Monday, November 15, 2010

Canberra's delusion: the budget is the economy

Notice anything strange about the release of the midyear budget update last week? Just about all the talking was done by politicians and political commentators, not economists and economic commentators.

Why? Because from an economic perspective the update isn't such a big deal. It is just a six-monthly update. Treasury revises its economic forecasts, but the changes usually aren't big and they're always old news because they're never very different from the Reserve Bank's forecasts, which are revised quarterly.

The revisions to the budget estimates cover the present financial year plus the next three years, but no one with any sense takes much notice of the last three. Why not? Because, with forecasting being so inaccurate, how could you take seriously mechanical "projections" about the state of the economy and the budget balance up to 3 years hence?

But if the update is of little economic significance, why did the political types get so excited? Although the midyear update is rarely used to announce new measures, this one was sharply criticised for its failure to include "deeper cuts to government spending".

So why? At the most obvious level, because some bright spark in the government had told the press gallery to expect such cuts. Robbed of this much bigger story, the media wrote it up as yet another failure of will from a weak government, whereas spin doctor incompetence is a more likely explanation.

But I think the explanation runs deeper. The denizens of the House with a Flag on Top have never really accepted that, at least since the the Reserve was made independent in the 1990s, the macro economy is no longer managed from Canberra.

Monetary policy - the manipulation of interest rates - has long been the main instrument for the management of demand, with the budget playing a much lesser role. It does get wheeled out to stimulate the economy during recessions but is then reeled back in during the recovery.

The main responsibility of the elected government and its Treasury is for micro-economic policy: combating climate change, water policy, education and training, tax reform, making particular markets more competitive and much else.

It's a vitally important role - carrying more than enough challenge for the Rudd/Gillard government to cope with - but still everyone in Canberra yearns to be back in the centre of the daily macro-management limelight.

The treasurer and Treasury want to be seen at the economy's helm. The press gallery wants in on the always prominent economy story. And there's no joy for the opposition in criticising the Reserve governor; it wants to blame every economic problem on the government.

So how does Canberra cope with its relevance deprivation syndrome? By exaggerating the economic significance of the budget. This is apparent when you see non-economists referring to the budget balance as "the economy's deficit". Whoops.

Essential to exaggerating the significance of the budget is exaggerating its relevance to the Reserve Bank's decisions about interest rates.

Since movements in the budget balance are one of many factors affecting the strength of demand, and since the strength of demand is the main factor influencing the Reserve's decisions about rates, there is a link between the two but it's much weaker and more attenuated than many in the political debate imagine.

For the opposition to blame every rate rise on the government rather than the unelected Reserve, it has to demonise rate rises as unnatural and excruciating, ignoring the millions of Australians who benefit from higher rates.

It also has to pretend that the multibillion-dollar-a-year cuts in government spending required to be sure of removing the need for just one 0.25 percentage-point rate rise could be easily and painlessly achieved, with no adverse economic consequences.

The other truth the fuss over the midyear update demonstrates is the full extent to which the government has lost control of the economic debate. Its success in limiting the effect of the global recession is the envy of governments around the world, yet the opposition has succeeded in portraying its performance as disastrous.

Even the press gallery is buying the Libs' propaganda about excessive, wasteful spending and the need for swingeing spending cuts to get the budget back on the rails. Nonsense. The real story is how amazingly responsible the government's been.

Every government spends big during recessions, but this is the first to force itself to make every spending measure temporary. In consequence, its task in returning the budget to surplus is much easier than in past recoveries. For instance, real government spending is set to fall by 1.1 per cent next financial year as the stimulus spending ends.

From the start, the government adopted a "deficit exit strategy" to bank all revenue growth and limit real spending growth to 2 per cent a year until the budget was back in surplus. No government has ever voluntarily donned such a chastity belt.

Yet it tightened the belt in last year's budget. And in the election campaign raised the status of the return to surplus in 2012-13 from a projection to a promise.

There's no reason to doubt Julia Gillard's resolve to keep that promise.

It requires a turnaround in the budget balance over three years of 4.5 per cent of gross domestic product - equivalent to about $63 billion a year - "the fastest budget turnaround on record". D'ya reckon that might have a helpful effect on interest rates?

And yet the political cognoscenti have been convinced the government is a profligate spender that isn't really trying to pull in its belt and is leaving home buyers to be tortured by central bankers.

It's not policy that's the problem, it's Labor's amateurish exposition of that policy.