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Fiscal Response to the Global Financial Crisis of 2008-09

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Fiscal Response to the Global Financial Crisis of 2008-09 Fiscal response to the Global Financial Crisis of 2008-09 Ken Henry AC Date created: February 2020 This paper explores several topics relevant to the extraordinary measures implemented by the Australian Government in response to the global financial crisis of 2008 and 2009 (GFC). The fiscal policy challenge is analysed, against the backdrop of the twenty-year evolution in thinking and practice that preceded it. The effectiveness of individual responses is evaluated. Institutional challenges are discussed. The paper concludes with some reflections on what fiscal agencies might do to be prepared better for future crises. Table of Contents 1. The proper role of fiscal policy ................................................................................ 1 A history of ‘activist’ fiscal policy ......................................................................................... 1 Textbook arguments against fiscal activism ........................................................................ 1 Political economy challenges to the timely use of fiscal policy ............................................ 2 The ‘twin-deficits’ and fiscal responsibility ........................................................................... 2 A medium-term fiscal strategy ............................................................................................. 2 A decade of ‘consenting adults’ ........................................................................................... 3 2. Lessons from earlier case studies ............................................................................ 4 Lessons from the recession of the early 1990s ..................................................................... 4 Lessons from the Asian Financial Crisis ................................................................................ 5 Lessons from the fiscal stimulus following commencement of the GST ............................... 5 Lessons from the collapse of HIH and the response to 9/11 ................................................ 5 3. War games ............................................................................................................. 6 4. Fiscal policy in Australia in the few years preceding the GFC .................................... 6 5. Systemic issues connected with banking sector liabilities......................................... 8 6. Unusual developments in the global financial system in 2007 and 2008 and Australia’s reaction .......................................................................................................... 9 Northern Rock....................................................................................................................... 9 29 February 2008 ................................................................................................................. 9 Bear Stearns ....................................................................................................................... 10 Spring 2008 IMF meetings .................................................................................................. 10 The Strategic Priorities and Budget Committee (SPBC) of Cabinet .................................... 12 7. How the collapse of Lehman Brothers and the bailout of AIG changed Treasury’s world 13 8. International reaction ........................................................................................... 13 G7 and IMF ......................................................................................................................... 13 G20 ..................................................................................................................................... 15 Early unilateral action ........................................................................................................ 15 9. Initial Australian action to supplement monetary loosening .................................. 17 10. Weekend of 11, 12 October 2008 .......................................................................... 19 The case for action ............................................................................................................. 19 Bank guarantees ................................................................................................................ 20 Reaction to the guarantees ................................................................................................ 20 The first fiscal stimulus package ........................................................................................ 21 Reaction to the first fiscal stimulus .................................................................................... 22 11. Daily monitoring ................................................................................................... 24 12. Second fiscal stimulus package ............................................................................. 27 13. Deteriorating international conditions .................................................................. 27 14. Third fiscal stimulus package ................................................................................ 27 Structure of the package .................................................................................................... 27 Reaction to the second and third stimulus packages ......................................................... 28 15. Assessment of economic impact ........................................................................... 29 Did the fiscal stimulus packages work? .............................................................................. 29 Was the external environment helpful? ............................................................................. 31 Did monetary policy help? .................................................................................................. 32 The importance of flexible labour markets ........................................................................ 32 The role played by other market interventions .................................................................. 32 Myths that can be exposed ................................................................................................ 33 (Myth i) China and the mining industry saved Australia from recession ...................... 33 (Myth ii) Australia’s early response damaged confidence ............................................ 34 (Myth iii) ‘Rorts’ damaged macroeconomic effectiveness ............................................ 34 (Myth iv) The fiscal stimulus is responsible for the growth in government debt .......... 34 16. What have we learned about fiscal policy? ............................................................ 35 17. Other lessons for the future .................................................................................. 37 Investment in economic literacy and developing a credible narrative ............................... 37 Institutional capability ........................................................................................................ 37 Confidence .......................................................................................................................... 39 Design issues ...................................................................................................................... 39 Institutional and other challenges ...................................................................................... 40 How to be better prepared next time ................................................................................. 41 18. POSTSCRIPT CONCERNING COVID-19 ............................................................................. 41 19. Tables and charts referenced in text ..................................................................... 44 20. Attachment A: Case studies .................................................................................. 51 The recession of the early 1990s ........................................................................................ 51 The Asian Financial Crisis.................................................................................................... 54 Fiscal policy challenges associated with the turn-of-the-century tax reform package ...... 55 Other unusual incidents ...................................................................................................... 58 21. Attachment B: Labour utilization........................................................................... 59 22. References ........................................................................................................... 62 1. THE PROPER ROLE OF FISCAL POLICY For most of the second half of the 20th century, Western governments considered themselves responsible for using fiscal policy to support macroeconomic stability. Yet by the end of the century most economists considered that, for the most part, macroeconomic stability could be achieved by an inflation-targeting regime implemented by a credible central bank with operational independence from the government. Monetary policy was king. The use of fiscal policy to achieve short- term macroeconomic stability had been consigned to history. A history of ‘activist’ fiscal policy Australian governments were enthusiastic fiscal activists during the last few decades of the 20th century, pursuing multiple macroeconomic objectives. Government statements announcing expansionary fiscal measures were common in the mid- 1970s, early 1980s and early 1990s.
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