McKibbin ignores the elephant in the room

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Australia’s newest economic interlocutor, Warwick McKibbin, has penned a great piece in the AFR this morning on the eve of the national Budget. He is on the money in my view and yet clearly off the pace as well. Let’s take a look.

The fiscal deficit or surplus in a single year is not the main indicator of a country’s success or failure in fiscal policy. A more relevant measure is the stock of government debt relative to gross domestic product. There is ample evidence that when the stock of government debt rises above 60 per cent of GDP increasing amounts of production need to be put aside to service the interest payments on that debt…it is estimated in Australia the gross stock of government debt to GDP will be 28 per cent in 2013.

Rational economic analysis does not suggest that there is a fiscal sustainability problem in Australia.

However, if the budget is designed to improve fiscal sustainability then it should be judged by the stock of debt relative to GDP in a future year, such as 2016. If the budget shifts spending and taxes across years to generate a surplus in 2012-13 but does not change the stock of debt relative to GDP at some future year, then it should be judged a failure.

The second aspect of fiscal policy that matters is the shift in spending and taxes that influence the business cycle…from a counter-cyclical fiscal policy position, the budget will be a success if it is at least neutral or to some extent anti-cyclical. It will be a failure if it is pro-cyclical; that is, removes demand from the economy when the economy is forecast to slow relative to trend.

…The third aspect of good fiscal policy is whether government spending yields a higher rate of return than the cost of funding this spending and whether the taxes that generate revenue lead to the lowest cost in terms of deadweight loss for the economy. Thus the economic criteria behind the choice of spending cuts and tax revenue increases will be critical. One hopes that there is a rigorous economic analysis of where changes in taxes and spending give the greatest benefit to the Australian people.

All good and true. Then McKibbin frames a very important question:

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The main question is, why do financial markets need to be persuaded that the government can manage a debt to GDP ratio of 28 per cent even though this is the second-lowest in the advanced world? It is not whether there is a surplus in 2012-13 that drives Australia’s fiscal credibility, but whether the government shows an understanding of the broad principles of sound fiscal policy.

The problem with the entire fiscal debate in Australia today is that many economic concepts have been spun so far they have lost meaning. There is serious economic damage being caused by attempting to reach political goals with no economic rationale.

In my view, McKibbin has very nicely layed out the the conditions of quality fiscal policy only to then draw entirely the wrong conclusion. He has done this by ignoring the elephant in the room: private debt. The tension in market perceptions of Australian fiscal management is not between the need for counter-cyclicality on one hand and the cause of politics on the other. It is, rather, fear of pro-cyclical fiscal policy on one hand and the failure to stabilise the Budget – that is, run supluses – because it implicitly guarantees Australia’s enormous private debt stock. Ratings agencies have intimated this for months and more recently stated it openly.

Ironically, until Australian leaders address the elephant then they will continue to exacerbate this tension, even when arguing for its resolution.

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About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.