Saturday, August 7, 2010

Don't be fooled by debt spin

In an ideal world, the economic debate between the two sides in election campaigns would leave voters with an accurate picture of the issues and choices. If one side said something wrong or misleading, this would be quickly refuted by the other.

Unfortunately, it doesn't work like that. Both sides are seeking votes, not enlightenment. When one side makes a misleading but seemingly persuasive point against the other, the reaction may be to change the subject rather than correct the error.

Rather than push them further apart, competitive pressure tends to push both sides towards the centre ground. So it may suit both to perpetuate the same misconceptions.

One simple truth that gets lost in election campaigns is that the primary responsibility for the day-to-day management of the economy rests not with the politicians, but with the bureaucrats in the central bank. It's they who determine the level of short-term interest rates, and it's the manipulation of interest rates ("monetary policy") that has most effect on the strength of demand (spending) in the economy.

The instrument of macro-economic management the elected government controls, the budget ("fiscal policy"), is secondary to monetary policy (although it does play a more prominent role during recessions). This leaves the denizens of Canberra (including journalists) with an inclination to exaggerate the role of fiscal policy in the management of the economy.

One way the Liberals do this (so far it hasn't suited Labor to run this line) is to exaggerate the effect of the budget on the level of interest rates. One rarely fully articulated argument is that budget deficits - which have to be covered by government borrowing - leave fewer funds available to be borrowed by the private sector and thus force up interest rates.

This would be true if our capital markets were cut off from the rest of the world but, since they're not, it isn't. Effectively, both our public and private sectors borrow in the global market, where their demand is too small to have any effect on world interest rates.

A better argument is that changes in the budget balance affect the strength of "aggregate" (total) demand in the economy and so affect the Reserve Bank's decisions about whether rising inflation pressure requires it to raise interest rates to discourage borrowing and spending. A fall in the budget deficit or a rise in the budget surplus could in this sense reduce upward pressure on rates.

But though this is true in principle, remember - as the denizens of Canberra keep forgetting - the federal government's budget balance is only one of the factors influencing the strength of aggregate demand. Other factors include the volume of exports versus imports, the terms of trade (the prices of exports and imports), the exchange rate and the strength of business and consumer confidence.

So, in practice, the effect of changes in the budget balance on the Reserve Bank's decisions about interest rates is usually pretty limited, as repeated comments by its governor make clear. But the whole Canberra obsession with (budget) deficits and debt, particularly in this campaign, can leave the unwary with an exaggerated impression of the federal budget's place in the scheme of things. You see this when journalists ask politicians when they plan to get "the economy" (or even "the country") out of deficit or out of debt. Sorry, the economy isn't in deficit, now or ever. It's just the budget that's in deficit, and there's a world of difference between the two.

Federal government spending is equivalent to only about a quarter of the economy as measured by gross domestic product, and even this exaggerates the budget's importance because much government spending merely involves transferring money between taxpayers and welfare recipients rather than producing goods and services (which is what GDP measures). No, it's important to understand that, apart from being a device for managing its own incomings and outgoings, the federal government's budget is an instrument that has effects on the economy without being the economy.

That's important because it helps you see the budget is merely a means to an end, not an end in itself. It's there to serve the economy; the economy isn't there to serve the budget. It's the economy that matters because the economy is us - it's the sum of the economic dimension of our lives, all the consuming and producing you and I do.

There's been such extraordinary fuss about the budget and its balance in this campaign that the uninitiated could be forgiven for concluding economic management is all about balancing the budget and avoiding debt.

Rubbish. Economic management is about keeping unemployment and inflation low (fortunately, this is the bit the Reserve Bank takes primary responsibility for). In conventional terms, it's about pursuing economic growth so as to continually raise our material standard of living.

To the more enlightened, it's about ensuring economic activity doesn't lead to the malfunctioning of the ecosystem, the most pressing instance of which is global warming. Both sides are running from their responsibility to combat climate change; their obsession with deficits and debt is a diversionary tactic. It will be a long time before they face up to the deeper question of whether endless economic growth is compatible with preserving an ecosystem that doesn't grow.

Economic management is about reforming those government interventions that reduce the efficiency of resource use without sufficient social justification. It's also about correcting market failures - instances where, left to its own devices, the market fails to maximise our wellbeing. That is, the federal government is responsible for micro-economic reform.

Government - state as well as federal - is responsible for ensuring the provision of certain vital services and infrastructure. We need, but don't have, sufficient investment in education and training - ranging from early childhood to schools to technical education to universities - to ensure a bright future for Australians and leave us with something to show for our mineral wealth.

To overcome present deficiencies and assure our future we need a lot more investment in economic and social infrastructure, particularly in transport and telecommunications.

If it's to happen, much of this investment will have to be financed by government. The notion that the Howard government left us with a debilitating infrastructure backlog used to be an incessant cry of the Labor government.

But the continuing obeisance to Costelloism - the doctrine that all public debt is bad - in this campaign suggests neither side would do much to deliver the infrastructure we need.