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How government executives can build better economic resilience
In this episode of the Government Insights podcast, host Kait Borsay discusses with her guests the best strategies for government executives to navigate the new macroeconomic environment.
Even as central banks work to tame higher for longer inflation through monetary policy, many economies are facing a structural mismatch between supply and demand in critical sectors. These imbalances are creating sustained inflationary pressures that will remain even after cyclical inflation recedes.
Speakers Gregory Draco, EY-Parthenon Chief Economist, Strategy and Transactions, Ernst & Young LLP; and Cherelle Murphy, EY Oceania Chief Economist, Ernst & Young Services Pty Ltd, share insights on how government leaders can adjust their strategies to better navigate this new normal.
Ensure fiscal discipline and structured spending: government leaders should emphasize fiscal restraint, carefully managing spending to avoid exacerbating inflation, especially in economies running at full capacity.
Look for strategic future-oriented investment and growth: Governments should set priorities for sustainable growth through strategic investments in infrastructure, digitalization, decarbonization, and other areas that enhance productivity and economic capacity.
Encourage a harmonized policy approach: Increasing economic stability requires harmony between fiscal and monetary policies, maintaining credible inflation targeting, and international cooperation to prevent inward-looking policy measures that can lead to higher inflation and deficits
Teaser
Government Insights from EY-Parthenon.
Kait Borsay
Hello and welcome to Government Insights, an EY-Parthenon podcast series for government leaders around the world. I'm your host, Kait Borsay, and we'll be examining how governments can transform to strengthen services for their citizens.
In this episode, we're looking at how to thrive in the new normal of higher inflation and interest rates.
Joining us to share their insight and opinion on this subject are Gregory Daco, EY-Parthenon, Chief Economist Strategy and Transactions, Ernst & Young LLP. Hello, Gregory.
Gregory Daco
Hi, Kait.
Borsay
Good to have you with us. And Cherelle Murphy, EY Oceania Chief Economist, Ernst & Young Services Pty Limited. Hi, Cherelle.
Cherelle Murhy
Hello, Kait.
Borsay
Cherelle, I wonder if you could set the scene for us to get us started. How did we get to where we are today in terms of inflation?
Murhy
Certainly. Well, the most recent bout of inflation was fueled really by the pandemic and the policy response to it. Governments around the world, of course, worked really hard to try and save their economies from the economic downturn. That support took many different forms. Central banks too, they were working hard. They lowered their policy interest rates mostly to zero or very close to it. They purchased government bonds, and in some cases even private sector assets, and they provided a lot of liquidity into the banking system.
At the same time, the world economy was blighted, of course, by supply side problems, as the movement of people across borders was stopped. As we all remember all too well.
And then, of course, in early 2022, the war in Ukraine broke out and that triggered global disruptions in key energy and food crops and fertilizer markets. And that added really quickly to food and energy inflation as well.
So of course, you don't need to be an economist to know that if you've got very strong demand coinciding with much more limited, the normal supply then the result is inflation.
And so globally, inflation moved higher very, very quickly and peaked in about mid to late 2022, with inflation rates at that point really the highest that we've seen since the late 80s in many countries.
Borsay
Greg, let's have your thoughts on the impact of this new coupling that no one wants, higher inflation and high interest rates.
Daco
Yeah, I think we're likely to be in an environment where, for the foreseeable future, we may see structurally higher inflation. I often refer back to the five D's as drivers of inflation on a structural basis. So, you have one element which is this idea of de risking where economies around the world and businesses around the world are trying to limit risk by diversifying their supply chains in this environment where there are increased risks. And that's increasing the cost of trade.
You have demographics with populations across the world that are ageing and therefore spending more and saving less. You have an environment in which you have governments that have accumulated larger deficits and larger debt loads, which is also inflationary. And then you have this advent of digitalization with a lot of investment in GenAI, which is also creating this additional investment and additional cost.
And then finally, you have many economies looking to green their economy to decarbonize and that initial investment is also leading to structurally higher inflation.
So, I think we're going to be in this higher inflation environment, which generally portends to an environment where central banks maintain their policy rate at a higher level. So, this combo of higher interest rates and higher inflation is important because it affects how people act, how businesses spend, how consumers spend. But also how governments have to think about managing their debt loads.
