The past: Most policy committees at central banks these days include a fair amount of (former) academic economists. Many of these have spent substantial parts of their careers studying ‘depression economics': the Great Depression of the 1930s, the Japanese slump of the 1990s, or both. (The two episodes hold an enduring fascination for economists, as they are both insufficiently understood and highly important from a policy perspective - therefore constituting a worthwhile intellectual battleground.) What informs the policy choices and strategies in these institutions at the current juncture are therefore, among other things, the lessons drawn from the past - including past mistakes.
The people: A list of the most important of these individuals reads like a who's who of modern central banking:
• Ben Bernanke at the Fed (the foremost scholar on the economics of the Great Depression, he has also contributed to the study of Japan's slump, including policy recommendations on how to deal with it);
• Athanasios Orphanides of the ECB (who has written papers on Japan and monetary policy at the Zero Lower Bound);
• Adam Posen of the Bank of England (who has written a long series of research papers on Japan); and
• Lars Svensson at Sweden's Riskbank (author of leading contributions on Japan and how to escape deflation).
These people are - to a greater or lesser extent - instrumental in shaping the policy response of the Global Central Bank. Importantly, the influence they exert over monetary policy goes beyond their voting power or the weight of their office in the institutional hierarchy. Through their research, they have shaped the thinking of a generation of economists - very likely including many of their colleagues on the various monetary policy committees.
The policies: So, what are the conclusions from this study of the past for monetary policy?
1. Avoid Deflation at All Costs
...not least because it could prove a trap, and we do not know reliably how to get out of this trap. This is the policy lesson the study of the past offers above all others. How the US emerged from deflation and the Great Depression in the 1930s is not yet well understood, while Japan never did emerge from deflation. Worse, there is still no consensus today about how to escape deflation once the economy falls into such a state. Cognisant of this, economists' single most important policy recommendation regarding deflation is: do not allow it in the first place!
The practical monetary policy implication of this is to be aggressive and, perhaps more importantly, to be proactive in the face of downside risks. All of the above policy-makers would agree that the Bank of Japan failing to act decisively contributed to Japan falling into, and remaining stuck in, deflation. It is this stance, we think, that explains the Fed's QE2 and Operation Torque, as well as the Bank of England's decision to relaunch QE recently - all measures taken pre-emptively in the face of mounting downside risks, rather than in response to such risks once they have materialised.
2. Err on the Side of Caution When Exiting
The past also offers insights about what not to do. Premature monetary tightening aborted the recovery out of the Great Depression in the 1930s (for more details, see Global Economics: Back to the Future? September 14, 2011). And Athanasios Orphanides emphasises that an early tightening of monetary policy by the BoJ contributed to the 2001 recession (the BoJ tightened in August 2000).
The policy prescription therefore is to avoid premature tightening, as this could tip the economy (back) into recession or deflation. The way we would put it is: err on the side of caution when exiting - in other words, it's better to exit too late rather than too early.
It is worth emphasising that central banks cannot, and should not, attempt to forestall the - unavoidable - structural adjustment (deleveraging of the private sector, restoring long-term fiscal sustainability on the public sector side). Indeed, that is not central banks' intention, and to claim otherwise would be to misunderstand both ability and goals of monetary policy. The large-scale and aggressive monetary easing major central banks have embarked on does not intend to prevent this structural adjustment. In the words of Adam Posen: "The real costs of recession and even financial crisis tend to accumulate over time as job loss turns to long-term unemployment and as financial disruption turns to underinvestment and capital misallocation. This is why a number of central bankers, myself included, have argued for very strong immediate monetary response ... [i]t is impossible to completely offset such negative structural effects ...".
That is, monetary policy can be useful by:
• Doing its best to prevent the economy from falling into a deflation ‘trap' (see above);
• Cushioning the blow - that is, acting as a parachute for the economy: rather than a precipitous, vertical fall with potentially disastrous economic and social consequences, monetary policy is attempting to ensure a more gradual adjustment.
