Wednesday, December 19, 2012

Making sense of the budget surplus saga

I hate to burden you with a topic as earnest as the budget deficit so close to the holidays - I had hoped to write about the idea of giving someone a goat for Christmas - but the saga of whether the Gillard government will manage to get its budget into surplus this financial year has reached farcical proportions.

A few weeks ago we learnt from the national accounts that the economy's rate of growth slowed to 0.5 per cent in the three months to September. When some parts of the media concluded the most significant implication of this news was that it increased the likelihood of the budget balance not returning to surplus (which it does) I realised the public debate was running off the rails.

Contrary to the impression we are being given, the budget balance is a means to an end, not an end in itself. We don't run the economy to balance the federal government's budget. And when we get our quarterly report on how the economy's travelling, the primary question is not what it tells us about the government's performance or it political prospects.

The budget was made to serve the economy, not the other way round. And the economy was made to serve us. So the primary question to be asked when we receive the quarterly report card is what it implies for us. Is our material standard of living improving more slowly than we'd prefer? Is inflation getting worse? Is the economy growing fast enough to stop unemployment rising?

These things matter because they matter to us and our lives. It's only because they matter to us that they also matter to the fortunes of the governments we re-elect or toss out. So the economic implications of the budget balance come first, the political implications are very much secondary.

Trouble is, for both the public and the media, the political implications of the budget balance are deceptively simple, whereas the economic implications are complicated and, to many, incomprehensible.

Politically, the only thing people think they need to know is that anything called a deficit must be bad and anything called a surplus must be good. Most political reporting about the budget balance is based on this assumption.

The opposition has been reinforcing this simplistic reasoning unceasingly from the moment in 2009 it became clear the global financial crisis had pushed the budget balance into deficit. Its success explains why, in the election campaign of 2010, a foolhardy Julia Gillard took a mere Treasury projection that the budget would be back in surplus by 2012-13 and elevated it to the status of a solemn promise.

Economically, however, it ain't that simple. From an economic perspective, budget deficits are bad in some circumstances, but good in others. Similarly, budget surpluses are good in some circumstances but bad in others.

How could this be so? It's because national government budgets operate at two quite different levels. At one level the government's budget is the same as that for a business or a household: it's a forecast of how much money will be coming in and going out during a year. You use budgets to ensure things go to plan and you don't get in deeper than you can handle.

At another level, however, the budgets of national governments are quite different from other budgets. Because they're so big relative to the size of the economy - equivalent to about a quarter - what's happening to the economy has a big effect on the budget. But the budget is so big it can also be used to affect what happens to the economy.

This is something few non-economists seem to understand. People who focus solely on the political implications of the budget, assume that if the budget moves from surplus to deficit this could only be because the government has chosen to spend more than it is raising in taxes. If the budget moves from deficit to surplus, this could only be because the government has chosen to spend less than it's raising in taxes.

Not so. The other reason budgets go from surplus to deficit is that when the economy turns down, this causes tax collections to slow or even fall and government spending (particularly on unemployment benefits) to grow rapidly. Similarly, the other reason budgets go from deficit to surplus is that the economy speeds up, causing tax collections to grow rapidly and spending on unemployment benefits to fall as more people find jobs.

This automatic deterioration in the budget balance is what happened after the financial crisis hit business and consumer confident so hard. In this case, the descent into deficit was good, not bad. Why? Because it represented the budget helping to break the economy's fall during the downturn.

What complicates matters was Kevin Rudd's decision to use a temporary burst of government spending to stimulate the economy out of its downturn. At this point we had the economy making the budget balance worse automatically, but also the government choosing to add to the worsening as a way of hastening the economy's eventual recovery.

But just as the budget balance deteriorates automatically when the economy turns down, so it improves automatically when the economy recovers and resumes its growth. Treasury's projection the budget would be back in surplus by 2012-13 was based mainly on its assumption of a strong recovery in tax collections.

This hasn't been happening, thus making the return to surplus unlikely. From an economic perspective, it's the weak recovery that's worth worrying about, not the delayed return to surplus. From an uncomprehending political perspective, however, that won't save Gillard from a caning.