Thursday, May 24, 2012


Economics Seminar Day, Pymble Ladies’ College, Thursday, May 24, 2012

I want to start by giving you the basic facts of the budget Wayne Swan brought down on May 8, look at the forecasts for the economy included in the budget, then assess the ‘stance’ of fiscal policy adopted in the budget and finally comment on where this leaves us with the ‘policy mix’ - the government’s economic objectives and the way these objectives are divided between the arms or instruments of macroeconomic policy.

Key budget facts

Mr Swan is expecting budget receipts to grow by 12 pc in the coming financial year, 2012-13, while budget payments fall by 2 pc. This would cause the expected underlying cash deficit of $44.4 billion in the old financial year, 2011-12, to become a surplus of $1.5 billion in the new financial year. As a proportion of GDP, the budget balance would swing from minus 3 pc to plus 0.1 pc. Mr Swan is expecting the budget to remain in tiny surpluses for the following three years.

He is expecting the federal government’s net debt to peak at 9.6 pc of GDP - or about $143 billion - in June this year, then have fallen to 7.3 pc of GDP ($132 billion) by June 2016.

The main measures to take effect from the beginning of the new financial year are the minerals resource rent tax - expected to raise about $3 billion a year - and the carbon pricing mechanism, expected to raise about $7 billion a year when it’s fully under way. Neither tax is expected to contribute to returning the budget to surplus, however, because both are part of tax packages that are roughly revenue-neutral. Proceeds from the minerals tax will be used to pay for various tax concessions for small business, for various increases in benefit payments, and for the cost to the budget in forgone income-tax revenue of slowly increasing the rate of compulsory superannuation contributions from 9 pc to 12 pc of employees’ wages. Proceeds from the carbon tax will be used to pay for compensation to households (a small income-tax cut and an increase in pensions and the family tax benefit), assistance to emissions-intensive, trade-exposed industries and subsidies to encourage renewable energy projects.

These two packages were announced in earlier budgets. The new measures announced in this budget involve savings of $33 billion over five years (but $4.7 billion in the budget year), offset by new spending of $22 billion over five years (but $1.7 billion in the budget year). The main savings come from reneging on promises to cut the rate of company tax by 1 percentage point and to introduce various new tax concessions, from various reductions in ‘middle-class welfare’ and from deferring spending on defence and overseas aid.

The main new spending measures are replacing the education tax refund with a schoolkids bonus (the first payment of which will be made just before the start of the carbon tax), an increase in the family tax benefit and a tiny increase in the dole; the first stage of the national disability insurance scheme and increased spending on dental health.

Budget forecasts

The economy is forecast to return to growing at about its medium-term trend rate, expanding at an average rate of 3 pc in the old financial year and by 3.25 pc in the coming financial year. The growth in 2012-13 would be brought about by another very big increase in mining investment spending and trend growth in consumer spending, but no growth in new home building and a small contraction in public sector spending as federal and state governments seek to return to operating surplus. Domestic demand is expected to grow faster than trend, but net external demand (exports minus imports) will subtract from growth as the volume of imports increases faster than the volume of exports.

This fall in ‘net exports’, combined with a further modest decline in the terms of trade, is expected to see the current account deficit worsen from a very low 3 pc of GDP in the old year to 4.75 pc in the budget year.

The headline inflation rate is expected to worsen to 3.25 pc in the budget before returning to 2.5 pc the following year.

Employment is expected to grow by a weak 1.25 pc, with the unemployment rate creeping up to 5.5 pc and the participation rate little changed.

The forecasts for our economy are based on a forecast that world GDP will grow by a slightly below-trend 3.5 pc in calendar 2012, with strong growth in developing Asia offsetting weak growth in the developed economies. There is a significant risk this forecast won’t be achieved if the eurozone economies get into greater difficulties, or if China’s economy slows more than intended.

The stance of fiscal policy

The strict Keynesian way to assess the stance of fiscal policy adopted in the budget is to ignore the expected change in the budget balance brought about by the operation of the budget’s automatic stabilisers (known as the ‘cyclical component’ of the balance) and focus on the net effect of the explicit (discretionary) policy changes announced in the budget (the ‘structural component’).

These days, however, it’s more common for economists to take the short cut of simply looking at the direction and size of expected change in the overall budget balance from the old year to the new year. Taken a face value, the expected improvement in the budget balance of almost $46 billion - equivalent to 3.1 pc of GDP - says the stance of fiscal policy is extraordinarily contractionary.

