Money Out the Door: Australia in the Shadow of Keynes

Around the time of the Whitlam government (I can’t remember the exact year), I was part of a large audience for Harry G. Johnson at the National Press Club. Johnson was a distinguished economist and a big bear of a man. He projected reassuring Presbyterian gravitas, befitting his Canadian nationality. He talked about biases in economic research. We are members of a profession that derives much of its income from the government, he said. As such, we face a standing temptation to bear false witness on the merits of government spending proposals. The Canberra audience was sullen and restive. Behind me sat Dr Peter Wilenski, surrounded by a sizeable entourage. At that time, he would have been either Principal Private Secretary to Gough Whitlam or the new Professor of Social Justice at the Australian National University. To the evident approval of his acolytes, Wilenski heckled Johnson, rudely and continuously, all the while keeping his voice just low enough to avoid a reprimand by the chair of the gathering. (His political street smarts had been honed on the Students’ Representative Council at the University of Sydney.) Johnson soldiered on. Opposing “money out the door” wasn’t meant to be easy.

Johnson was educated by leaders of the field, including Keynes and Schumpeter. He achieved a remarkable command of the leading schools of economic thought. Initially a Keynesian, he became an eloquent critic. Johnson said in articles and a book that Keynes had cast a “shadow” over macroeconomics. Keynes had over-generalised the exceptional circumstances of the Great Depression. He undermined the objective of putting big-picture economics on a more scientific footing, while purporting to promote that objective. Alas, we’ve ignored Johnson’s warning and remain in thrall to Keynes. As we struggle to mop up after the latest excesses of money out the door—our unsubtle response to both the Global Financial Crisis and Covid—it’s time to heed Johnson.

The story of John Maynard Keynes has often been told. He was the oldest child in an upwardly mobile Nonconformist family. After winning a scholarship to Eton College, and a first in mathematics from Cambridge, he went on to receive instruction in economics from Alfred Marshall, an old family friend and one of the Cambridge greats. Marshall showed how the analytical tools of supply and demand could put economics on a more scientific footing. Keynes was initially a conventional Marshallian, bringing to economics his diverse experiences in Whitehall and the City. He proved to be a gifted writer and speaker. In the aftermath of the First World War, Keynes emerged as a leading public intellectual. The UK was grappling with hefty war debts and an increasingly militant labour movement. The year 1929 saw a worldwide stock market crash. There were runs on banks and some went bust. During the early 1930s the UK unemployment rate was around 20 per cent of the labour force. Keynes was a part-time lecturer at Cambridge and took his mentoring duties seriously. The nation’s intellectual elite-in-waiting was turning sharply left. It liked the look of what was happening in the Soviet Union.

Keynes was conflicted. Part of him wanted to follow the Middle Way: “How could I bring myself to be a Conservative? They offer me neither food nor drink—neither intellectual nor spiritual consolation. I should not be amused or excited or edified.” On the other hand, “the Labour Party will always be flanked by the Party of Catastrophe—Jacobins, Communists, Bolshevists”. For a graduate of elite Anglican institutions, and as a lifelong insider, the Middle Way was the natural path. At the same time, as a journalist—an extraordinarily successful one, though a part-timer—Keynes was attracted to rising forces and repelled by declining forces. Journalism has always been like that. The Left was on the rise, so it was time to break left. He acknowledged something like this in a private note on Albert Einstein and interwar German politics:

The Left is for twisting and turning and lying, and for accommodation with International Finance and Red Russians and everything. The Right is only Capitalist because it is Conservative. No doubt it would be impossible to herd with the bulls and pigs of the Right and one would have to fly with the insects.

Britain’s distinctive national skill is politics. It has the knack of empowering Middle Way types able to unite the country in times of trouble. Keynes’s new blueprint for big-picture economics was eagerly awaited around the world. In 1936 he finished The General Theory of Employment, Interest and Money. Proof copies were rushed out to Australia and other imperial outposts.

