the Australian economy is engaged in the delivery of services.

This can surprise Australians and others. People often think of Australia as a predominantly mining and agricultural economy. And while it is true that combined, mining and agriculture make up a relatively large portion of the economy compared with other advanced economies (10 per cent), they are still dwarfed by the service sectors. For example, around 11 per cent of the workforce or 1.2 million people are employed in the retail sector alone, making the retail sector the single largest employer in the Australian economy.

Immigration has been and continues to be an important driver of Australian growth. Just over 25 per cent of Australians, or one in four, were born overseas. Over the past 10 years, net migration has accounted for around half of the increase in the labour force.

Robust growth in immigration, especially with its focus on skilled migration, helped Australia adjust to a rapid increase in demand for its mineral resources from 2003 to 2008, which drove commodity prices to record highs.

While income growth in Australia was strong before the global financial crisis hit because of the surge in commodity prices and associated mining boom, it was also clear in this period that Australia was running up against capacity constraints.

The labour market was tight, despite the strong growth in immigration, with the unemployment rate hitting a 33-year low of 3.9 per cent in February 2008.

Perhaps the clearest signs that the economy had run up against capacity constraints were the steady deterioration in Australia's productivity performance and the rise in inflationary pressures.

It was against this domestic economic context that the new Australian Labor Government delivered its first Budget in May 2008. However, even in early 2008, the global financial crisis was already on the scene, with possible serious flow-on implications for global growth.

Hence, the Government framed a Budget that sought to balance domestic inflation concerns and the need to expand the economy's productivity capacity, with the need to guard against the possibility that there might be a rapid deterioration in global growth. Though I should say that while some of us were aware there was the possibility of a significant deterioration in global conditions, there were few people that anticipated the full ramifications of the global crisis that would ensue.

The Global Financial Crisis and Australia

As for much of the world, the key turning point for the Australian economy was the change that swept through the global economy in mid-September 2008, with the collapse of Lehman Brothers. Of course, it does not all start and end with the collapse of Lehman Brothers, as there were many signs of financial stress before and many factors that contributed to the crisis [see Gruen 2009 for an analysis of the various factors surrounding the global financial crisis].

In Australia, there was considerable discussion about the prospect of global recession among the Prime Minister, Deputy Prime Minister, the Treasurer and other senior Government ministers and their advisers in July and August of 2008.

This, in part, reflected information that the Prime Minister and Treasurer had gleaned first hand from trips to the US and Europe through 2008, as well as signs of increased difficulties within the Australian economy. In a period when events are moving rapidly, leaders often hear about developments before they have filtered through their bureaucracies.

Following Lehman Brothers' filing for bankruptcy in the week beginning Sunday the 14th of September, the global financial crisis intensified markedly. The provision of credit dried up around the world and business confidence plunged.

While most expected that the financial crisis would have large real economy effects, I don't think many realised how quickly the financial crisis would affect the real economy. We now know that many businesses responded very quickly to the financial crisis by slashing production and running down inventories. In Australia, in the December quarter 2008, businesses ran down their stocks by $3.4 billion (in real terms), the largest fall on record.

Consumer confidence plummeted along with consumption. Throughout the month of September and into October, the financial crisis spread from the US to Europe, and all around the world economies began to contract.

Australia's first policy responses to the global financial crisis

In Australia, the first significant macroeconomic policy response to the global financial crisis came from the Reserve Bank of Australia (RBA).

On October 7, the RBA Board cut interest rates by 100 basis points.

The minutes of this RBA Board meeting noted:

The paper prepared for the Board recommended a large reduction in the cash rate, of at least 50 basis points, with the amount to be subject to review in light of any events occurring between the preparation of the paper and the time of the meeting. In the event, the recommendation put to the Board at the meeting was for a reduction of 100 basis points, to 6.0 per cent.

Throughout this period the Australian Government's Strategic Policy Budget Committee, comprised of the Prime Minister, the Deputy Prime Minister, the Treasurer and Finance Minister, were meeting regularly to discuss economic developments and develop
policy.

The Treasurer left for the US on the 8th of October to attend the IMF and World Bank Annual meetings. While events were moving rapidly it was thought important that the Treasurer obtain first-hand experience of the crisis in the US while remaining in daily contact with the Prime Minister and his colleagues back in Australia.

As the weekend of the 11th and 12th of October approached, it became clear that the Government needed to act proactively to cushion the Australian economy from the emerging global crisis.

On Sunday the 12th of October, the Australian Government announced it would guarantee all Australian bank deposits and, for a fee, the wholesale funding of Australia's banks.

This was the first time such actions had been taken in Australia's history.

