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Why the stimulus was bad policy

January 19, 2010

There is a general perception that the economic stimulus package was good public policy and saved the Australian economy from recession. It wasn’t, and it didn’t.

Most of the economic commentary in Australia has been fairly simplistic. The standard story goes that the economy was heading for recession, so the government spent lots of money, and that made the economy stronger so we avoided recession. This is the line repeated by the Rudd government and some of the media.

But this story is wrong on several levels.

First, in any meaningful sense Australia did go into recession, and by some accounts we still are in recession. The government is quite right to claim that total GDP growth has remained mostly positive: for the last five quarters it has been +0.1%, -0.9%, +0.5%, +0.6%, +0.2%, with a total of +0.5%. However, the more useful measure of wellbeing is GDP per person, and that measures has been mostly negative: for the last five quarters it has been -0.4%, -1.4%, 0%, 0%, -0.4% with a total of -2.2%.

In short, since the GFC started Australians have become on average 2.2% poorer.

Of course, the Rudd government is not responsible for this recession (which was caused overseas) and the Australian economy has done relatively better than most other economies (mostly because of our strong banking system)… but it’s still worth getting the facts right.

The more important point is that the stimulus package has done little to improve the economy and has come at a huge cost. It is true, as the ALP says, that government spending and handouts added to GDP. But that is only half the story. We must ask the follow-up question “where does the money come from”?

The answer is that the money has been borrowed, and a large part has been borrowed overseas. Open-economy macro-economics teaches us that when the government borrows money from overseas, this must lead to a matching drop in net exports. This is not idle speculation, but an accounting identity. In economic jargon, the rule is that the current account deficit (trade in goods & services) must equal the capital account surplus (international financial transfers).

Several economists, including Australia’s leading open-economy macro-economist Professor Tony Makin, have been making this point for over a year, but so far the government has failed to respond. They are not responding because they cannot respond. Either they must deny a basic economic fact, or admit that the stimulus directly hurts exporters and people who compete with imports.

By keeping quiet on this issue it may seem like the Rudd government is trying to deceive the Australian public. There is another, more worrying, explaination. It is quite possible that the Rudd government doesn’t understand open-economy macro-economics, and that they honestly don’t know that their policies are destroying jobs in the traded sector. We know that Kevin Rudd cares about foreign policy issues, but so far there has been little evidence that Rudd either cares about or understands economic policy.

Sadly, late last year we started to feel some of the negative consequences of the stimulus package. Exports went down by 2.3% and imports rose by 5.8% in the September quarter. The impact of net exports on GDP growth was -1.6% and this was the main reason why GDP/person went down in that quarter. It is quite possible that the stimulus package caused the economy to go backwards in September and rather than saving us from recession, the Rudd government is keeping us in recession for longer than necessary.

So some people gain from the stimulus, while other people lose. The net impact is likely to be close to zero. This is consistent with the international and historical data which overwhelmingly shows that expansionary fiscal policy (ie stimulus packages) don’t work.

But unfortunately, this failed policy has come at a very high cost. The borrowed money must be repaid, with interest, and this will be paid for by higher taxes. In turn, these higher taxes will lead to lower productivity growth and relatively lower incomes. So future generations will have lower incomes and higher taxes to pay for a policy that provided nearly no benefit. As Robson and Ergas have shown, the stimulus fails a benefit-cost analysis even under a range of overly-optimistic assumptions.

The only benefit from the stimulus was political — allowing Rudd to look like he was “doing something”. That may get him some support in the short-term, but once people start to see that Rudd doesn’t understand the economy and once they start to feel the long-term pain, the tide may change.

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