Saturday, May 13, 2017

Budget gives mild fiscal stimulus to economy

Will Scott Morrison's big-spending, big-taxing, big-borrowing budget impart a big fiscal stimulus to the economy in the coming financial year? Not so much.

Why not? Short answer: because the higher spending is offset by higher taxes – so we get a bigger public sector, but not a big net budgetary stimulus – while most of the increased borrowing for infrastructure is years away.

The longer answer requires a little arithmetic gymnastics, partly because different economists have different ways of measuring the size of the impetus – whether expansionary or contractionary – a new budget imparts to the rest of the economy.

The Reserve Bank has its own shortcut way of assessing the impact of the budget ("fiscal policy") on the economy – which it does as part of its assessment of what it must do with its own "monetary policy" (manipulation of interest rates) to ensure the combined effect of these two "instruments" – which the economic managers use to smooth the strength of demand as the economy moves through the ups and downs of the business cycle – is as it should be.

The Reserve does this because it, not the elected government, accepts ultimate responsibility for stabilising demand. It thus uses its monetary policy as the "swing instrument".

If, for example, the Reserve found that a government was using its budget to stimulate demand at a time when demand was already growing strongly (and thus threatening to increase inflation pressure beyond its 2 to 3 per cent inflation target) it would seek to counter that stimulus by "tightening the stance" of monetary policy (that is, by increasing interest rates).

This is just what was happening under treasurer Peter Costello in the early years of the resources boom before the global financial crisis.

The government's coffers were overflowing with money and it was spending it and giving it back in eight tax cuts in a row – presumably because it believed the boom would last forever – when it should have been saving the excess for lean years to come, and thereby stopping the economy from "overheating".

Meanwhile, the Reserve was trying to counter this "pro-cyclical" fiscal policy – that is, policy that amplifies the business cycle rather than smoothing it – by jacking up interest rates.

It had the official cash rate up at 7 per cent by the time the crisis occurred in September 2008, but then lost little time in slashing the rate to 3 per cent.

This was an extreme reminder that fiscal and monetary policies aren't the only sources of stimulus or contraction bearing on the economy. The other main source is the rest of the world, the "external sector".

For example, a rise in the dollar ("an appreciation of the exchange rate") has a contractionary effect on demand – because it worsens the international price competitiveness of our export and import-competing industries – whereas a fall (depreciation) in the dollar has an expansionary (stimulatory) effect.

Point is, it's usually best for the two "arms" of macro-economic management to be reinforcing each other, by having them adopt similar stances.

This is why, now, while the Reserve has been cutting the official interest rate as low as 1.5 per cent in its effort to stimulate demand, successive governors have appealed to the government to use the budget to give them more help.

This could be done by distinguishing between the budget's deficit on "recurrent" (day-to-day) spending – which the government could continue reducing – while increasing its spending on capital works, thus adding to demand.

The year's budget is a belated response to that appeal.

But back to the Reserve's shorthand way of assessing the stance of fiscal policy. It's to look at the direction and the size of the expected change in the budget balance between the old year and the coming year.

ScoMo is expecting the underlying cash deficit to fall from $37.6 billion in 2016-17 to $29.4 billion in 2017-18, a drop of $8.2 billion.

A decline in the deficit (or, in other circumstances, an increase in a surplus) says the stance of policy is contractionary.

But $8.2 billion is less than 0.5 per cent of the size of the economy – nominal gross domestic product – which is expected to be $1.82 trillion ($1822 billion) in 2017-18, meaning it's barely visible on the economic radar.

The Reserve's shorthand measure doesn't distinguish between the two reasons for a change in the budget balance: cyclical factors (what the economy does to the budget as it moves through the business cycle) and structural factors (what the government's policy decisions do to the budget, and thus to the economy).

The strict Keynesian way of judging the stance of fiscal policy is to ignore the cyclical change and focus on the structural (or "discretionary") change.

(BTW, the budget papers estimate that the structural component of the budget deficit will be equivalent to about 2 per cent of GDP in 2017-18, compared with an overall underlying deficit of 1.6 per cent, implying the cyclical component is now back in surplus.)

If we look at the effect of the discretionary policy changes announced in the budget, but take account of the reversal of the "zombie" measures that had been included in the budget even though they never happened, decisions were made to increase spending in 2017-18 by $1.9 billion, but offset this with increased revenue of $1.7 billion, leaving a net addition to the structural deficit of about $200 million.

To this, however, we need to add the government's additional capital spending – on the national broadband network, the second Sydney airport and Melbourne to Brisbane inland freight railway – totalling about $12.8 billion, which for strange reasons Treasury excludes from the underlying cash deficit.

This takes discretionary policy spending up to about 0.7 per cent of GDP which, by Keynesian lights, makes the budget stimulatory, but only mildly so.