The title of Keynes’s magnum opus hints at a major scientific breakthrough. It references Einstein’s general theory of relativity, which had recently superseded and encompassed the century-old laws of Isaac Newton. The book itself provided ammunition for those wanting more government spending, especially investment spending. A $1 rise in government spending would typically raise GDP by more than $1, for some indefinite period (possibly quite long). If the government spends money on a contractor to build public housing, for example, that contractor will spend too, thereby generating further income and work for others. This virtuous circle was reminiscent of the wonderful New Testament parable of the loaves and fishes. It promised to liberate economics from its historical role of the “dismal science”.

By contrast, monetary expansion, in the form of purchases of government bonds by the central bank, could be ineffective in an economy that was stuck in a so-called “liquidity trap”. During a depression, expansionary monetary policy was like pushing on a string, albeit equally innocuous. It would not lower interest rates. So far as national economic management was concerned, then, the times called for Treasury to step up. That unpopular institution could lead the nation back to full employment.

Keynes’s fiscal and monetary calls played into the politics of the 1930s. There was a clamour for more public housing, to clear slums and provide jobs. The Bank of England had resisted further loosening of monetary policy, and fiscal expansion looked like a promising way to get around its obduracy. The General Theory said private investment was “fickle”, suggesting under-investment was endemic. This necessitated “the somewhat comprehensive socialisation of investment”. If business tosses a coin when deciding to invest, why not turn to reliable government-funded investment?

The General Theory stayed onside with the labour movement. “Every trade union will put up some resistance to a cut in money-wages, however small,” the book said. It would have been impolitic to explore the qualification that such resistance might weaken over time. For the most part, money wages and prices were assumed to be sticky. As a consequence, real wages were effectively assumed to be sticky as well, and employment bore the burden of adjustment to shocks. The General Theory was indeed general in that it could easily rationalise any rate of unemployment between zero and 100 per cent of the labour force. Explanatory overkill, surely?

Pop behavioural economics did not stop with the labour market. The General Theory assumed that aggregate household consumption was a mechanical function of current household income. Left out of account was the role of credit markets in buffering households against income fluctuations. Business investment did contribute to aggregate demand, but its role in raising labour productivity and aggregate supply could be ignored. By contrast, more public spending would be beneficial, even in the extreme form of burying old bank notes and then digging them up again. Keynes knew how to provoke.

By contrast, Marshall was the great synthesiser. He said supply was as important as demand, just as a pair of scissors needs two blades. He also recognised the budget constraints faced by households and governments: “There’s no such thing as a free lunch.” This pithy observation is of course due to Milton Friedman, a post-war disciple of Marshall. However, the General Theory had audaciously dispensed with the supply side and budget constraints alike. Supply curves were stable and flat over the relevant range. Supply bottlenecks could be ignored. Neither taxes nor regulations impeded aggregate supply. Potential problems with high public spending, such as rising public debt relative to GDP, rising interest bills, or plunging exchange rates? They could all be left out of account.

The General Theory often disappointed Keynes’s legion of fans. In seeking to paper over cracks, the book inevitably lacked the sparkling clarity of Keynes’s previous writings. For example, generations of Australian economists have given up on trying to make sense of the book’s rambling and obscure critique of our system of centralised wage determination, even though criticism was probably warranted. Still, there were flashes of the old magic, and there was no mistaking the book’s central message about inadequate public spending.

In the early 1930s, Australia faced even more acute economic problems than the UK. Unemployment peaked at around one third of the labour force, exacerbated initially by high minimum real wages. Our terms of trade (ratio of export prices to import prices) halved. Inflation was sharply negative for several years, increasing the real burden of debt. Historically, business and government had relied heavily on the London capital market. From the 1920s onwards, however, the City had become increasingly wary of Australian debt. In his capacity as director of an insurance company, Keynes had been among the City people who shunned Australian interest-bearing securities. Some states had over-borrowed, for projects such as uneconomic new railways. Between 1929 and 1931 our exchange rate fell 30 per cent, part market-driven, and part deliberate policy to revive exports. Jack Lang, the Premier of New South Wales, threatened to default on his state’s debts to the UK. The federal government moved to protect our national credit rating. It picked up the tab.

