Government stimulus: Will Cullen be able to save the day?

There has been a lot of discussion around the internet about whether and what type of fiscal stimulus is appropriate in the US. That is not the issue I am going to discuss here. This is a New Zealand blog, and as a result, I’m more interested in the claim that Michael Cullen will be able to intervene in the economy to save us from any impending doom.

I’m not entirely convinced that Dr Cullen will be able to save us in the case of an imminent economic collapse, and here is why:

Firstly it is an issue of timing. As a conservative spender Dr Cullen will only intervene when he sees that the economy has hit the ropes. As current economic data is for a few months earlier, this will be too late. Furthermore, the effect of fiscal policy takes time to diffuse through the economy (see multiplier), implying that the true stimulatory impact of fiscal policy is likely to appear once the recession is finished.

Secondly, a fiscal injection may not provide the stimulus we expect. If there is an increase in government spending, or a cut in taxes that the public believes is only temporary, then the public may save the tax cut/increase in funds in order to smooth consumption between now and the future. The usefulness of a temporary tax cut/spending increase depends on how the banks are functioning – primarily how liquidity constrained are households.

Something else that is related to ‘Ricardian equivalance’ is the effect of a tax cut in general. I will go into more detail on this another time, but it is possible that, since people believe they will be getting a significant tax cut soon, they will have already spent it. If this is the case, even a permanent tax cut may not stimulate economic activity! (Update:  I found this interesting survey)

If we don’t actually have, or look like having a recession, then I have another issue with this announcement. This type of announcement gives Dr Cullen scope to spend a whole lot of money, stating that it won’t have inflationary repercussions (as a recession ‘is coming’) – notice that he is already doing this with the announced tax cuts. Currently the New Zealand economy looks incredibly robust, implying that this sort of justification for spending/tax cuts is relatively uncalled for – unless you truly believe the downside risks from a recession outweigh any inflationary concerns.

Can anyone add some more good or bad features of a fiscal stimulus in New Zealand in the comments?

  • CPW

    From what I’ve read (about the US position) the suggestion is often made that a fiscal stimulus (in the most pure form, sending everyone a cheque) normally impacts the economy more quickly than monetary policy (assuming simultaneous delivery). This might be all the more true in NZ with the predominance of fixed mortgage rates.

    And then there’s the attractiveness of fiscal intervention if you’re concerned about a liquidity trap/ zero interest rate bound.

    But generally I agree with you, I’m not a fan of using fiscal policy to fine-tune economic growth unless its a dire emergency. I don’t even think the US is necessarily in that situation yet (it’s only the fact that the problems originated in the credit markets, and thus monetary policy might prove ineffective, that might convince me otherwise)

  • Hi Chris, great points, a few extra points I thought of were:

    It’s bad if it takes longer to get a fiscal package through government than to cut interest rates (something more akin to the US government than the US government). Also because according to real business cycle theory a recession is the equilibrium reaction to an external shock – any stimulus will be inefficient.

    It’s good because you can target areas of the economy that are struggling/spend in areas that provide the highest multiplier. Also the announcement is good by itself as it helps consumer confidence, which should by itself help stimulate domestic demand.

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