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Some Thoughts on the Budget Deficit

Some Thoughts on the Budget Deficit
Should reining in the budget deficit be an urgent priority for the Federal government, as is widely proclaimed? I have my doubts. The government faces two serious but conflicting objectives. In the short-term it needs to reduce our excessive unemployment rate – currently over 6 per cent. In the long-term it needs to reduce the budget deficit, which is expected to worsen as the population ages.
Our current budgetary problems have their origins, in part, in the policies of the Howard/Costello government, which failed to build up adequate surpluses in the good years. Standard economic theory explains how the economy comes in cycles, of an average duration of about 4 or 5 years, although their severity can vary significantly – from very severe to very mild.
Expansionary years of the cycle, when inflation is considered more serious than unemployment, require contractionary monetary policy (higher interest rates) and/or contractionary fiscal policy (reduced deficits or larger surpluses) designed to reduce aggregate spending throughout the economy. When the cycle eventually turns and the economy goes into recession, as it did when the GFC struck in 2008, those policies need to be reversed. The Rudd government moved swiftly to do this and prevented a major economic collapse. The official unemployment rate peaked at 5.9%, instead of double digits as many expected, but because the previous government had failed to build up adequate surpluses the blow-out in the deficit resulted in an enlarged government debt which the current government is saddled with.
Unfortunately it is not quite as simple as that. Because of the complex interplay of variables that make up the economic jigsaw puzzle, appropriate policy responses are complicated by many other factors. For example, the Howard government inherited the tail end of the stagflation era when unemployment and inflation were both excessive, such that action taken to overcome one problem would exacerbate the other. Another constraint has been the sluggishness in the world economy, which has been very slow to recover from the GFC because of inadequate fiscal policies in many countries. This sluggishness has not helped Australia’s exports – an exception being the recent mining boom. But the mining boom has hindered Australia’s recovery by adding an overlay of structural unemployment (as distinct from cyclical unemployment described above). The mining boom was allowed to run for too long, causing an overvalued Australian dollar which led to closure of many manufacturers and penalised agriculture. The mining boom has now collapsed but it is too late to reverse the damage to manufacturing.
So where are we now? Commentators are reluctant to use the word ‘recession’ to describe the current sluggishness in the economy, but the reality is that the unemployment rate has been steadily rising over the last two and a half years - from around 5.1% to 6.3% currently. To arrest the decline the government has been relying on an easing of monetary policy rather than fiscal policy, because of its desire to rein in the deficit. The Reserve Bank has forced interest rates down so low there is not much further they can go, and is reluctant to push them lower for fear it will exacerbate the housing bubble, which if it bursts could trigger another economic downturn.
For a more sophisticated analysis of the complexity and limitations of monetary and fiscal policy you might care to read Ross Gittins in The Age, Sat. 21 March, Business 6.
The government and some commentators have whipped up such a frenzy of fear over the need to reduce the budget deficit that a reversal of rhetoric would be politically embarrassing (or ‘very courageous’ as Sir Humphrey would say). But consider this. If unemployment becomes stuck around 6%, the adverse effects on tax revenue and unemployment pensions would seriously impede efforts to get the budget back to surplus. Further, if discretionary fiscal stimulus were to be pursued now, while interest rates are so low, the cost of servicing an increased government debt would not be as burdensome as would usually be the case.
Now what about the budgetary implications of the longer term problem of an ageing population? Modelling revealed in the latest Intergenerational Report reveals a disturbing prediction for future budgets as government spending on the elderly increases, especially on health services and the age pension. The ageing problem is a result of two factors – declining mortality rates and declining fertility rates. But these trends have existed for the last 155 years or more. In 1860, Australia’s death rate was 2.0% p.a. - it is now 0.7%. The birth rate was 4.3% p.a. - it is now 1.2%. But ageing has not been a problem. Why? Because per capita incomes have been steadily increasing as part of the normal economic growth process. In other words, we and our ancestors could afford to support the growing proportion of elderly (as well as support children to an older school-leaving age).
According to the Intergenerational Report, average per capita incomes are projected to grow by an average 1.5% p.a. in real terms over the next 40 years, compared with 1.7% over the previous 40 years; a decline of 0.2% attributed mainly to the ageing effect. But 1.5% p.a. is still a significant rate of increase, and suggests there should be no need to reduce living standards by cutting back on existing services, as the government proposed in last year’s budget. Rather, the need will be to restrict expenditure on services that raise living standards.
The projected increase in incomes of 1.5% p.a. is at odds with the dire predictions of mounting budget deficits for years to come, but if they do occur taxes will need to increase to ensure the burden of ageing is spread evenly across the private sector as well. Taxes that improve efficiency and equity in the economy would be welcome, particularly environmental taxes. Abolition of wasteful expenditure such as unnecessary industry subsidisation is obviously called for.
It will be interesting to see if the forthcoming budget will reveal a change in emphasis - from fiscal restraint to fiscal stimulus directed at reducing unemployment.