Saturday, May 15, 2010

An early surplus is not just due to mining boom

The most common criticism of this week's budget is that the projected return to surplus in three years is no thanks to anything the Rudd government has done, but simply because of the returning resources boom.

There's much truth to this observation, but it also reveals an ignorance of the way budgets work and a willingness by some to make logically inconsistent criticisms of the government.

These people would have you believe the budget's descent from surplus to deficit was solely the result of the government's big spending, whereas the budget's return to surplus will be solely the result of forces beyond its control. That's wrong.

It is true that the $41 billion improvement in the projected budget balances for the four years to 2012-13 since the midyear review last November is more than fully explained by "parameter variations" (expected improvements in the economy).

But this should surprise only those who don't know much about budgets. It's always the upturn in the economy that brings the budget back into surplus. Why? Because it's always the downturn in the economy that does most to turn the surplus into a deficit.

In other words, the ups and downs in the budget balance are the product of two factors: what the economy does to the budget as it moves through the business cycle, and what the government does to the budget by its policy decisions.

The simple souls who fell for the opposition's claims that it was solely the government's reckless spending that had put the budget into deficit and was racking up debt that would be left to our grandchildren, were taken in because they assumed the budget balance could be affected only by government decisions.

Not true. The bigger factor affecting the shape of the budget is the economy. When it turns down, causing tax collections to fall and spending on dole payments to increase, it turns surpluses into deficits; when it turns back up, causing tax collections to rebound and spending on dole payments to fall, it turns deficits into surpluses.

This time last year, the government estimated the recession would reduce its tax collections by $210 billion over the five years to 2012-13. Now, with the mild recession behind us and the economy recovering, it has reduced that expected loss to $110 billion.

And, yes, that's the main reason the budget is now expected to return to surplus three years earlier than was expected a year ago.

Even so, that lost $110 billion was sufficient to wipe out five years of expected surpluses and push the budget into deficit. Then the government came along and initiated about $97 billion in stimulus spending. Together, those two factors explain the expected cumulative deficit of $137 billion over the five years to 2012-13.

It's because the economy does what the economy does that economists studying budgets focus their attention rather on what the government does. Did its decisions bolster the economy and help to minimise the downturn? Then, when the cycle has turned around, did it curtail its stimulus so as to get the budget back in surplus ASAP and start paying down the debt racked up during the recession?

The answer to the first question is, yes, the government's alleged reckless spending on fiscal stimulus did play a significant role (along with other factors, including the Reserve Bank's mammoth cut in interest rates) in keeping the recession so mild that the uninitiated even imagine we didn't have one.

Treasury calculates that the fiscal stimulus added about 2 percentage points to the growth in gross domestic product in 2009. Since the actual growth was 1.4 per cent, this says that without that stimulus the economy would have contracted by about 0.7 per cent.

The next question is: having used its discretionary spending to minimise the downturn, is the government now turning off that spending, and limiting any new spending, so as to allow the recovery in the economy to get the budget back in the black as soon as possible?

Surprisingly, the answer again is yes. That's why most economists gave the budget a tick this week. Though Kevin Rudd's first instinct is to spend, spend, spend, the budget revealed that the purse-string ministers, Wayne Swan and Lindsay Tanner, had managed to pull him into line.

The government had set itself a "fiscal framework" to ensure its actions were consistent with its "medium-term fiscal strategy" to "achieve budget surpluses, on average, over the medium term" and, despite the earlier scepticism of many, so far it's stuck to it.

The first element of the framework was the requirement that its explicit stimulus measures be temporary - that is, one-off. Because that spending was temporary, and most of it is past, the stimulus is now being withdrawn. That is, it's now exerting a contractionary influence on the economy.

According to Treasury's calculations, the withdrawal of the stimulus will subtract about 1 percentage point from gross domestic product growth this calendar year, and a further 0.75 percentage points in 2011. (I make that a subtraction of about 0.88 percentage points for the coming financial year, 2010-11.)

But the government makes many more budgetary decisions than just those officially labelled as "stimulus" and all decisions have an effect on the economy regardless of their label. To cover this, last year the government set itself a "deficit exit strategy".

It was that once the economy was returning to at least the trend rate of growth (with trend apparently being 3 per cent a year) it would, first, allow the level of tax receipts to recover naturally (that is, avoid further tax cuts) and, second, hold real growth in spending to no more than 2 per cent a year - all of this until the budget returns to surplus.

Without quite saying so, the government imposed on itself a third objective that all new spending measures be fully offset by savings measures over the four years of the forward estimates. And on Tuesday night, Swan announced an extension of the deficit exit strategy: "Once the budget returns to surplus, the government will maintain expenditure restraint by retaining a 2 per cent annual cap on real spending growth, on average, until the budget surplus is a least 1 per cent of GDP".

Bottom line: by hook or by crook (see my column on Monday), the government delivered on all these commitments. That's why, while all the political types were crying "it's just the resources boom," economists were giving the budget an unexpected tick.