In such ways we reluctantly knuckled down to most of an austerity package recommended by Sir Otto Niemeyer, a visiting official from the Bank of England. That we had invited him in the first place did not lessen his unpopularity. We were largely of British stock, albeit with a sizeable Irish contingent. We were dedicated followers of British fashion and we took our lumps. The steely indifference of Niemeyer, Keynes and other members of the British elite to our plight did not alter this. On the contrary, our intellectual elite-in-waiting anticipated Keynes’s new book with as much enthusiasm as its British counterpart. The Second World War saw the ascension of the “Seven Dwarfs”, a cohort of up-and-coming administrators, all diminutive, and largely Keynesian in outlook.

In 1945, Ben Chifley became Prime Minister and Treasurer. He engaged “Nugget” Coombs, one of the top three Dwarfs. Chifley and Coombs together oversaw Australia’s White Paper on Full Employment. A job was an “entitlement”, and “governments should accept the responsibility for stimulating spending on goods and services to the extent necessary to sustain full employment”. The full-employment objective marched through the institutions. Under the stewardship of Coombs, the Reserve Bank of Australia was progressively carved out of the Commonwealth Bank, then still in public hands. One of the RBA’s three statutory objectives was “the maintenance of full employment in Australia”. How this could be squared with the objective of “price stability” was a tough question and was not addressed. For the next three decades, an unemployment rate above 2 per cent was viewed as a crisis.

Thanks to William Phillips, 1958 saw some progress towards understanding aggregate supply. Phillips was as versatile as Keynes, having job-hopped from dairy farmer to crocodile hunter, cinema manager, electrical engineer, academic economist and, towards the end, mature-age student of Chinese novels at the Australian National University. He showed that there had been a loose negative correlation between the unemployment rate and the rate of money wage inflation, in the UK, over the period 1861 to 1957. His “Phillips Curve” could accommodate most of the pre-existing Keynesian apparatus and policy implications. It was embraced by most central banks, including the RBA, and was improved in 1968 by Milton Friedman (although plenty more remains to be done). However, Friedman’s version of the Phillips Curve was much less friendly to Keynesian economics (more on this later).

From 1963 to 1969, President Lyndon Johnson ran the US economy hot. He sought simultaneously to deliver “guns and butter”, in particular, victory in Vietnam and the Great Society at home. Inflation eventually broke out and metastasised into stagflation. Because purchasing power tends to be equalised across different currencies, the existing system of pegged exchange rates transmitted US inflation around the world. In 1973, however, the major economies floated their currencies, and this provided the policy autonomy needed to get local inflation down. You could offset rising prices for imports in terms of US dollars by tightening policy, thereby appreciating your currency against the US dollar. Almost invariably, an unwelcome side-effect was protracted unemployment (Portugal may have been an exception). A positive side-effect was that inflation expectations were bashed down. In most of the developed world, inflation was under control by the early 1980s.

Friedman foresaw that a fall in inflation expectations would enable a more favourable trade-off between unemployment and actual inflation. The actual unemployment rate fluctuated around a “natural” rate. The gap between the actual and expected rates of inflation was proportional to the gap between natural and actual rates of unemployment. In equilibrium, actual inflation coincided with expected inflation, and the actual unemployment rate was nailed down by the natural rate. Once unemployment rose to its natural rate, there was no longer any upward pressure on inflation from policy. For this reason, the natural rate was re-labelled the NAIRU—the non-accelerating inflation rate of unemployment. Expansionary policy could not permanently lower unemployment. What Harry Johnson described as the “Monetarist counterrevolution” had arrived. In 1975, Friedman visited Australia. He had fans here, but my recollection is that he was received more often like a latter-day Niemeyer.