Borsay
And as you say, with central banks raising rates aggressively to curb inflation, how will that then have influenced the fiscal outlook?
Daco
Well, it changes the dynamics quite significantly because if you think about a government having a certain amount of deficit on an annual basis, that feeds into their debt load, their overall debt load. But when interest rates were low over the prior decades before the pandemic and in particular, between the financial crisis of 07/09 and the pandemic of 2020, interest rates were historically very, very low.
That means that the debt servicing cost, how much you have to pay on an annual basis relative to that debt, was fairly minimal. And in some cases in the US for instance, historically very, very low. The situation today is very different because many central banks have raised interest rates to record high levels or at least levels that we hadn't seen in 15 years, and that means that the debt burden is rapidly increasing via this increased interest rate cost servicing.
If you take the US, for example, you have an environment in which the Congressional Budget Office, which is the agency that estimates debt loads, debt burdens and forecasts these deficits, it estimates that over the course of the next decade, 75% of the increase in the deficit will come from increased interest expenditures. And by the end of this decade, we will be in an environment where spending on interest expenses will be equal to spending on discretionary spending.
The reason why that is important is because any money that goes towards paying interest on the debt is not put to productive use by the government. And that is a key issue as we navigate this environment of higher inflation and higher interest rates, you want to be able to ensure that government policies are aimed at productive investments rather than unproductive investment like interest spending.
Borsay
Cherelle, cyclical inflation may be reducing broadly, but the cost of goods and services, well feels like it's remained elevated. What's driving that dynamic?
Murhy
Well, inflation definitely has responded to higher interest rates and those headline consumer price index rates in most developed economies have fallen and by quite a bit too.
But the elevated cost of many goods and services will simply not reverse, because most goods and services consistently rise in price, of course. And look, we're really used to inflation. You know, here's a nice example of something that’s just as popular in the US as Australia, is Taylor Swift. In 1989, when Taylor Swift was born, a ticket to the movies cost around US$4.00 in the US. And last year would have cost fans around sort of 10 to 15 maybe US$16.00 to see her Eras concert, at the movies anyway.
So elevated prices is not the concern, as economists we’re much more worried about the rate of change of prices and the inflation rate. And as long as that's running somewhere close to 2%, which is round about where most central banks target their inflation rates, then economies can run really well, you know, with good employment and moderate interest rates.
But inflation is not yet down to where most central banks want it to be.
And, most worryingly, really is the fact that it's services inflation that's running strongly. So the really, kind of core domestic part of the economy that's causing the problem.
And really, once inflation becomes domestically focused and driven by that high level of domestic demand it can be really quite hard to return it to those target rates.
Borsay
10 out of 10 for bringing Taylor Swift into a conversation about high inflation and interest rates. Let's stick with you Cherelle and look at the risks of dialing up inflation. In most countries, higher inflation strengthens the case of course, for fiscal restraint. What do governments then need to think about to identify strategies that avoid the risks of dialing up inflation?
Murhy
Well, I mean, you kind of answered your own question there, Kait, in the sense it really is about fiscal restraint. You know in the sense that it doesn't matter how you dress it up, excess government spending in economies that are running at or above their full capacity will be stimulatory. So I think primarily governments simply need to control their spending growth.
Especially in an environment where structural changes in the economy means that the governments also have ongoing things to deal with, and that's the list or five D’s that Greg brought up. The demographics, for example. The ageing of populations is expensive. It adds to health costs and age care costs and indirectly lowers the proportion of the people in the economy that are going to be paying the taxes.
The green transition, building climate resistance again, all very expensive and very necessary policies. Defense and national security, something else again getting quite a lot of attention here in Australia at the moment. A lot more money going towards these policies as well, as in many other parts of the world.
So, I think it's a difficult environment. The pressures that are on government are already there from factors that are well outside their control. So, anything that's discretionary really needs to be very, very well thought through and only if absolutely necessary.
I think maybe one counter to that is when they can spend such that it adds productive capacity to an economy. And that's where you can kind of almost get away with that extra spending without adding the inflationary pressure. But that's a different category again.
Borsay
Well let's focus on that with you, Greg, and ask you what you see as the priorities for governments to increase long-term productivity?
