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Win the war but lose the peace?

1 April 2020

John Curtin has a message for a government grappling with a crisis

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What happens next? Prime minister Scott Morrison (right) and treasurer Josh Frydenberg speaking to the media at Parliament House last month. Lukas Coch/AAP Image

What happens next? Prime minister Scott Morrison (right) and treasurer Josh Frydenberg speaking to the media at Parliament House last month. Lukas Coch/AAP Image


He was often drunk and, as a backbencher, peripheral to the arguments raging in Australia, yet John Curtin possessed an understanding of the Great Depression, its causes and cures, unusual for his time. He saw that it was caused by lack of demand, and he knew that cutting wages and government spending wouldn’t remedy that. He recognised the credit tightening evident in the money supply numbers. He wanted a cheaper Australian pound and thought it should float rather than be fixed against Britain’s. He wanted governments to spend, and he thought the central bank, the Commonwealth Bank in those days, should supply government with the money to do so. He wanted the money supply expanded to fund credit.

Curtin wanted exactly what the Reserve Bank of Australia and the Morrison government are now doing in response to the coronavirus pandemic. He was way ahead of his time. Only Ted Theodore, the first Scullin government treasurer, shared his understanding of the Depression, but he had been forced from office by a mining scandal at the critical time. Neither Scullin’s Labor government nor the opposition-controlled Senate would accept Curtin’s views, though a devaluation could hardly be resisted, and budget deficits proved hard to contain.

After nearly a century Curtin’s views have become orthodoxy, but we have yet to acknowledge one element of his thinking. During the Great Depression he frequently made the point that conservative governments (which in his mind included the Scullin government) refused to adopt during peacetime slumps the policies they readily adopted in war. They would spend on armies and weapons, and borrow to do so, but not on dams, roads and bridges during slumps. As leader of the opposition from late 1935 he continued making the same point. It was remarkable, he told the House, how the Lyons and Menzies governments, stern upholders of financial orthodoxy, were spending vast amounts on armaments as war with Germany approached and cheerfully running up debt to do so.

It was this insight, widely shared, that informed the full employment white paper and postwar planning during Curtin’s wartime prime ministership. It was the same elsewhere. Clement Atlee’s postwar Labour government in Britain; the Marshall Plan under US president Harry Truman and the national highways program under his successor Dwight Eisenhower; the vast state-driven national reconstruction programs in France, Germany and Japan — all these maintained the wartime mobilisation of resources into the subsequent peace. As a result, the world averted the kind of global slump that had followed the end of the Great War.


The contrast Curtin pointed to back then is analogous to the policy choice Australia will soon face. Prepared to spend stupendously vast sums on what it perceives to be a “war” on the virus, will the Morrison government maintain an expansionary policy in the more normal but fragile economic circumstances to follow? Prepared to buy any quantity of government bonds necessary to maintain his declared 0.25 per cent interest rate ceiling on three-year government bonds, will RBA governor Philip Lowe be willing to keep buying when his bond holdings are many multiples of what they were a month ago and the nation is back at work? Both the Morrison government and the central bank have responded well to the demands of a global pandemic. Having done what they have done, in what circumstances and with what speed will they set about undoing it?

Australia is likely to come out of this crisis before the end of the year. Asian economies were first into the pandemic, and will be first out, and East Asia is the market for three-quarters of Australian goods exports. Iron ore and coal prices have held up surprisingly well. Locally, travel, tourism, accommodation, restaurants, entertainment and sports, and discretionary retail have all been devastated. Even so, large parts of mining, manufacturing, construction, the whole healthcare sector, electricity, water and gas utilities, land and sea transportation, most of the public service, much of the finance industry and professional services, and most of the media have all in one way or another continued to work. When the number of new infections turns convincingly towards very small numbers, the Commonwealth and the states will presumably encourage a staged reopening of those parts of the economy now shuttered.

That is when the policy choices will become more conflicted.

The federal government’s deficit will be a tenth of GDP or more — the biggest deficit in modern times, and more than twice as big (as a share of GDP) as the biggest of treasurer Wayne Swan’s deficits when Australia was successfully riding out the global financial crisis. Government gross debt, today equal to two-thirds of Australian GDP, will be over four-fifths and still rising.

Much of the government’s additional spending will fall away as the economy returns to normal. But revenue will be well down (as will GDP) and spending will remain elevated by lingering higher unemployment and healthcare costs.

The economy will be fragile. Households and businesses will become more indebted during the crisis, and probably considerably longer. They will emerge cautious and intent on rebuilding savings and controlling debt. After an initial bounce, household consumption is likely to slow. Business investment plans may well be even more modest than before the crisis began. With increased debt, households and business will be extremely sensitive to interest rates.

In this new world the RBA will be dealing with two difficult issues.

One is the future of its new ceiling on bond rates. Private market interest in buying Australian bonds may be only modest while the RBA has capped their yields. Because the price of a bond and its yield move inversely, investors will reckon there is every chance of a bond losing value when the RBA eventually stops supporting the ceiling. Without strong private buying, the RBA itself will have to buy sufficient bonds to maintain the ceiling, building a balance sheet several times the current size.

In just the week or so after Lowe announced the yield cap on 19 March, the RBA’s holdings of Australian dollar investments, mainly Australian government bonds, doubled to $157 billion — the highest total by far in the twenty-six years of the statistical series. Although some of that reflects operations to calm an agitated bond market, this is the beginning of what will probably be a prolonged increase in its bond holdings. To finance its immediate deficit, the Australian government will need to issue at least another $300 billion in bonds. The RBA may well find itself with half of them, and perhaps more — after all, that is a large part of the point and purpose of capping bond yields.