While the Australian banking system was in good shape — as at mid-October 2008, Australia's four largest banking groups were among only 10 that were rated AA or higher by Standard & Poor's — the Government acted to ensure the stability of the Australian financial system and secure flows of credit to the economy. Because other governments had guaranteed the borrowings of their banks, Australian banks were being put at a competitive disadvantage despite being in better shape than were their international competitors. There were also emerging signs of fragility among Australia's second-tier or smaller banks.

These financial stability measures effectively involved the Government taking on risk to ease consumer and business concerns about the financial sector and more broadly economic conditions. In this highly volatile and risk-averse environment where there was the potential for disorderly and irrational behaviour, it was essential that governments calmed the situation by temporarily taking on private sector risk.

The second aspect of the Government's policy response was fiscal action and it is on this aspect of policy that I will focus the rest of my talk.

Two days after the financial stability measures were announced, the Government announced a $10.4 billion stimulus package, which for Australia is around 1 per cent of GDP. The package was comprised of $8.7 billion that would flow to pensioners and low-income families in the form of cash bonuses, $1.5 billion to support housing construction, and $187 million for new training places.

The Government and its advisers had been discussing possible fiscal policy responses for some time before the package was announced, and considerable thought had gone into its structure.

The fiscal package was directed at the economy's weak sectors, which at that time were consumption and housing. With housing and consumption representing over 60 per cent of the economy, it was thought important that these weak sectors were supported.

The package also followed the key tenets of good-quality discretionary fiscal policy in that it was timely, targeted and temporary.

The housing aspect of the stimulus package – a time-limited grant to first home buyers – took effect immediately. This was not the first time that grants to first home buyers had been used to stimulate the economy. A similar policy had been effective in bringing forward housing construction activity when the economy had slowed in the early 2000s.

Further, the Government was aware of significant pent-up demand for owner-occupied housing after a period of relatively high interest rates and strong migration. Hence, it knew that if this policy was withdrawn at the right time and in an appropriate way, it could bring forward activity without leading to a substantial collapse in activity when the policy was withdrawn.

The consumption aspects of the stimulus package were also designed to be quick acting, with significant cash bonuses paid to pensioners, carers and seniors, and low-income households within weeks of the announcement.

These are household groups that tend to have relatively high propensities to consume out of income. That is, they tend to spend more out of any additional income they receive than do other groups, thus maximising the economy-wide stimulus effects of the package.

This consumption component of the package had the added advantage of providing much-needed cash assistance to the less well off in the community.

In October, this first, as it was to become, stimulus package was considered by the Government a prudent response to the dramatic deterioration in global conditions, although the potential need for further stimulus down the track was fully appreciated.

Thus, to prepare for the possibility that the global financial crisis might be deeper and longer lasting than expected, the Government started planning to bring forward the commencement of large-scale infrastructure projects. A first tranche of these projects worth $4.7 billion was announced in early December.

There were other important developments in late 2008 worth noting.

Through November and December, interest rates were cut aggressively and the global response to the crisis intensified.

Prime Minister Kevin Rudd attended the first G-20 Leaders summit on the 15th of November and spoke of the potential for the financial crisis to affect the real economy and most importantly, unemployment.

Not long after the October stimulus package, the Australian Government had begun planning for the possibility that the unemployment rate might rise dramatically should the economy slow.

In the recessions of the early 1980s and 1990s, the unemployment rate rose quickly. After peaking at over 10 per cent, the unemployment rate took around 10 years to fall below 6 per cent after the 1990s recession and around 6 years after the 1980s recession [see Kennedy 2007 for a discussion of unemployment in Australia].

Given that the likelihood of recession was increasing, the Government wanted to be ready to respond with policies to support the work force that went beyond support for aggregate demand.

In late 2008, another important factor was working in Australia's favour and that was a depreciating Australian dollar.

The floating of the Australian dollar in 1983 has turned out to be one of the most important economic reforms in Australia's history. It has worked as an effective automatic stabiliser, curtailing demand in the good times and supporting in bad.

And it has been especially beneficial for the Australian economy because of the relative importance of mineral production. With the potential for commodity (mineral) prices to rise and fall dramatically, movements in the exchange rate have helped to buffer the effects of these price swings on the broader economy.

The global recession becomes worse than previously thought

Through December 2008 and January 2009, it became clear that global conditions were much worse than initially envisaged. By late January, it was also becoming clear that the global economy had experienced a very weak December quarter.

Something that wasn't clear in January was just how synchronised the global downturn would be. Around 75 per cent of countries are now expected to contract in 2009 – a remarkable outcome and one that has not been seen for over 50 years.

As has been noted by the IMF, financial crises and global recessions with high degrees of synchronisation are associated with long and deep recessions and weak recoveries