Daco
Well, I think that the key focus for governments is really to focus on policies that drive sustainable growth. And yes, fiscal discipline I think is very, very important as Cherelle mentioned, but we also have to consider the possibility of driving stronger productivity output and stronger supply. Because essentially stronger productivity growth is the Holy Grail in economics. It lifts the supply side and curbs the inflationary pressures that we've been facing over the past few years.
Now, in order to drive that stronger productivity, you really want to focus on the long-term investments, investments that generate that stronger supply. So investment in infrastructure, investment in decarbonizing and economy, investment in enhancing the environment for digitalization. We know that GenAI is a revolutionary technology. It has great potential, but it also necessitates the essential investment in order to gain the potential productivity benefits from that.
So, I think from a government perspective, what the focus should be on is really this combo of fiscal discipline, avoiding unnecessary spending, being scrutinous about where you're investing.
But also thinking about long-term investment strategies that lift the supply, the capacity of an economy as well as limit the inflationary cost pressures by focusing on these types of policies that drive that long-term growth.
Borsay
Is there generally too much short-termism do you think, Greg? It's really hard for governments to commit to spending on long-term productivity if they're facing a crisis right now across their budgets, sometimes the last thing they want to do is think 20, 30 years ahead.
Daco
Yeah. Generally, that's the “kicking the can down the road” type of approach, right? You have elections that are fairly regular and policymakers and politicians that tend to focus on the near term in terms of driving growth in the near term. And that is one of the issues that we're facing across governments around the world.
Is that there is a focus on the next few years, the next four or five years, but thereafter when fiscal sustainability becomes central, there is much less attention to how to curb potential excess spending and how to have a tax environment that generates the right amount of tax to be able to spend into the future and build a more productive and stronger economy.
Borsay
Interesting.
Finally, let's get both your thoughts on how governments can mitigate the risk of future inflationary environments for more sustainable outcomes, Cherelle?
Murhy
So, I think governments really need to be very focused at the moment on doing everything they can to pull off the soft landing. And by that, I mean obviously getting their inflation rates down while not destroying their economy by wrecking jobs. So, it's getting that nice combination, though. Again, it's going to take a lot of focus, I think, particularly over this next sort of 12 to18 month period while we get back into those target bands for inflation.
Just to give you an example, I guess of where there's been a nice kind of real-life success story here, I think is with childcare. So this is something that actually does bring down the consumer price index because childcare is cheaper where government has subsidized it more. But it also has the added bonus of increasing workforce participation rates. And if we make childcare cheaper and more available to all families, including high income parents, then you can actually bring quite educated people back into the workforce sooner. So, you're getting a second bang for your buck, if you like. I think these types of policies should be the focus in the short term.
Borsay
And what about you, Greg? How can governments mitigate the risk of future inflationary environments for more sustainable outcomes?
Daco
Yeah, I think there are probably five key avenues to focus on that. The first one is what we talked about, fiscal and monetary policy coordination. Doesn't mean colluding, but it really means focusing on the same objective of long-term sustainable growth.
The other, which Cherelle highlighted is very important, is fiscal discipline. We have to have governments that focus on sustainable investments that drives longer term growth.
The third one is monetary policy credibility. We have a number of governments that have inflation targeting systems in place and that generally tends to favor a stable environment when it comes to monetary policy interest rates, and therefore sustainable growth.
The fourth one is this idea of investing in long-term growth. We talked about investing in social care and medical care and infrastructure and greening of the economy in the digital revolution that we're currently experiencing with GenAI. And then the fifth one is international co-operation.
We are in an environment where we have to be very careful not to look excessively inward. There is this increasing tendency to see national policies that are aimed at sustaining one's own industries to the detriment of the rest of the world. And this isolation with growing geopolitical fragmentation is another risk that generally tends to lead to higher deficits, but also higher inflation. So those five points I think are the key ones to focus on.
Borsay
Well, that's all for now. It's been a really interesting, fascinating conversation. Greg, thanks so much for joining us.
Daco
Thank you.
Borsay
And to Cherelle, thanks to you too.
Murhy
Thank you. It's been a pleasure.
Borsay
Well do join us again soon when we'll continue to look at how governments can transform to strengthen services for their citizens. And please subscribe to this series so you won't miss an episode.
From me Kait Borsay, thanks for listening and bye for now.
Teaser
Government Insights, back soon.
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Presenters
Kait Borsay
Journalist, author, TV presenter, Radio moderator at Times Radio
