Saturday, May 14, 2011

Lousy budget? Don't be fooled by harsh critics

If you listen to the economists and commentators complaining the budget wasn't tough enough - a "missed opportunity" - and involves budget deficits higher than earlier expected, you could easily conclude it's a weak effort that does little to keep the economy on the right track. But you'd be misled.

It's true the budget's estimate of an underlying cash deficit of $49.4 billion for the financial year just ending is about $8 billion higher than expected in November. And the estimated deficit for the coming financial year of $22.6 billion is about $10 billion higher than earlier expected.

But just about all of that deterioration is caused by a weaker-than-expected economy, not by government spending decisions. The government's expected tax collections over the two years have been cut by $16 billion as a result of all the natural disasters locally and in Japan, the appreciation in the dollar (which cuts the foreign earnings of Australian companies) and the lingering effect of the recession we supposedly didn't have, which left many companies with losses (which they are now charging against their more recent profits, thus reducing their liability for company tax).

So these setbacks can't be blamed on a government that isn't trying.

It's also true that, though Wayne Swan - or more likely, Penny Wong - achieved savings worth $22 billion over four years (with two-thirds of the savings coming from spending cuts and the remainder from the temporary flood levy and cuts in "tax expenditures" or concessions), these have been offset by new spending programs worth about $17 billion over four years.

Net savings of $5 billion over four years isn't a lot to write home about. That's what the critics were saying.

But here's another truth: Swan is expecting this year's deficit of $49.4 billion to turn into a surplus of $3.5 billion in 2012-13, just two years' time. And that would be the fastest turnaround ("fiscal consolidation") in the 44 years that records go back.

Sound like a weak effort to you? It's a turnaround equivalent to 3.8 percentage points of gross domestic product - 2.1 points in the coming year and 1.7 points in 2012-13.

This means that, in the simple way most economists (including those at the Reserve Bank) measure it these days, the "stance of policy" is highly contractionary.

During the recession we supposedly didn't have, the turnaround in the budget balance, from a surplus of $19.7 billion in 2007-08 to a peak deficit of $54.8 billion (4.3 per cent of GDP) in 2009-10, represented the budget being highly stimulatory, helping to prop up the private sector and minimise the downturn in the economy.

Now, however, it's doing the reverse. The budget's net contribution to demand is negative - contracting rather than expanding - thus leaving more room for private sector demand to expand without generating as much inflation pressure.

With high coal and iron ore prices doing so much to increase the nation's income and a massive mining construction boom getting under way, this fiscal (budgetary) contraction won't be sufficient to remove all inflation pressure, so the Reserve is likely to continue making its "monetary policy" more contractionary by raising interest rates. The fiscal contraction, however, should give the Reserve less to do.

Back to the point: if the budget's such a weak effort, how come the deficit will turn to surplus so quickly? First, it's because, contrary to the impression many people have gained, more of the deterioration in the budget balance was "cyclical" (caused by the downturn in the economy, otherwise known as the budget's "automatic stabilisers") than it was "structural" (caused by the government's explicit decisions to stimulate the economy with higher spending or tax cuts). Second, it's because the government has stuck to the highly disciplined strategy it imposed on itself at the time it was worsening the budget balance with its discretionary stimulus.

The first part of the strategy was to ensure all the stimulus spending measures were temporary. Once the designated amount of money had been spent, they would stop.

So the stimulus would be withdrawn automatically; it wouldn't be necessary to make an explicit decision to turn off the tap. This means the budget would return to surplus automatically as the recovery in the economy caused a cyclical recovery in the budget's tax collections and a fall in spending on dole payments.

That's how it would work in principle. To make sure it also worked in practice, the other part of the strategy was for the government to exercise special restraint in its spending and taxing decisions until the budget was well back into surplus.

It pledged to "allow the level of tax receipts to recover naturally as the economy improves", which means it swore not to have any further tax cuts for the duration. So it promised to put the proceeds from bracket creep into improving the budget balance.

On the other side of the ledger, it pledged to limit the real growth in its spending to 2 per cent a year. This is lower than the natural rate of growth in spending if left to its own devices, so many critics were sceptical that Labor would have the discipline to achieve it.

Well, so far the government is on track to achieve it. The budget expects real growth in spending of 0.7 per cent in the year just ending, 0.5 per cent in the coming "budget year", minus 0.1 per cent in 2012-13 (the year of the promised return to surplus) and 1.9 per cent in each of the following two years. That's average real growth of 1 per cent a year over the coming four financial years. It compares with average growth of 3.7 per cent a year over the 10 years before the financial crisis, when Peter Costello controlled the purse strings.

This says the Labor government's record on fiscal responsibility isn't bad. It's true, however, that the speed with which the budget is expected to return to surplus is owed also to the return of the resources boom. So one critic has written that "the inadequacy of Wayne Swan's fourth budget has left Australia highly vulnerable to the gathering risks in the global economy, punting everything on our China luck continuing to hold".

It's true that, should China fall in a hole, our return to budget surplus would be greatly delayed. But can you spot the weakness in that argument? If our boom evaporated, the need to get back to surplus ASAP would also evaporate.