Tuesday, May 23, 2023


UBS HSC Economics Day

There’s never been a better time to be studying macroeconomics than this year. If you want to know why economics is interesting and important – why it deals with real-world problems – turn on the radio or television news, read the paper, look on the internet or just look out the window. What you see is people struggling to cope with the cost of living, as prices rise much faster than wages, as the Reserve Bank keeps increasing mortgage interest rates, rents keep rising and Treasurer Jim Chalmers makes sure his budget isn’t worsening inflation, while giving families a little relief from the rising cost of living.

Macroeconomic management involves national governments and central banks trying to smooth the ups and downs in aggregate demand – spending – as the economy moves through the business cycle of boom and bust. The economic managers try to keep the growth in demand as stable as possible because, when growth’s too weak this increases unemployment, while when growth’s too strong this causes inflation. The two tools or “instruments” the economic managers use to stabilise demand are monetary policy (the manipulation of interest rates) and fiscal policy (use of the budget to manipulate government spending and taxation).

When the Covid pandemic broke out in early 2020, the great fear was that our use of lockdowns – ordering everyone to stay at home and leave the house as little as possible – to slow the spread of the virus until a vaccine could be developed would lead to massive unemployment. To prevent this, the economic managers applied extra stimulus to demand. Interest rates were already very low, but the Reserve Bank cut them further. However, the main stimulus came from the federal government increasing government spending and tax concessions by more than $300 billion over two years.

The return to full employment

The result of all this stimulus was that the economy rebounded quickly from the lockdowns and then grew very strongly. As a result, after shooting up to 7.5 pc, the rate of unemployment quickly fell back and kept on falling until it had dropped to 3.5 pc, its lowest in almost 50 years. The rate of under-employment also fell sharply, with the rate of participation in the labour force rising to a record high. As well, an unusually high proportion of the extra jobs created have been full-time. So the one good thing we have to show for the pandemic is our unexpected return to full employment, after an absence of half a century.

The return of high inflation

For a number of years before the pandemic, economic growth was slow, the unemployment rate got stuck above 5 per cent, there was little growth in real wages, and nothing the Reserve Bank did could get the rate of inflation up into its 2 or 3 pc target range.  But about two years ago inflation began shooting up, reaching a peak of 7.8 pc at the end of last year (2022). It has since begun falling back, and was 7 pc in March this year, but this is still way too far above the target band.

Many factors contributed to this surge in inflation. One was shortages of cars, computer chips and many other things, caused by the pandemic’s disruption of their supply. Another was leaps in the world price of fossil fuels and some foodstuffs, caused by the war in Ukraine. These are cases of imported inflation, caused by shortages of supply, not demand. But it’s also clear that the strong growth in demand in our economy following the stimulus and end of the lockdowns is adding to the prices of locally made goods and services. It’s this local source of inflation pressure that has prompted the RBA to increase the official cash rate 11 times since May last year, increasing the rate by 3.75 percentage points to 3.85 pc.

The “policy mix”

Since the 1980s, Australia has followed the practice of giving monetary policy the primary role in achieving “internal balance” – price stability and full employment, aka low inflation and low unemployment. This leaves fiscal policy (the budget) playing a subsidiary role. It assists monetary policy by allowing the budget’s “automatic stabilisers” to improve the budget balance when the economy is booming and monetary policy is trying to restrain demand. Fiscal policy assists monetary policy when the economy is dropping into recession, by allowing the budget’s automatic stabilisers to worsen the budget balance.

Apart from assisting monetary policy, fiscal policy’s primary role is to achieve “fiscal consolidation” – to cut the budget deficit when the economy is recovering from a downturn, so as to limit the growth in the public debt (and the annual interest bill on it). This is so the budget and fiscal policy will be well-placed to be used to support the economy during the next recession or pandemic.

Note, however, that it is good for fiscal policy to take the main stabilisation role from monetary policy during emergencies such as recessions and pandemics. The stage we’re at now is that the emergency has passed, so the primary stabilisation role has passed back to monetary policy and it’s time to get the budget deficit down and keep it low.

The 2023 budget

The former government’s use of the budget to respond to the pandemic caused the budget deficit to blowout to $85 billion (or 4.3 pc of GDP) in 2019-20 and rise to a peak of $134 billion (6.4 pc) in 2020-21.

But most of the pandemic measures were temporary so, with the end of spending measures and the strong recovery causing the budget’s automatic stabilisers to change direction and start tax receipts growing strongly, the following year (2021-22) saw the deficit fall back to $32 billion (1.4 pc).