In fact, by cushioning the blow, monetary policy makes structural adjustment easier, rather than preventing it: deleveraging is much easier, and faster, against a backdrop of (even very weakly) growing disposable income, stable or slowly declining unemployment rather than rising joblessness, and increasing price levels which erode the real burden of the debt somewhat.
By the way, we have little time for ‘liquidationist' arguments:
• The economic costs of depression in terms of lost output and wasted physical and human capital are enormous - and long-lasting;
• The attendant social costs, in terms of unemployment and human misery, could lead to unpredictable political developments: few countries on earth can boast Japan's degree of social cohesion. And lest we forget, the last time we had a depression it led directly to a World War.
In short, deflation is not a path one wants to take because we don't know where it leads us, nor what lurks at the end of it. It's a gamble with huge stakes and unknown odds. But we digress.
Has it worked? Yes... The proof of every pudding is in the eating. There is no doubt in our minds that the aggressive and timely response of monetary policy globally averted another Great Depression. The Great Depression, in our view, is the most reasonable counterfactual against which to measure the efficacy of monetary policy. That is, it would be wrong to infer from the fact that, say, unemployment remains above 9% in the US that QE has not worked. Rather, the question is, "what would unemployment have been if the Fed had not embarked on QE?" To which, a plausible answer for us is "well into double-digits" (unemployment in the Great Depression peaked at 25%). In addition, with the exception of Japan, inflation in DM remains comfortably in positive territory even on core measures that strip out food and energy and is forecast to remain there - three years after the largest deflationary shock of the last 70 years.
...but it has limits: That said, expansionary monetary policy does have limits. Such limits are not operational - that is, there is no limit to the size of central banks' balance sheets. But there are, at the present stage, limits to what further expansion of monetary policy can achieve - limits which are recognised by most policy-makers. In short, expansionary, determined and proactive monetary policy is necessary but not sufficient to return the economy to sustainable growth.
Risks: Aggressive monetary policy to avert deflation and ensuring one does not exit prematurely does not come without risks of its own - there is, after all, no free lunch. In particular, erring on the side of caution likely implies exiting too late, which in turn means elevated medium-term inflation risks. Yet, it is rational for a risk-averse central bank to prefer the lesser of two evils: if inflation is the price for avoiding deflation, then so be it - because central banks know how to deal with inflation (see The Global Monetary Analyst: Better the Devil You Know, August 18, 2010). To quote Adam Posen again: "I'd certainly rather have us temporarily overshooting by around 1 percent than facing oncoming deflation." (Meanwhile, the overshoot is around 3 percent.) This is one of the main reasons why we see inflation risks skewed to the upside over the medium term. But if we get to a medium term with higher inflation, it will mean that we did not fall into a deflation trap, and that's because policy-makers have learned the right lessons from the past - not least thanks to people like Bernanke, Orphanides, Posen and Svensson.
Summary
If you were driving along the interstate, and had a flat tyre, you would generally be faced with two options: Reel out the spare wheel or preserve the spare for ‘later' and risk being stranded. It is no different with fiscal accounting: If one made provision for unforeseen contingencies (e.g., unanticipated spending requirements, revenue shortfalls, a dry up in funding, etc.) and one or more of these contingencies unfolded over the course of the fiscal year, it would not be out of place to draw down on such reserves to plug the hole. In this case, the National Treasury of South Africa chose to make use of its contingency provisioning for this fiscal year, thereby allowing it to report a slightly smaller-than-expected deficit.
The Macro Backdrop
The Treasury's macro assumptions have been downgraded across most categories, driven in the main by a weakening external environment, deteriorating levels of confidence, and volatility in global asset markets. GDP growth is now seen at 3.1% in 2011 and 3.4% in 2012, compared to earlier estimates of 3.4% and 4.1%, respectively (Morgan Stanley forecasts 3% GDP growth for both years). Household consumption has been revised lower, while fixed investment has been downgraded by close to a percentage point in each year across the forecast horizon. A weaker demand environment has done little to rein in the Treasury's inflation forecasts, however. Indeed, domestic inflation, expected to be driven almost exclusively by cost-push factors, is now forecast at 5.4% in 2012 and 5.6% in 2013, from 5.2% and 5.5%, respectively. Finally, the current account deficit is expected to shrink in line with the more somber growth backdrop.
