How to Capitalize on Low Interest Rates

Warwick J. McKibbin
Warwick McKibbin
Warwick J. McKibbin Former expert - Economic Studies, Center on Regulation and Markets, Distinguished Professor of Economics & Public Policy - Crawford School of Public Policy, The Australian National University

December 27, 2012

The decision by the Labor government to jettison a surplus for the 2012-13 fiscal year is a good one. To continue with such a promise in the face of years of government overspending based on uncertain revenue outcomes would have been very damaging economically once the revenue shortfalls hit home.

However, the eventual losses from the economic management of the past decade will not be avoided by this decision. The damage will now be spread over many years rather than causing a sharp economic contraction in 2013.

The key debate in fiscal policy should be about the quality of spending and taxes and less about the size of the budget surplus or deficit. Both the spending and tax sides of the fiscal accounts need to be urgently reviewed for the economic benefits they bring rather than the votes they buy. Also, a transparent distinction in the government accounts should be made between current expenditure, including transfer payments, and capital expenditure.

Government spending can be productivity-enhancing or it can be wasted. Spending that does not generate an economic return but which is financed by debt can be very difficult to service. Taxes can destroy incentives, raise input costs and damage economic activity but they can also be used to change behavior in a way that society values. Well-designed infrastructure spending based on credible evaluation of expected rates of return can reduce input costs in a growing economy and acts like an increase in private sector productivity.

Good government is about risk management. Australia is facing a number of risks such as a declining terms of trade while undergoing enormous structural change. The problem is due not only to a strong exchange rate but also to a large rise in input costs relative to productivity. The cost of labor, energy and other costs such as inefficient environmental regulation are making Australia more uncompetitive. Working on addressing reducing input costs should be a key focus of policy.

Understanding the reason for the strong exchange rate today is also a potential source of advantage. The strong exchange rate today is partly due to the mining boom but it is increasingly due to a shift in global preferences towards Australian assets. Foreigners want to  have assets that reflect Australia’s still relative high rate of return, which is due to our factor endowments and our comparative advantage relative to Asia. Economic management that is better than other countries which are in crisis also makes Australia an attractive place to invest.

This major shift in global investor preferences is potentially an enormous opportunity but it is also volatile. How should Australia respond during 2013?

The first response should be to produce more assets that foreign investors want to hold. If the capital flowing into Australia pours into existing assets there will undoubtedly be a surge in the value of these assets and perhaps an eventual crash if that funding is not used to create more physically productive assets to back the financial assets.

A more direct option that reduces the risk of this volatility is for the government to create an explicit capital account in the government accounts and issue 50-year government debt on this account. If sold to foreigners at current world interest rates, the cost of servicing this debt is locked in at very low levels for a very long time. This would take pressure off other domestic asset values to minimize asset bubbles. It would also provide a large cheap source of funds that should then be used to undertake infrastructure projects with high rates of return. The assessment of these projects would need to be undertaken independently and with full transparency. The result would be a once in a generation opportunity to avoid another asset price boom and bust and a substantial expansion of the supply capacity of the economy to support private sector productivity.

The problem is how to constrain the political process from making the mistake of driving decisions by ideology rather than economic returns. The answer surely is to place more reliance on independent institutions such as the Productivity Commission.

Fortunately, unlike many other countries, Australia is not a basket case facing a fiscal crisis. It is a lucky country that has unfortunately wasted a significant amount of national wealth on ideological exercises that did not (and possibly will not) give the rates of return that were imagined by decision makers who rolled the dice and believed in the wrong forecast. It would be a mistake to rule out what is good policy for the problems that Australia faces today because these policies were badly implemented in the past.

It is better to react now to the opportunity of cheap global finance and the benefits to avoiding excessive asset price rises over 2013, rather than waiting and regretfully looking backwards over the decade that might have been.