From 1981 to 1989, Ronald Reagan presided over disinflation in the US. He cut government outlays measured net of interest payments and as a share of GDP. He also reformed the supply side of the economy, including cuts to business taxes and regulations. The Federal Reserve Board tightened monetary policy. Initially there was stagflation. With a lag, growth resumed and inflation fell.

Australia did not float its currency until 1983 and was half-hearted in implementing spending control, supply-side reform and tight money. In 1986, the Australian dollar dipped below fifty US cents. As with the exchange rate crisis of 1929 to 1931, the “banana republic” episode served as a reality check. Policy tightened. In January 1990 the “cash rate”—the interest rate paid by the RBA on overnight private bank deposits with the RBA—hit 17.5 per cent. In 1990-91 we knuckled down to the “recession we had to have”. The unemployment rate hit 11 per cent. In 1992 or 1993 (accounts differ), we adopted an inflation target, belatedly copying New Zealand. The aim was to anchor inflation expectations. These measures succeeded in restoring low inflation, at a high short-term cost in terms of jobs. Full employment was no longer a sacred cow.

“When troubles come, they come not as single spies but in battalions,” said the Bard. In the mid-2000s, the US experienced a housing boom and bust. The resulting loan defaults led to falls in stocks and a run on the extensive shadow-banking system in the US. By 2008 this had developed into the Global Financial Crisis. There was also an incipient run on Australian banks. The RBA responded with a cut of one percentage point in the cash rate. Lender of the last resort facilities to private banks were beefed up. Deposits were guaranteed. Services Australia and the Australian Tax Office together paid $21 billion to low-income households. These initial measures ensured ample liquidity, and probably did good, by and large. They stopped the incipient run and propped up the CPI, preventing a recession. But then Canberra got involved more deeply, long after it had become clear our private banks were stable and deflation had been averted. This second-round package had a price tag of $42 billion. Its initial component was Kevin Rudd’s “Pink Batts” program of free roof insulation, sometimes installed by untrained workers. Four young workers died. Julia Gillard followed up with her Building the Education Revolution. This program delivered infrastructure to schools, though only for prestige structures—unglamorous yet pressing facilities such as new toilet blocks were deemed to be unsuitable backdrops for ribbon-cutting politicians. Builders were paid via inordinately expensive arrangements involving several layers of middlemen. (This system became the template for the National Disability Insurance Scheme.) In 2012, Dr Ken Henry—former Keating adviser, immediate past Treasury Secretary, and perennial alpha Keynesian—defended government policy:

Chris Uhlmann: Was there a problem not with the first stimulus package, but perhaps with the shape and delivery of the second one?

Ken Henry: Well, a lot of people say that in hindsight. But you know when you’re putting money out the door so to speak, and I know this is difficult for people to understand, it sounds counterintuitive, but actually if it’s fiscal stimulus the most important thing is to get the money out the door. But whether the money is in some sense wasted because there’s overcharging or whatever, of course it’s an important point but from a macroeconomic perspective it’s very much second order, maybe even third order. 

Did Ken Henry actually answer the question?

The years 2020 to 2022 marked the Covid epidemic. Around the world, borders were closed and workers were furloughed. Treasury’s JobKeeper program paid out $89 billion to workers forced to stay at home. Support payments were often higher than what people had received while working. There were also state assistance programs. More money out the door. Between 2019 and 2021, Commonwealth public debt rose from 35 to 48 per cent of GDP. The debts of New South Wales, Victoria and Queensland rose even faster. The Commonwealth government has so far retained its AAA credit rating. Yet this extra public-sector borrowing took up fiscal space needed for deteriorating national security and unfunded boomer retirements, not to mention future civil emergencies.

