Monday, February 16, 2015

Don't fix the budget while the economy is weak

We are hearing a lot of muddled thinking about how the Liberal Party's leadership ructions affect the budget and the economy, much of it coming from business people. For the sake of their businesses, they need to think more clearly.

There must be some truth to the idea that the political uncertainly is adding to the lack of business confidence, but the contention it's a big factor is dubious. "Confidence" is such an amorphous thing that you can say what you like about why it's up or down without anyone being able to prove you're wrong.

What's incontrovertible is that non-mining business investment spending isn't growing very strongly - not as fast as the Reserve Bank was hoping it would be by now, nor fast enough to offset the rapid slide in mining investment.

I think the main reason for this is simply that businesses don't see much need to expand at present: their sales aren't growing all that strongly and they're not about to run out of spare production capacity.

Any chief executive who has failed to take advantage of profitable investment opportunities because he's so worried about the instability in Canberra deserves the sack.

No, I think it works the other way round: because the economy's flat and you're waiting for an attractive investment opportunity to arise, you rationalise your inactivity by drawing attention to all the failings of the pollies supposed to be running the economy.

The danger with all this hand-wringing about "confidence" is that it's supposedly hard-headed business leaders resorting to wishful thinking: "if only we could have a change of prime minister, everything in the economy would be much better".

Part of the business angst has been worries about the budget: "it's vital we get the budget back to surplus to help the economy" and "it will be a terrible thing if Abbott tries to buy back some popularity by spending big in this year's budget".

Such comments reveal a weak understanding of the macro-economic basics. The budget isn't the economy. They're quite separate things and the fate of the economy matters far more that the fate of the budget and the size of the government's debt.

Getting the budget back to surplus within a year or two wouldn't make the economy grow any faster. In fact, it would make growth much slower. You'd have to let budget deficits roll on for at least another decade before you got to the point where it was damaging the economy.

Its main downside would be a level of public debt so high it made the government reluctant to add to it by using the budget to stimulate the economy out of a recession. At some point the government's credit rating might be downgraded, but the fear of downgrades is exaggerated. Its blow to the government's ego would be greater than the cost to taxpayers or the economy.

The budget and the economy are interrelated, of course, but it's a two-way relationship. People know the budget affects the economy: cut taxes and increase government spending and you'll make the economy expand faster; raise taxes and cut spending and you'll slow the economy down.

The bit many don't get is that the economy also affects the budget. Stronger growth in the economy leads to faster growth in tax collections and so reduces a budget deficit, whereas slow growth hits tax collections and so worsens a budget deficit.

That's where we are now. The prospective budget deficits over the coming three or four years are now much higher than they were when Joe Hockey took over as Treasurer. That's partly because of the budget measures blocked by the Senate, but mainly because commodity prices have fallen much more than expected and tax collections are growing much more slowly than expected.

The point is, to start slashing and burning in this year's budget would give the economy another kick in the guts, which would slow growth even further and probably make the deficit bigger rather than smaller.

This is precisely why, contrary to popular impression, the big cuts proposed in last year's budget weren't intended to really kick in until 2017, by which time it was hoped the economy would be back to growing strongly.

We now know the return to strong growth will be delayed. That's why the Reserve Bank cut interest rates again. But even the Reserve admits that, at such low levels, monetary policy isn't as effective as it was in stimulating growth.

That's why what we should be thinking about is whether the budget ought to be used to support the economy further by investing in more infrastructure projects.