But there are various reasons for doubting the contractionary effect is as big as it seems. The most important is that the budget includes decisions that push almost $9 billion worth of spending measures back into the last few weeks of the old financial year. Whether government spending occurs a bit before or a bit after June 30 makes little difference to the real economy, but it exaggerates the true size of the turnaround in the budget balance by almost $18 billion (ie it makes the old year $9 billion worse and the new year $9 billion better).

Another factor is that the new year’s budget is expected to benefit from increased revenue from resource rent taxes of $5.7 billion (that’s from the existing petroleum rent tax as well as the new minerals rent tax). These taxes are explicitly designed to be taxes on ‘economic rent’, so they have no effect on the incentive to exploit petroleum or mineral deposits and thus have no effect on economic activity.

A further factor is that, thanks to a quirk of public accounting, Swan’s underlying cash surplus of $1.5 billion takes no account of the government’s spending on the continuing rollout of the national broadband network. The relevant budget item is expected to involve increased spending of about $6 billion in 2012-13. Not all of that would relate to the broadband network, but to the extent it involves the government funding increased economic activity, it has the effect of reducing the budget’s adverse effect on activity.

To these arguments the Secretary to the Treasury, Martin Parkinson, has added one of his own: to some extent the budget redistributes income from higher income-earners (who would have a lower marginal propensity to consume ie be likely to save a higher proportion of their income) to lower income earners (with a higher propensity to consume), thereby tending to increase net consumer spending somewhat. Taking all these factors into consideration, Dr Parkinson has suggested the contractionary effect of the budget is probably less than 1 pc of GDP. Even so, that’s still a contractionary stance of fiscal policy.

The changing policy mix

The textbooks list two longstanding objectives of macro-economic management: ‘internal balance’ and ‘external balance or stability’. Internal balance means ‘full employment and price stability’ or, in more modern language, low unemployment and low inflation. The RBA regards its inflation target - ‘to maintain inflation between 2 and 3 pc, on average, over the cycle’ - as the achievement of ‘practical price stability’ and regards full employment as being the level of the non-accelerating-inflation rate of unemployment (the NAIRU) - that is, the rate below which unemployment can’t fall without labour shortages leading to an upsurge in wage and price inflation. It could thus be regarded as the lowest sustainable rate of unemployment. Economists’ best guess is that, at present, the NAIRU is sitting at about 5 pc, meaning the economy is travelling at close to full capacity.

The point to remember is that it’s easy to achieve low inflation by running the economy too slowly and ignoring high unemployment, or to achieve low unemployment by running the economy too quickly and ignoring high inflation. What’s hard is to keep both inflation and unemployment low at the same time. The way you do it is to aim for a steady rate of growth, which thereby avoids both high unemployment when the economy is growing too slowly and high inflation when it’s growing too quickly. Macro management aims to be ‘counter-cyclical’ - to speed the economy up when demand is growing too slowly and slow it down when demand is growing too fast. So macro management is also known as ‘demand management’.

The objective of external stability meant achieving an acceptable CAD and a manageable foreign debt. Under the Hawke-Keating government, fiscal policy was allocated the role of achieving external stability. Because the CAD represents the amount by which national investment exceeds national saving, the goal was to contribute to higher national saving by achieving the biggest budget surplus possible. Soon after the election of the Howard government, however, it quietly abandoned external stability as a policy objective. Since then governments haven’t worried too much about the size of the CAD or the foreign debt.

It was under the Hawke-Keating government that the policy makers acquired a third objective: faster economic growth, combined with a more flexible economy, one capable adapting to economic shocks (shifts in the aggregate demand or the aggregate supply curves) without generating as much inflation and unemployment. Stable economic growth minimises inflation and unemployment, whereas faster growth in GDP per person causes a faster rise in material living standards.

Dr Parkinson made it clear in a speech after this year’s budget that the government has acquired an additional economic objective: fiscal sustainability. This is the desire to ensure we don’t run a long string of budget deficits and thus build up an excessive level of public debt (as we see has helped create the present European debt crisis).

We’re left with three macro-economic objectives: internal balance, faster economic growth and fiscal stability. To deal with these three objectives the policy makers have available for their use three economic instruments: fiscal policy, monetary policy and micro-economic policy. The policy makers’ decisions about which instrument to assign to which objective determines the ‘policy mix’.

Internal balance: the budget papers say monetary policy plays ‘the primary role in managing demand to keep the economy growing at close to capacity, consistent with achieving the medium-term inflation target’. They say that returning the budget to surplus will allow monetary policy to play that primary role.

