Finance Finance News Reforms could backfire as economy braces for deflation

Reforms could backfire as economy braces for deflation

During a liquidity trap, boosting the nation's productivity could make things worse. Photo: The New Daily
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Productivity-enhancing reforms could worsen the economic impacts of COVID-19 unless governments simultaneously increase public spending, a prominent economist has warned.

Prime Minister Scott Morrison has made it clear that the government plans to make reforms to support the eventual economic recovery.

He told reporters last week that his team were “looking at all options with fresh eyes” after Reserve Bank governor Philip Lowe urged policymakers to seek inspiration from previous reports on how to boost productivity.

But Outlook Economics director and former Treasury forecaster Peter Downes told The New Daily that economic reforms would have to be matched by a large amount of government spending to reduce the negative effects of deflation.

This is because reforms that increase productivity would boost overall economic output, or the “supply” of economic goods and services, at a time when demand has collapsed.

“There’s a conundrum involved in structural reforms which will be quite important next year as … we’re facing deflation through 2021,” Mr Downes said.

And that’s a problem for the economy, because with interest rates at their effective zero bound, if inflation falls and inflation expectations start to fall, we enter the upside-down world of a liquidity trap.”

A liquidity trap is when central banks can no longer stimulate economic growth by cutting interest rates.

It opens up when demand for goods and services is so weak that low interest rates are not enough to encourage more spending – and a string of weak economic data suggests Australia might fall into one.

ANZ bank spending data shows year-on-year growth in retail spending, which accounts for roughly 40 per cent of GDP, has slipped into negative territory, after panic-buying triggered a temporary record surge in sales.

CentreLink has processed a year’s worth of JobSeeker applications (formerly Newstart) in just three weeks, as businesses axed more than 780,000 positions.

And the Reserve Bank has said it expects Australians to work 20 per cent fewer hours and economic output to fall by 10 per cent in the June quarter, with the unemployment rate expected to hit at least 10 per cent.

“Normally, structural reforms that increase competition and productivity, which lower inflation, are a good thing for the economy, as they lower prices and increase real incomes,” Mr Downes said.

“But if you’re in a liquidity trap, and you’re increasing productivity and reducing prices, you just make the problem worse – so that’s the conundrum.”

The Australian Bureau of Statistic releases inflation data for the March quarter at 11.30am on Wednesday.

Economists expect a 0.3 per cent lift, but predict year-ended inflation in the June quarter to fall into negative territory (deflation) for the first time since the 1960s.

Deflation looms

Economists do not like deflation, which showed up on a nominal basis in the national accounts at the end of last year, as it increases debt burdens and discourages spending and investment.

The theory is that consumers and businesses will put off spending when they believe goods and services will become cheaper down the track, which then hastens deflation and encourages even more saving.

Mr Downes said the way out of the trap is for governments to announce “a very credible and concrete” program of future investments – such as large-scale infrastructure projects – that lifts confidence and boosts inflation expectations.

“That means households will be expecting their incomes to rise in future, so will start spending more now, and businesses would be expecting their output and sales to increase, so that would encourage them to increase investment now,” he said.

“So I think, from a macro point of view, the most important thing is for the government not to do it in a piecemeal way, but to work up a credible and concrete set of reforms and a program to implement over the next few years.

“You don’t have to do everything now, but if that shapes confidence, then that will be a big thing.

“And there are lots of small things you can do – there are lots of obvious things like replacing stamp duty with a [broad-based] land tax. There’s a whole agenda that’s been sitting there since Ken Henry raised his review.”

Workers warned of so-called ‘reforms’

Centre for Future Work director Jim Stanford agreed that governments will have to ramp up spending to support the economic recovery, arguing that policymakers must boost public sector employment and lead a comprehensive rebuilding of the economy.

But he said Australians should be sceptical about the idea that reforms put forward by the Coalition will boost productivity and improve living standards – with Australia last year recording negative productivity growth for the first time in history, despite the government’s decidedly pro-business agenda.

Dr Stanford said the term “reforms” had become a codeword for trickle-down economics – exemplified by business tax cuts and deregulation – that focus on redistributing Australia’s wealth to the top end of the town rather than growing the size of the pie for all Australians.

“These quote unquote reformers can always come up with an argument for why rich people need to be paid more to elicit their economic effort, but poor people should be paid less in order to elicit their work effort,” Dr Stanford said.

“It’s very hypocritical and it’s an absolute misuse of the very term reform to describe these things.

“A true reform agenda would talk about how government can promote more investment, more work, more innovation and more sustainability – and that’s going to require more government spending, more public investment, and more rules and regulations to push private-sector agents to treat workers, ideas and knowledge, and to treat the environment with more value.”

Dr Stanford said governments could boost productivity overnight by offering free childcare on a permanent basis, allowing more women to take on full-time work.

He said the policy would pay for itself by massively increasing Australia’s tax revenues.