Monday, February 3, 2014

Hockey faces daunting budget challenge

In shaping this year's budget - their most important macro-economic task for the year - Tony Abbott and Joe Hockey face a dilemma: the timing for a particularly tough budget may be right politically, but it's anything but right economically.

It's clear they intend to follow the example of John Howard and Paul Keating by using the first budget after their election to have an almighty cleanout and strike a lasting blow for fiscal sustainability.

A lot of this simply involves replacing policies favouring your predecessors' heartland supporters with those favouring your own supporters - that is, making room for your election promises - but it has to go further and achieve a significant net improvement in the "structural" budget balance (the balance we would have if this were a normal year in the business cycle).

The first budget after a government's election is the one where it can take unpopular measures with greatest political impunity. You blame it all on the incompetence of your predecessors, and you give voters the maximum time to forgive and forget before the next election.

Fine. But the economy is so fragile at present, and its transition from mining-led to non-mining-led growth so tentative and uncertain, that Hockey would be crazy to produce a budget that cut the deficit significantly in the coming financial year or even the one after.

You can't be forecasting growth as weak as 2.5 per cent, with slowly worsening unemployment this year and next - implying below-trend growth for three years in a row - and also be tightening fiscal policy. After all, the Labor government's eminently worthy "deficit exit strategy" (which it only pretended to stick to) kicked in only "once the economy returns to above-trend growth".

The sad truth is the economy's prospects are so uncertain - and the fall-off in mining construction spending so unpredictable - that Hockey must not only avoid doing anything that adds to the weakness, but also stand ready to inject emergency fiscal stimulus the moment it becomes clear a collapse in mining investment threatens to push us into overall contraction.

The point is that, while it's undeniable we need to return the budget to cyclical surplus (and structural balance), this shouldn't happen - and, thanks to our still low level of public debt, doesn't need to happen - with any urgency.

So, how should Hockey resolve this contradiction between smart politics and responsible macro-management and avoid the charge that he's descended to a counter-productive policy of "austerity"?

One solution would be to announce all the tough measures in May, and get them through Parliament, but time them to start only slowly, then build up rapidly in the "out years" - by which time, we presume, the economy will have returned to healthy growth.

An alternative, but riskier approach would be to press on with the deficit-reducing measures, but offset their contractionary effect by embarking on a big new program of spending on infrastructure. This makes the point federal governments have hitherto ignored in their rhetoric: it's only the recurrent (or operating) budget that needs to be balanced over the cycle.

It's perfectly responsible for capital works spending to be financed partly by borrowing - thereby requiring future generations to contribute to the cost of the long-lasting infrastructure they benefit from - provided the projects aren't wasteful but yield a high social return.

Another worry is Hockey's statement before Christmas that his budget-repair measures would be limited to cuts in government spending, which was reinforced by Abbott's homily at Davos praising smaller government and lower taxes.

As John Daley of the Grattan Institute has noted, there's no precedent for successful fiscal consolidation here or elsewhere that didn't involve both spending cuts and tax increases.

The plain fact is that, though there's much scope for spending cuts - reduced business welfare, including subsidies to chemists, inefficient arrangements with fee-for-service doctors, home-made submarines, excessively generous grants to well-off private schools and so on - no remotely plausible list of spending cuts would be sufficient to achieve fiscal sustainability.

This is mainly because the greatest single contributor to Treasury's projections of unending budget deficits is the inexorable real growth in spending on healthcare. Any pollie who imagines they could do any more than temporarily slow that growth, or cover its cost by never-ending cuts in other areas of spending, is an ideologically crazed fool.

The other problem is that for many years much "spending" by governments has taken the form of tax exemptions, rebates and other concessions. Unless Hockey and Abbott's definition of spending cuts includes cuts in "tax expenditures" I can tell you now their efforts will fall far short.