Among the many economic casualties of the COVID-19 crisis is the federal budget. A projected surplus for this financial year will now be a combined deficit during the year and next of well over $250 billion. It will be the biggest deficit in Australia’s peacetime history, including the Depression years. But out of adversity comes opportunity. In these entirely unorthodox times, the government has an opportunity to rethink the orthodoxy of hurriedly returning the budget to surplus. Otherwise, the slashing of spending and hikes in taxes will strangle any recovery and keep the economy in a deep, prolonged recession.
Indeed, the COVID-19 pandemic and lockdowns have changed pretty much everything. Before the crisis, Australian consumers were cutting back on spending while businesses outside the mining sector had little appetite for investing. Compounding the problem, Australian households are among the most heavily indebted in the world and the debt-laden business sector will emerge from the crisis with even more debt.
Any expectation that the federal and state governments will seek an early return to surplus would be more than enough to keep consumers and investors – responsible for three-quarters of GDP – not just in hibernation but in a cryogenic sleep.
At some stage, the government should signal it is contemplating a new approach for a new world. The budget to be brought down in August will formally acknowledge the expectation of large deficits over the four-year budget period. To finance those deficits the government has two broad choices: borrow or monetise the deficits by printing money.
Borrowing by issuing Treasury bonds to private investors is the orthodoxy. With global and domestic interest rates sitting at less than 1 per cent, and Australian government debt low by international standards, this looks feasible. But is it smart?
From the beginning of the crisis the Reserve Bank, by buying Treasury bonds from the secondary market, has been injecting more cash into the economy to help keep it alive. This is a form of quantitative easing, but with interest rates the target rather than a quantity of bond purchases. Wisely, the Reserve Bank has indicated it will continue its bond purchases as long as needed to maintain the yield on three-year bonds at no more than 0.25 per cent. So far, this has been working well.
As the Reserve Bank’s holdings of Treasury bonds continue to climb in the future, the question will arise: what will it do with all that debt on its books? It could sell the bonds back to the public or directly to Treasury, which issued them in the first place. Either way, the government would need to raise extra revenue to pay for them. If the future economy were sufficiently productive it could pay off this debt. That’s why a new productivity agenda is so important.
Another option is for the Reserve Bank to let its holdings of Treasury bonds sit on its books indefinitely and return the interest income to the government as dividend payments, thereby neutralising their cost. This is a way of monetising the deficits.
In the pre-COVID-19 world of secular stagnation, policy makers were hoping for more inflation, not less. But it would be unwise to let the inflation genie out of the bottle, totally unrestrained, to conjure up a new financial crisis. This is the possible fate of highly-indebted developing countries in the years after the crisis has passed.
Following the inflationary bouts of the 1970s and 1980s, central banks around the developed world were given independence from the government of the day – specifically to prevent politicians spending vast sums of money and expecting future generations, who didn’t elect them and can’t punish them, to pick up the tab.
If the Reserve Bank saw merit in holding Treasury bonds at a level consistent with its inflation and unemployment rate targets, the integrity of the system could be preserved. Investors wouldn’t lose confidence, just as they haven’t lost confidence in the Reserve Bank’s current unorthodox bond-buying program.
A variation of this approach, floated by former NSW Treasury Secretary, Percy Allan, is for the federal government to issue equity – shares – against public social infrastructure works such as schools and hospitals and request the Reserve Bank to buy them, retaining them in public ownership.
This could be done in combination with investments in productivity-raising infrastructure of the type recently recommended to the government by the Reserve Bank, that otherwise would have to be debt financed. The size of the program would need to be totally consistent with the Reserve Bank’s charter rather than a free-wheeling spend-a-thon.
This mechanism would boost money supply, just as will the existing quantitative easing program, but it is assumed that under the current program the Reserve Bank will sell its newly acquired bonds after the pandemic has passed. Any such quantitative tightening could undermine economic recovery.
Whatever the mechanisms, if we are to avoid a prolonged recession, policy makers and the Reserve Bank need to start thinking about how to fund the coming deficits.
Craig Emerson is CEO of Craig Emerson Economics, Distinguished Fellow at the ANU, Director of RMIT’s APEC Study Centre and Adjunct Professor at Victoria University’s College of Business.