The Reserve Bank of Australia is stabilising the economy

04 November 2020

In the wake of COVID-19’s massive economic impact, much of the recovery will have to come through structural economic reform, Warwick McKibbin writes.

Australia’s public health and economic policy responses to the COVID-19 pandemic are the envy of much of the world. The public health responses have been based on scientific evidence, and most Australians have accepted the tough decisions to make short term behavioural changes and the costs of lockdowns to enable the emergence of a recovering economy.

The fiscal and monetary packages that were quickly put in place played a critical role in stabilising a sharp economic contraction. Now that the public health crisis appears to be under control (although ever-present) there is still a great deal yet to be done to produce a sustainable economic recovery.

The initial policy responses had many dimensions and an even more comprehensive array of policies that will be needed to manage Australia’s economic recovery. The Reserve Bank of Australia (RBA) has played an essential role in stabilising the financial system, in managing low interest rates and in providing a term finance facility (TFF) for banks to cover the financing costs of lending.

The RBA reduced the policy rate from 0.25 per cent to 0.1 per cent, in addition to lowering the three-year bond target rate and the interest rate on the TFF to 0.1 per cent. The policy also included the additional purchase of $100 billion of five to 10-year government bonds.

The reduction in the policy rate alone might have been counterproductive in current circumstances. But in combination with the full set of announcements, it does everything the RBA could do. The RBA policy change alone does not provide anywhere near the stimulus to the economy that is needed.

It is essential insurance to stabilise the economy while implementing the real policy inventions that will be required to kick start the Australian economy. The most critical role of the RBA is to maintain the stability of the financial system. Volatility is to be expected due to possible resurgent spikes in COVID-19 in Australia but also in response to the global economic shocks caused by the COVID-19 pandemic.

As shown in McKibbin and Fernando (2020), the economic impact of COVID-19 on the Australian economy depends on the policy responses in Australia but also the public health responses and macroeconomic policies in the rest of the world.

Low interest rates enable stressed borrowers to remain liquid and low rates along the yield curve tends to weaken the Australian dollar, which provides some support through competitiveness for exports.

A fundamental dilemma still to be faced is how to continue to fund illiquid but solvent firms to aid their survival while insolvent firms exit the economy. A lesson from the long period of quantitative easing in Europe and Japan is the survival of zombie firms that continue to absorb valuable resources that otherwise would boost more productive firms.

Much of the burden of the economic recovery will be borne by fiscal policy and fundamental economic reforms. In the near term, it is essential to maintain demand through income policies and to prevent a financial crisis from emerging.

While the scale of the fiscal response in the recent Australian federal budget is appropriate to tackle the economic fallout from COVID-19, the composition of the package could have been better targeted. For example, income transfers would be a better way to stimulate the economy than tax cuts in the short term. And support for childcare would be a way of maintaining labour supply as well as an income support mechanism.

The specific lack of support for some sectors based on ideology rather than economic reality contributes to the poor targeting. Over time the key policies that are needed are substantial economic reform and other policies that increase productivity while maintaining domestic demand.

A vital part of the recovery plan should be policy clarity. The ideal economic policy framework implemented for a sustained recovery would be a bipartisan approach with broad support across the Government and the Opposition on the critical policy platforms. Bipartisan support for the core drivers of economic growth reduces policy uncertainty and gives a less uncertain environment for firms to invest and for households to save and invest.

A key driver of policy uncertainty is the state of play of climate and energy policy in Australia. While the Technology Investment Roadmap was a good outline of the available technologies that would enable Australia to reach a low emissions future, there’s nothing in the Roadmap that would drive adoption of technologies by the private sector.

The last thing needed in the current fiscal environment is for governments to add further pressure on the budget by paying for a technology transition. The adjustment to a low emissions future needs to be undertaken by firms and households in response to clear market signals. A well-designed carbon market can drive the adoption of existing technologies and innovation in new technologies.

The urgency of an energy transition in Australia has risen substantially with the announcements by China to reach zero net emissions by 2060 and by Japan and Korea to have zero net emissions by 2050. These announcements have important implications for Australia’s economy.

Chapter three of the recent October International Monetary Fund World Economic Outlook (which I co-authored) examines the mix of green infrastructure and other energy and climate strategies that can both stimulate the economy in the short term and provide economic growth in the medium to long term.

The key is how to transition from a fossil fuel-intensive economy but also a reliance on fossil fuel-intensive income through our exports to a dramatically different economy as the world transitions away from fossil fuels. Australia has a significant advantage in this space in the sense that new industries such as renewable energy, hydrogen and a range of other technologies have enormous potential within Australia.

One option that is consistent with the Technology Roadmap but focuses on fairness and economic efficiency is the Climate Asset and Liability Mechanism recently published by the Australian Academy of Social Sciences.

There has never been a better or more critical time to reopen the debate on how to create a world-leading framework for climate and energy policy in Australia. As with the COVID-19 response, this can be done well if based on science.

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