Jonathan Reeves: Govt needs to spend more to kick-start economy

The headlines of rising unemployment in New Zealand and falling unemployment in Australia highlight important differences in government responses to the global financial crisis.

In 2008 both countries put in place fiscal measures to counter the worst global economic crisis since the Great Depression. Australia's response was large increases in government spending, including increased beneficiary payments to stimulate aggregate consumption.

New Zealand's response was a small increase in government spending and tax cuts.

The rationale behind the Australian fiscal response was that market failure was occurring around the world and likely falls in private spending in the economy needed to be offset by government spending.

The rationale behind the New Zealand fiscal response was that a moderate increase in government spending would be sufficient because a tax cut to individuals would stimulate spending.

It is clear from recent data the New Zealand response did not have the desired effect. There has been a substantial reduction in aggregate consumption and investment in the economy and unemployment is rising at a much higher rate than expected (presently 7.3 per cent).

So what went wrong?

Put simply, New Zealand is experiencing market failure (like many other countries) where individuals are too scared to spend. For example, concerns over job security result in individuals saving rather than spending a tax cut.

Across the Tasman, the Australian government's fiscal response of large government spending has been a great success. Unemployment is much lower than expected (having fallen to 5.5 per cent) and general confidence in the economy is strong.

The Reserve Bank of Australia has even had to start raising interest rates to dampen down the economy slightly.

The desired economic prescription in times of severe market failure, dating back to the work of British economist John Maynard Keynes in the 1930s, is for large direct government spending, and is commonly referred to as Keynesian economics.

In fighting unemployment, Keynesian economics also prescribes printing money. The United States, Britain, China and Australia, among others, have all been following heavily Keynesian economic policies over the last two years.

Why did the New Zealand Government not follow other governments around the world in strong Keynesian government spending?

In some ways, New Zealand's current economic policy orientation is not dissimilar to New Zealand approaches in the 1980s and 1990s. During these times, it was believed "free market forces" or "the invisible hand" (a phrase attributed to Scottish economist Adam Smith in the 1770s) would lead to desired economic outcomes. It was believed marketplaces were self-regulating.

In addition to recent comparisons, New Zealand and Australia can be compared in the 1980s and 1990s in their transition to more open market-oriented economies.

Australia's approach was slow and controlled by the government, whereas New Zealand's approach was swift and radical in the belief the "the invisible hand" would guide the way through the transition.

It is evident from the relatively weak economic growth New Zealand experienced over the 1980s and 1990s and the present weak economic performance that the "the invisible hand" has not served it well.

In fact, large numbers of highly skilled New Zealanders have migrated to other countries.

New Zealand economists and policy makers were not alone in the 1980s in their belief of the "invisible hand". At this time, American economist Milton Friedman (winner of the 1976 Nobel Memorial Prize in Economic Science) was very influential in economic policy making in a number of countries and was one of the great believers of the "invisible hand".

Today, however, believers of the "the invisible hand" are far fewer. Economic events from the 1980s to now and a large body of economic research have led many to believe unregulated markets do not always behave in a desirable manner.

Bubbles in markets have received much attention, in particular the global housing price bubble, and research has focused on analysing the irrational behaviour observed in so many markets.

Most notable contributions include the work of American economist Robert Shiller who in his book Irrational Exuberance correctly identified the global housing bubble and predicted the global financial crisis.

Another prominent American economist, Paul Krugman (winner of the 2008 Nobel Memorial Prize in Economic Science) wrote in the New York Times on September 6, 2009 that "financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds" and that "Keynesian economics remains the best framework we have for making sense of recessions and depressions".

It is important for New Zealand to increase its present level of government spending, a standard Keynesian prescription to support consumer and business confidence during times of market failure. Otherwise its unemployment rate may soon exceed 10 per cent.

In the prevention of deep recessions, temporary increases in government spending are well worth their cost.

It is not too late for New Zealand to follow the fiscal path that Australia and many other countries have already taken.

Recent suggestions of further income tax cuts are likely in the short term (in the next three years) to have the same negligible stimulatory impact as the earlier tax cuts.

* Dr Jonathan Reeves is Visiting Economist, University of Auckland. He is from the Australian School of Business, University of New South Wales.