Contingency Reserves to Fund Spending Increase
Details of the October 2011 Medium-Term Budget Policy Statement (MTBPS) show an increase in recurrent expenditures from R588 billion in February to R592 billion - exactly as we had expected. Transfers and subsidy allocations of R313 billion were in line with our R315 billion estimate, while capital assets and other expenditures also came out in line with the R75 billion print that we had expected. Interestingly, however, the headline expenditure reading remained unchanged at R979 billion - much lower than our forecast of R987 billion, thanks largely to a drawdown on the contingency line (R4 billion) as well as a modest undershoot in the wage bill (R4 billion). We must point out that, although basic wage negotiations in the public service were concluded in 3Q11, outstanding issues surrounding housing allowances are yet to be resolved. On our estimates, this could lead to a further R2-3 billion increase in the wage bill once settlement is reached. We are therefore happy to stick with our wage bill estimate of R347 billion for fiscal 2011/12, which is slightly higher than the Treasury's R343 billion estimate.
Over the medium term (2012-14), the government hopes to spend some R802 billion on infrastructure - slightly lower than the R808.6 billion that it planned to spend over 2011-13 as per the February 2011 Budget. Of this, the estimated outlays on economic services infrastructure such as water & sanitation, transport & logistics and energy have been raised from R664 billion to R676 billion, while supportive infrastructure on social services such as health and community facilities has been scaled back while spending capacity is being built in these latter sectors.
Looking forward, although the Treasury's wage bill for the upcoming two fiscal years is likely to push the recurrent/capital ratio in the ‘wrong' direction, it is important to note that this is already priced into our forecast. Increases in transfers, subsidies, capital assets and other expenditures are also as we had expected. The headline expenditure reading, however, is slightly lower than we expected - again simply because the Treasury has decided to halve its contingency provisioning for the outer years to help plug the burgeoning revenue gap.
Revenue Undershoot in Line with Expectations
With regards to fiscal revenues, Treasury estimates of R814 billion are in line with our R815 billion estimate, although details on the various tax handles as well as between tax and non-tax revenue do show some variation. The greatest variation is expected in VAT receipts, which the Treasury expects to come in at a rather conservative R187 billion (our estimate R195 billion), thanks to higher-than-anticipated VAT refunds. Revisions to corporate and personal tax estimates were in line with ours.
Fiscal Deficit Lower than Expected
As expected, the fiscal deficit was also revised upwards, thanks to higher spending and lower revenues. The Treasury's estimate of 5.5% of GDP for this year is however marginally lower than our 5.8% estimate, thanks mostly to the drawdown in contingency reserves.
Excess Cash Holdings to Fund Borrowing Requirement
With regards to funding, the MTBPS presents an unchanged debt position, as it hopes to fund the higher deficit from two key sources: i) a drawdown on its cash holdings in the National Revenue Fund; and ii) embarking on a switching program that will allow it to swap maturing debt for longer paper, allowing for better cash flow management.
With regard to the drawdown in cash, it appears that most of this will be a part-liquidation of its effectively dormant foreign exchange deposits at the SARB - again, another prudent decision to fall back on idle reserves in difficult times.
This not only allows the Treasury to minimize net interest payments, but also ensures that its debt ratios are kept in check - an important metric that rating agencies have focused on lately. And while there may be some liquidity and/or FX implications as the cash holdings are withdrawn, we believe that such an impact will be virtually negligible.
On the whole, the Budget is reflective of a rather innovative Treasury team that has been able to adeptly maintain its expenditure targets in the face of a shrinking resource envelope without compromising the country's debt ratios. Faced with lower revenues and a slightly higher baseline expenditure bill, the Treasury appears to have made good use of the cash buffer that it has built over the years. From a macro perspective, we believe that this was the prudent thing to do in such difficult times.
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