COVID-19

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Australia must have a new macroeconomic framework

04 February 2021

The pandemic is an opportunity to rethink how the government co-ordinates monetary, fiscal, and climate policy and prepare Australia for the future, Warwick McKibbin writes.

The outbreak of the COVID-19 pandemic has been a significant shock to the global economy. There will be ongoing significant structural change and macroeconomic stress in all countries due to the pandemic. In addition to these disruptions, the primary greenhouse gas-emitting countries will be undertaking significant global action on climate change.

The pandemic was an unexpected shock. Climate change and climate policy are known shocks that can have an even more substantial impact on economic structures and macroeconomic stability.

The new commitments by the group of seven to target greenhouse gas emissions reductions to be net zero by 2050 and China’s commitment to zero net emissions by 2060 have particular significance for the Australian economy.

It matters far less to Australia what Canberra and state governments do on climate and energy policy. What is far more important is the impact of climate shocks and global climate policy changes. The macroeconomic adjustments and structural changes across all economies will significantly affect the Australian economy over the coming decades.

At the macro level, there are now three major policy issues that need a rethink. The original frameworks for monetary policy, fiscal policy, and climate policy need to be reconsidered urgently – not individually but as a coherent approach, with all three policies working together to achieve the best possible macroeconomic outcomes for this country.

While there have already been calls for each framework individually to be reassessed, it is crucial to have an overarching context to design the macroeconomic frameworks as we advance from the pandemic shock.

For example, there needs to be continual fiscal support as the COVID-19 pandemic keeps on affecting the global and Australian economies. Fiscal retrenchment would be a significant mistake under present conditions.

Australia’s success in reducing the economic impacts of COVID-19 is more than offset by the dangerous state of the world economy.

The pandemic is far from under control, with many countries still facing the prospect of severe economic crises. Substantial fiscal support will need to continue.

The nature of that financial support is critical from an economic perspective. Fiscal policy needs to be consistent with the objectives of climate policy and be supported by monetary policy.

For example, there is a significant body of evidence, summarised by the International Monetary Fund’s October 2020 World Economic Outlook, that substantial gains from government investments in green technologies and green infrastructure are possible.

Thus, fiscal policy can stimulate the demand side of the economy in the short run and support the structural changes and growth prospects that will coincide with the restructuring of global energy systems and structural change to deal with climate change.

Another example is monetary policy. Monetary frameworks in most countries were designed during a period of high inflation. However, inflation is no longer the main problem facing the world economy.

Today’s goal should be to ensure that nominal growth in the economy is sufficient to support the debt that has been generated by the pandemic. It is also important not to reduce the substantial private and public investments needed in a changing world because of climate change and climate change policies.

In the Australian context, the Reserve Bank of Australia should as such be targeting nominal expenditure in the economy at a level sufficient to stabilise government debt.

It would be counterproductive in the face of climate policy, which may cause a temporary spike in inflation due to changes in relative prices of energy, for a central bank to increase interest rates to tackle inflation.

The last thing needed when there is excessive government debt in the economy is for a central bank to start to target inflation at the risk of reducing real output growth. A thoughtful approach to the current state of the economy requires co-ordination of fiscal, monetary, and climate policies.

There is also a vital role in the climate policy framework to support fiscal policy and monetary policy. McKibbin, Wilcoxen, Morris and Panton discuss this at length in the special issue on Rethinking Macro in the Oxford Review of Economic Policy.

Climate policy needs to be designed to manage the uncertainty faced with a significant restructuring of the domestic economy and a restructuring of the global economy while moving away from dependence on fossil fuels.

A recent study by the Academy of Social Sciences in Australia, Efficient, Effective and Fair Climate Policy, outlines an approach called the climate asset and liability mechanism.

This climate framework is designed to support the monetary and fiscal adjustment expected over the coming decades, while directly addressing climate change.

Now is the time for government and opposition to embrace a fundamental rethink of how to co-ordinate the monetary, fiscal and climate frameworks that prepare Australia for the post-COVID-19 world.

This piece was first published in the Australian Financial Review.

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