What is not actually a problem for the government and the RBA is the much-lamented problem of financing the government’s vast spending increase. Much of it can and will be resolved by a couple of keystrokes and a bit of creative accounting. What is really happening at the moment is that the RBA is creating money to give to the government in exchange for bonds, not directly but via the secondary market in bonds. The government will pay interest on the bonds, most of which the RBA will then give back to the government as part of the profit it pays to its owner, the Commonwealth. To the extent that the government’s spending is financed by this roundabout money creation by the RBA, it is free. There will be no bill to pay, ever.

If an inflation problem arises with the unexpectedly large increase in the money supply at a time of reduced output, the RBA could and would sell some of its bond inventory to the public, and allow interest rates to rise. Rising inflation, however, is not the immediate risk.

The real problem arises because the RBA can’t buy government bonds forever, and therefore can’t sustain a bond rate ceiling forever. When it withdraws the ceiling, bond rates will probably rise. It is certainly not beyond the wit of RBA officials to figure out the least damaging way of exiting the commitment, but whichever route they choose is sure to be unpleasant — witness the US Federal Reserve’s late-2017 attempt to sell down its bond inventory, reversed a year or so later.

As for the RBA’s cash rate, the one that determines the rate on most home mortgages and most business loans from banks, it is now as low as it will go. With markedly higher household and corporate debt the economy will be very sensitive to the smallest increase, or even the suggestion of one. Lowe has said the cash rate will remain at the current level until such time as inflation is back in the target band and unemployment is on the way down. That is probably some years away. Until such time, the RBA will be on the policy sidelines, its monthly meetings of diminishing interest. It has a useful role to play in smoothing or avoiding credit crises, but the next big monetary policy challenge will be to judge when the low cash rate can safely be increased.

The treasurer and Treasury have a similar but even bigger problem of exiting their crisis strategy. Unless the epidemic is prolonged, much of the additional spending announced over the past few weeks will fall away before the end of the year. The budget deficit will shrink rapidly, but not to pre-crisis levels. Tax revenues will be well down, spending on unemployment benefits, healthcare and interest servicing well up. The central bank will have no additional capacity to offset a fiscal tightening, as it did from 2011. Household consumption and business investment will be weak. If the Morrison government is sensible — if it continues to respect Treasury advice — it will allow a much bigger budget deficit to run a lot longer than it would have accepted before February of this year.

With extremely low interest rates likely to prevail for years, superannuation funds and other investors will find themselves in a similar position to three months ago, but more so. The returns on cash will be minuscule. So, too, the returns on bonds — with a serious risk of taking a capital loss on bonds when the RBA withdraws its rate ceiling, as one day it must. Investors must therefore pile back into shares. Super funds, looking to long-term retirement funds for their members, will be driven even more into shares, infrastructure and other illiquid investments.


The issue that then arises is whether running a large deficit and very low interest rates will be enough to get the economy on to a path of firm growth. Having busted all the orthodoxies about central bank deficit financing and vast government spending initiatives, will the Morrison government soon feel a little ashamed of itself, and want to return to respectability? Prepared to win the war, will it lose the peace?

Even before the epidemic, the Australian economy was merely drifting along. Business investment was flat, productivity growth barely apparent. We had experienced the slowest ten-year growth of real per capita incomes for more than half a century. Output growth was less than 3 per cent, and unemployment more than 5 per cent. Output will likely fall in the second and perhaps the third quarters of this year, and unemployment will rise. We will certainly come out of this downturn, but with an economy weaker than it was last year. It will need considerable support, especially for investment and productivity growth. The RBA will have done everything it can. It will be up to the Morrison government and its advisers to continue the fiscal revolution they have so splendidly begun. •

A NOTE ABOUT SUPERANNUATION

As an independent director on the board of the construction industry superannuation fund, Cbus, I might be thought to have a biased view of the government’s offer of time-limited tax-free access to up to $20,000 of superannuation savings to a very wide range of claimants. But my duty as a trustee is to the best interests of our members, and I have no doubt the announced policy is not in their best interests. This is the one policy among those announced that seems to me very poorly designed. In effect, the government is asking people to supplement their income out of their own savings, otherwise preserved for retirement. The time limit obliges superannuation fund members to withdraw cash precisely when their balances have sharply dropped. It will force many superannuation funds to sell shares into a falling market to finance the cash payouts at a time when they would be looking to buy shares at bargain prices. All their members are disadvantaged by this sudden cash demand.

A far better result could have been achieved by giving qualified contributors tax-free access to $20,000 of their retirement balance, but with no time limit. The money would then have been available if and when needed, but would otherwise remain within the fund earning returns for the member. It would be a savings back-up, which a very much smaller proportion of people would likely tap.

Senator Jane Hume, the relevant minister, has declared that though there was no warning or discussion, superannuation funds ought to have been prepared for this. That is another way of saying they must be prepared for it to happen again. If funds are obliged to provide for the contingency that every now and then governments will offer tax-free access to fund members’ retirement balance, the funds must redesign their portfolios to have more cash and fewer illiquid investments, like infrastructure, that governments usually encourage them to buy. The result must be lower returns, and a poorer retirement. It would be a different system, but not in a good way.

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