Investment markets

The role of governments in controlling our economies

July 2009
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Actions taken by governments have a huge influence over the direction of a country’s economy. Whilst consumers and producers ultimately make most of the decisions that mould the economy, the government is at the helm of the economic ship and its policy decisions can potentially steer us through either calm or stormy waters. Currently we are in a chaotic period that none of us have experienced before, as we increasingly call upon government intervention to pull us out of this Global Financial Crisis (GFC). governments have a number of sails to their boat when it comes to steering the direction of the economy. Two of the main policies that governments can use to lever the economy in a desirable direction are: Fiscal Policy, which adjusts the level of government spending and taxes; and Monetary Policy, which controls interest rates and the supply of money.

In balancing these policy decisions, federal governments attempt to guide the overall pace of economic activity, maintain a steady rate of growth, sustain a high level of employment and keep prices stable.

At present, the government plays a crucial intervention role to get the financial system back on track, which at the end of 2008 was looking rather bleak.

Government intervention

When the US government allowed the investment bank Lehman Brothers to collapse in September 2008, credit markets froze up and sent world stock markets into freefall.

As the credit crunch led to a worldwide economic slowdown, including rising unemployment and decreasing industrial production, the chaos that followed Lehman’s collapse raised the question as to whether it was wrong for the US government to let Lehman fail.

It has since been argued by policy makers around the world: “What is the role of government in controlling the state of our economies?”

The best balance between the market and the state is one that has been debated for many years. Many continental European countries are stern supporters of heavy government regulation and protection, as is our major trading partner, China. The US, on the other hand, has historically leant towards free market capitalism and the idea that the best allocation of resources is achieved through the free choice of consumers.

Allowing Lehman to go bankrupt was an example of letting markets run their course. However, the US government had previously intervened to prevent giant financial institution Bear Stearns, amongst others, from going bankrupt. The Chairman of the Federal Reserve, Ben Bernanke defended their intervention of Bear Stearns as a bid to ‘prevent the unpredictable but likely severe consequences for market functioning and the broader economy’. Since then, the US government has gone on to prevent government sponsored mortgage companies Fannie Mae & Freddie Mac, as well as insurance giant AIG, amongst others, from going under.

Many financial experts believe that this government intervention has been for the best. Following are a number of actions taken by governments around the world that are also having significant impacts on how the world economy is faring:

Fiscal Stimulus Packages

World governments have been industriously rolling out their fiscal stimulus packages. Through their control of tax rates and their own spending, they are aiming to lift their respective economies out of recession and support long-term economic growth.

The US government plans to spend US$787 billion on a range of initiatives to get their ailing country out of recession. Amongst these, President Obama announced tax cuts to ease pressure on family budgets and boost spending within the economy. After all, spending drives growth and jobs – a major area of focus of the US stimulus package.

The Chinese US$586 billion stimulus package, announced in November last year, is already showing promising signs of traction. There are signs that the government’s infrastructure-led fiscal stimulus package is working and fixed asset investment has shown signs of improvement. Infrastructure spending and business investment not only supports the creation of jobs, but sets the foundation for long-term growth.

Closer to home, Kevin Rudd announced a $42 billion fiscal stimulus package in February this year, to support jobs and invest in future long-term economic growth. In a similar vein to tax cuts, government handouts are designed to ease pressure on families, and provide a boost to short-term spending, increase consumer and business confidence and ultimately save jobs.

As you can see from these three examples, the underlying intentions of the various government fiscal stimulus packages are very similar.

Monetary Policy Action

The other tool available to government in influencing the economy is monetary policy – which is the controlling of interest rates and the supply of money.

Interest rates around the world have been slashed in a coordinated effort to breathe life into the global economy. In a western world up to its eyes in debt, the lowering of interest rates endeavours to reduce that debt burden to free up cash flow and once again ease the pressure on families. This will, in turn, lead to an increase in consumer- and fixed-capital spending, and ultimately create more jobs.

A number of governments have reached the stage where they cannot further cut interest rates as they near rates of 0 per cent. This has prompted a host of unorthodox practices such as the lending and purchasing of government securities, in a bid to continually increase the supply of money in the markets.

The US Federal Reserve (Fed) has adopted such unorthodox strategies, setting out to drive down long-term interest rates by buying Treasury securities, bonds and mortgage-backed securities. By buying these securities, the Fed is effectively increasing the amount of funds that banks have available to lend, which encourages them to lend to consumers and each other at lower interest rate. This, in turn, stimulates growth in credit and money markets – and ultimately the wider economy.

Creating trust and confidence within the financial system is a huge challenge for all governments in a world that has been scarred by recent economic events.

The actions taken by governments around the world are largely complimentary, which is vital as we have never experienced a global crisis of this nature before.

Whilst there will undeniably be a number of further speed humps along the way, a strong commitment and a coordinated effort in steering the global economic ship will lead to a smoother ride towards a future of long-term economic growth.

As Ben Bernanke said in a recent speech on US fiscal policy: 'Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.'