Commodity Talk: Policy Prozac

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Global financial markets have focused attention on policy makers’ Herculean measures to meet the financial crisis head on. Taxes have been cut, government spending has been raised and interest rates have been slashed — to near zero levels in many cases. What is the effect of these actions? Each plays a role. Tax cuts have, on current evidence, tended to be saved. This is necessarily a bad thing. For example, a consumer wishes to save RM1,000. It is economically better that the consumer is given a RM1,000 tax cut and told to save that amount, compared to cutting their consumption by RM1,000 to meet their desired level of saving. Government spending offsets the fact that the private sector is demanding less. There has been some weakening in consumption and a decline in investment spending. In particular, government spending helps to mitigate the negative impacts of unemployment. The damage of rising unemployment is (in a broad economic sense) less from the impact of those who actually lose their jobs. While it is distressing to the individuals concerned, the economic damage is more likely to come from shifts in the behaviour of those that remain in employment. If those with jobs fear that they may lose them, they will cut back on spending and increase “precautionary saving”. The rise in precautionary saving will do more damage to the economy than the reduction in income of those who have lost their jobs. Government spending supports demand and limits the fear of unemployment.Reducing interest rates will not boost growth via credit if banks remain reluctant to lend. However, reducing interest rates helps those people who already have debt. A rate cut reduces the income of savers, but will increase the disposable income of borrowers. The average UK household, for instance, has already received around £100 (RM525) per month through lower mortgage costs (as the Bank of England has reduced interest rates). This means that for those people who already have debt and are under most pressure to reduce their debt, they are receiving an increase in their income with which to achieve that goal. It would be wrong to call these policies “stimulus”,  however much politicians like the term.  Policy is providing the world economy with an anti-depressant. This is policy Prozac for a world that is decidedly dispirited. None of these measures will raise growth significantly: the tax cuts (that are saved); the government spending (which offsets weaker private sector spending); the interest rate cuts that transfer money from savers to borrowers (rather than stimulating borrowing). All these effects are mitigating the downturn.And this is good news for Malaysia. Indebted households and firms will get some relief from the reduction in Bank Negara Malaysia’s overnight policy rate to 2% at present from 3.5% in November. Moreover, the government’s RM7 billion November stimulus package should be augmented by a second package on March 10. And even if these moves are not the most significant stimulus steps in Malaysia’s history, Malaysia as a small open economy, will also benefit from the more momentous moves undertaken elsewhere. We should be grateful that these policy measures are coming through. In terms of a fiscal and monetary policy response, the largest economic crisis in 30 years is being met with the largest policy response in 40, or maybe, even 60 years. But the response so far is simply limiting how bad things get — and perhaps shortening the time it takes to heal. For policy to actively raise growth, we may have to wait another two or three years. Paul Donovon is deputy head of global economics at UBS Investment Bank  This article appeared in The Edge Malaysia, Issue 745, March 9-15, 2009