In the days when the exchange rate was fixed, macro economists used to think of the exchange rate as an additional instrument of policy. It could be ‘revalued’ (raised) to counter the inflation caused by a commodities boom, for instance, or ‘devalued’ (lowered) to cope with a balance-of-payments crisis. After the dollar was floated in 1983 - that is, after the market was allowed to determine the dollar’s external value - the exchange rate ceased to be an arm of macro policy. But in his recent speech, Dr Parkinson identified the macro role of the floating exchange rate, linking it with monetary policy. ‘Monetary policy is supported by a floating exchange rate, which acts as a shock absorber that offsets some of the effects of global shocks on the economy and naturally adjusts in response to other economic developments.’

Fiscal stability: Fiscal policy played a major role in the government’s efforts in 2008-09 to ensure the global financial crisis and the Great Recession it precipitated didn’t lead to a severe recession in Australia. The Rudd government announced at least three major fiscal stimulus packages. All of this spending was carefully designed to be temporary, rather than ongoing. But in his speech Dr Parkinson made it clear that this use of discretionary fiscal policy to assist monetary policy in maintaining internal balance was the exception to the rule.

‘A key objective of fiscal policy is to maintain fiscal sustainability from a medium-term perspective,’ he said. ‘Outside of the automatic stabilisers, discretionary fiscal policy should only be used for supporting demand during extreme circumstances, such as when: the effectiveness of monetary policy is impeded; and/or a shock is sufficiently large and sufficiently sudden that monetary and fiscal policies should work together effectively to support activity, such as during the GFC.’

There are a few points to note about this. First, Dr Parkinson draws a clear distinction between the effects of the budget’s automatic stabilisers (cyclical component of the budget balance) and discretionary decisions to increase or decrease taxation and government spending (structural component). Second, the stabilisers should always be unimpeded in their role of helping to stabilise aggregate demand by reacting in a counter-cyclical way, thereby assisting monetary policy to achieve internal balance. Third, in normal circumstances, the role of discretionary fiscal policy is to pursue fiscal sustainability over the medium term. So, while the automatic stabilisers and monetary policy work together, in normal circumstances discretionary fiscal policy and monetary policy don’t work together because they have different objectives. Fourth, the budget’s expected return to surplus represents the return to normal circumstances.

The objective of fiscal sustainability is encapsulated in medium-term fiscal strategy: ‘to achieve budget surpluses, on average, over the medium term’. Stick to this strategy and, over time, the accumulated deficits will be offset by the subsequent accumulated surpluses, leaving the government’s net debt little changed over the medium term. Note that the medium-term focus of the strategy allows for a) the unrestrained role of the automatic stabilisers and b) the application of discretionary fiscal stimulus during a major downturn in demand provided the stimulus is withdrawn promptly as the economy recovers.

At the time the government engaged in fiscal stimulus spending in 2008-09, it committed itself to a ‘deficit exit strategy’ to ensure the medium-term strategy was complied with. It set itself two targets: first, to allow the level of tax receipts to recover naturally as the economy improves (without breaching the government’s commitment to keep taxation as a share of GDP below its level in 2007-08 - 23.7 pc) - that is, to avoid unfunded tax cuts. And, second, to hold real growth in government spending to 2 pc a year, on average, until budget surpluses are at least 1 pc of GDP and while the economy is growing at or above trend.

Faster growth: the objective of faster and more flexible growth is pursued by the instrument of micro-economic (or structural) policy. Whereas macro-economic policy seeks to stabilise demand over the short term, micro-economic policy works on the supply side of the economy over the medium to longer term, seeking to raise its productivity, efficiency and flexibility. Over the medium to longer term, the rate at which the economy can grow is determined by the rate at which the economy’s ability to supply additional goods and services is growing. Micro policy works mainly by reducing government intervention in markets to increase competitive pressure. Much microeconomic reform since the mid-80s - including floating the dollar, deregulating the financial system, reducing protection, reforming the tax system, privatising or commercialising government-owned businesses and decentralising wage-fixing - has made the economy significantly less inflation-prone. In the second half of the 1990s it also led to a marked improvement in productivity. But the micro reform push has fallen off and much of the government’s attention is directed to other reforms: the introduction of a minerals resource rent tax and the introduction of a price on carbon.

Bottom line on the policy mix: Remember that, whatever job the policy makers decide they want fiscal policy to do, that doesn’t stop changes in the budget balance having an effect on demand. And, as we’ve seen, the stance of fiscal policy is contractionary. Even so, the present stance of monetary policy is mildly expansionary (market interest rates are a little below average). With inflation well controlled, however, the RBA has plenty of scope to ease monetary policy further should, for any reason, demand prove weaker than expected.