Yesterday’s MYEFO was a turning point for me. Never has it been so clear how badly our leadership has managed the spectacular bounty of the past ten years of our economy. Our leaders yoked the budget to the terms of trade, spent the revenue windfall as it rose, and must either take the revenue back or run endless deficits.
Famous business people want the former. From the AFR:
Business Council of Australia chief executive Jennifer Westacott said overcoming years of deficits will require a decade of committed reform.
“There must be a re-prioritisation of expenditure and all sides of politics must be honest with the Australian community about the cost of government programs and what is likely to be affordable within current tax settings,” Ms Westacott said in a statement.
“A disciplined 2014-15 budget, which includes structural measures that contain government expenditures over time, needs to be matched by greater efforts to boost economic growth and productive capacity, which will greatly assist the budget repair job.”
Australian Chamber of Commerce and Industry chief executive Peter Anderson said there were no “pain-free options” to solve the budgetary problem.
“The heavy lifting has to be done on the expenditure side, because we are already an expensive place to live and do business, meaning that there is no tolerance factor in households or enterprises for higher taxes to finance profligate spending,” Mr Anderson said.
Some grey beards are also calling for the Government to rally the public behind the cuts, says Alan Mitchell:
But the critically important task confronting the Abbott government is to galvanise public support for the budget repair task it faces.
While Australia’s budget problem is small by comparison with those of the major developed economies, the consolidation task will be painful and will need public support.
Fair enough. But I submit to you that these folks do not know of what they really asking for: proposing a European doom loop for the economy.
The budget is now forecasting 2.5% growth for the next eighteen months, rightly. With current expenditure levels, that will run the Budget into deficits of $34billion in 2014/15 and then $24 billion in 2015/16.
Let’s say the Government cuts hard enough to produce a surplus in both years and that the other forecasts remain equal. That would wipe off roughly 2% of GDP in 2014/15 and 1.5% in 2015/16 and that’s before you add in fiscal multipliers which will be substantial.
The broader forecasts would not remain equal thankfully. The RBA would be forced to cut rates again and the upside would be that interest rates would fall further and so would the dollar, boosting tradable activity but threatening a housing boom and swift bust. I submit to you as well that given the state of household debt and prudence, apart from Sydney’s mad speculators, consumers will not borrow and spend enough to offset the downdraft.
That means the economy would be close to or in recession in 2014/15 and probably close to it again in 2015/16. The Budget will then end up with an unintended deficit of $100 billion per annum before you can draw breath. Clearly this is not a viable public policy option.
Let’s say instead that the Government takes a slower approach. If it plans to cut $15 billion from 2014/15 and the same again in 2015/16 then it will be cutting at least 1% off its own GDP forecasts and it may not crash the economy but the Budget will run on the spot as growth still slows materially and revenue downgrades plus automatic stabilisers blow up forecasts.
It really doesn’t matter what approach you take to austerity, you still end up chowing down on your own tail.
And this it the problem that ten years of poor leadership has left us. The Budget was the principle beneficiary and re-distribution mechanism of mining boom income. It took that income and gave it to us. We levered it up and blew it on costly houses gifting the nation years of spectacular economic growth.
But, now that that income is falling, the machine is running in reverse. There is no way to fix the Budget swiftly without shrinking the economy in the process. And ratings agencies will need to see a path surplus in the next four years or the AAA rating will be cut and Australia’s cost of funds begin to rise, also hitting growth and the Budget.
There are only three ways to fix the deficit. The first is through a new terms of trade boom, which isn’t likely.
The second is to follow the doom loop to its logical conclusion by cutting spending until the economy deflates enough that competitiveness returns and tradable investment and profits rise sufficiently to boost taxes and balance expenditure. That is a very long way down. Just ask Greece.
The third way is to cut recurring expenditure like middle class welfare and boost by the same amount expenditure on productivity enhancing infrastructure for probably a decade. As well, you must engineer a real exchange rate adjustment that improves competitiveness and gets investment going in tradables, via macroprudential policies at the RBA. Eventually that’ll deflate us enough without killing ourselves in the process to turn the Budget back to surplus.
The Government clearly has some version of this last process in mind. It has a clever trick up its sleeve in that it’s aiming to engender a building takeoff via infrastructure bonds which are not counted in the Budget. That will enable some cuts to give the appearance of Budget repair without killing the economy. But what it has proposed so far on roads is neither large enough nor productivity enhancing enough to help long term.
Crucially, the cut and invest approach to Budget repair should be a medium term process, with little austerity until LNG exports kick in good and proper in 2015/16 and so does the infrastructure spending, two years hence. The critical question now, then, is does the Government’s political and ideological timetable for Budget repair match these needs in the economy?