Mr Chalmers forecast that the budget balance would improve further in the financial year that ends next month, 2022-23, to a tiny surplus of $4 billion (0.2 pc). This further improvement was caused by the continued strong growth in the economy, with more people in jobs, pay tax and not having to get unemployment benefits. Although wages aren’t rising fast enough to keep up with prices, they are rising faster than they were, meaning more of workers’ wages is being lost to “bracket creep”. In other words, it’s the budget’s automatic stabilisers that are doing most to get the deficit down. As well, mining companies are paying more company tax because world prices for our mineral and energy exports have stayed high. So the only credit Mr Chalmers should get for this is for keeping his new spending limited, so that almost all the surge in tax collections went through to the budget bottom line.

In the coming financial year, 2023-24, the economy is expected to slow, while government spending grows faster than tax collections. This should cause the budget to return to a small deficit of $14 billion (0.5 pc) and go a bit higher to about $36 billion (1.3 per cent of GDP) in the following two financial years.

The “stance” of policy adopted in the budget

In deciding whether the budget helps or hinders its efforts to slow the growth in demand (spending) the RBA doesn’t look at particular budget measures. Rather, it looks at the direction and size of the expected change in the budget balance. Mr Chalmers is expecting the budget balance to improve from a deficit of $32 billion in 2021-22 to a surplus of $4 billion in the financial year just ending. This means the gap between how much the budget puts into the economy in spending and how much it takes out in taxes should improve by $36 billion, a tightening equivalent to 1.6 pc of GDP. But in the coming financial year, the budget balance is expected to worsen by $18 billion, a loosening equivalent to 0.7 pc of GDP. Putting the two years together, I think the RBA will conclude the budget in no way hinders its efforts to slow the growth in demand and reduce the upward pressure on prices.

On these forecasts, I judge the “stance” of fiscal policy adopted in the budget to be “mildly contractionary”.

The outlook for the public debt

Because the strength of the economy’s growth means the budget deficit has fallen much faster that was expected this time last year, the outlook for future budget deficits and levels of gross public debt is now not as bad as we’d earlier thought. Whereas a deficit of $78 billion for the financial year just ending had been expected, a surplus of $4 billion is now expected. This means no increase in the debt this year, and no consequent increase in the annual interest bill in this and subsequent years. Over the 12 years to 2033-34, this is estimated to avoid a total of $83 billion in interest payments. It also implies gross debt is now expected to reach a peak of 36.5 pc of GDP in 2025-26, five years earlier and more than 10 percentage points lower than expect in last October’s budget.

The outlook for the economy

With prices rising faster than wages, bracket creep taking a bigger bite out of wage rises and the RBA raising mortgage interest rates, it will be no surprise to see the economy’s growth slow sharply in the coming financial year. The government’s forecasts predict that, after growing by a very strong 3.25 pc in financial year just ending, real GDP will slow to a very weak 1.5 pc.

The main thing driving that slowdown is likely to be slower growth in consumer spending from 5.75 pc to 1.5 pc. This should get the inflation rate down from 6 pc at present to 3.5 pc by next June, then down into the inflation target zone by June 2025.  Wages are expected to grow by 4 pc over the year to next June – but I wouldn’t start spending the money yet. All this is expected to increase the unemployment rate to 4.5 pc, but not until June 2025. 

And if all that sounds a bit too good to be true – it probably is.

The medium-term fiscal strategy

For many years under Liberal and Labor governments, their “medium-term fiscal strategy” was “achieving budget surpluses, on average, over the economic cycle”. This left the government free to run budget deficits during years when the economy was weak, provided these were offset by budget surpluses during years when the economy was growing strongly.

 With the arrival of the pandemic and all the fiscal stimulus it involved, the liberal government changed to a two-part strategy: first, to support demand during the pandemic. But then, second, once the crisis had passed, to “focus on growing the economy in order to stabilise and reduce debt”.

The new Labor government has adopted its own, rather wishy-washy strategy: “to improve the budget position in a measured way, consistent with the overarching goal of reducing gross [public] debt as a share of the economy [nominal GDP] over time”.  The budget “will be improved in a manner consistent with the objective of maintaining full employment. The government will “allow tax receipts to respond in line with changes in the economy, directing the majority of improvements in tax receipts to budget repair”. This means the new government has abandoned the old government’s 23.9 pc cap on the level of tax receipts as a percentage of GDP.