Judging by the recent testimony of Dr Philip Lowe to parliamentary committees, the RBA was caught up in Canberra’s Keynesian panic. In November 2020 it cut the cash rate to 0.1 per cent. May 2021 marked just one occasion on which the Bank came close to promising that its suite of expansionary measures would ensure the cash rate stayed close to 0.1 per cent until well into 2024: “Maintaining the target of 10 basis points for the April 2024 bond yield will continue to keep interest rates low at the short end of the yield curve and support low funding costs in Australia.” Official assurances like this encouraged people to dive into the booming property market. In the course of attempting unsuccessfully to retain rock-bottom interest rates, the Bank bought up government bonds at artificially high prices, thereby incurring untold capital losses amounting to billions of dollars—bond prices vary inversely with bond yields. The RBA held the cash rate at 0.1 per cent until May 2022. Inflation hit 8 per cent by December 2022.

There are no prizes for originality in policy. Adopting models created elsewhere in the Anglosphere served us well for a long time. We should continue to copy and work with successful Anglosphere institutions. Just as our national defence should remain anchored by traditional alliances with the US and the UK, our economic generals should continue to tighten policy whenever the value of the Australian dollar falls below fifty cents US, as it did in the late 1980s—a policy harking back to the floor put under the Australian pound against the pound sterling in the early 1930s. But macroeconomic management in the Anglosphere seems to have lost its way. Take the US. Joe Biden has presided over public spending that has kept US federal public debt above 100 per cent of GDP. “Primary” federal deficits—deficits net of interest payments—stand at 5 per cent of GDP, and stretch ahead as far as the eye can see. Guns for the Ukraine, butter for green energy and, most recently, for the so-called “processing enterprise” of supporting seven million illegal immigrants. The UK experienced similar problems in controlling public spending. It’s time to look beyond the Anglosphere for economic role models. As they say in show business, copy by all means, but copy the best.

This essay appears in the latest Quadrant.
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In the developed world, Switzerland is the country that is furthest out of the shadow of Keynes. It should be our new lodestar. Swiss fiscal policy imposes flexible caps on public spending at both federal and cantonal levels. These caps resemble the flexible inflation targets that have worked well in Western countries during most of the last three decades. In 2001, Swiss voters passed a referendum on the “Debt Brake”. It stipulates that government outlays ordinarily should not exceed “ordinary” tax receipts, that is, tax receipts adjusted for where the economy sits in the business cycle. In this way, fiscal deficits are permitted either when there are extraordinary circumstances on the spending side, as during Covid or, on the revenue side, when a cyclical downturn temporarily depresses tax receipts. But not otherwise. Excessive spending must be made good by spending cuts further down the track. As a consequence, public spending relative to GDP is restrained, and the ratio of public debt to GDP trends down. Interest payments relative to GDP also trend down, opening up fiscal space for either cutting taxes or raising public spending. It’s easy to see why the modern theory of public finance says something like the Debt Brake is indeed the optimal policy.

The Debt Brake is not just good in theory. It now has two decades of successful operation behind it. It’s become a source of national pride, with Switzerland’s Federal Department of Finance extolling its virtues in well-written articles on the internet. Admittedly, that country’s public sector has recently blotted its copybook, by mishandling the collapse of Credit Suisse. In this vale of tears, no public sector is perfect.

Why hasn’t the Debt Brake caught on? Imagine you are an elderly politician or public servant, holding the strings of the public purse and trying to stay in office a bit longer—perhaps to secure a generous superannuation payout. You stand between a bag of public money and its vociferous claimant. The standing temptation is to sign off on it. Keynesian economics seems to say that’s the right thing to do. Your incentives can be contrasted with those prevalent in the private sector. Take parents with young children. They need to plan for the long term and budget carefully. Keynes was childless (though apparently not by choice). “In the long run we are all dead,” he said. This wizard with words was the high priest of money out the door.

Geoff Kingston is an Honorary Professor in the Department of Economics at Macquarie University.