Australia’s last chance Budget

After a year of fiscal deterioration, last year’s Budget “emergency” has vanished, from Peter Martin:

Tuesday’s budget is genuinely new. Two of the six-member expenditure review committee that put it together weren’t there before – the new Social Services Minister Scott Morrison and the new Assistant Treasurer Josh Frydenberg​. The three top bureaucrats who put it together are new in their jobs – Michael Thawley​ in prime minister and cabinet, John Fraser in treasury and Jane Halton in finance.

This time the Prime Minister Tony Abbott chaired almost every meeting. The nominal Treasurer and deputy chair Joe Hockey played less of a role.

Abbott declared a “budget emergency” back in 2013 after Labor forecast a deficit of $18 billion. On Tuesday Hockey will announce a deficit closer to $45 billion. But the emergency will have vanished.

…What’s changed is that the government no longer has the political strength to make big inroads into the deficit. Bruised by the reaction to its first budget and behind in the polls it will face an election next year.

Laura Tingle and Jacob Greber at the AFR capture the basic outlines of what has happened:

We’ve been told for weeks that the budget will be boring and dull. The message about its economic strategy has been blurred at best:

“The economy is a bit fragile so we can’t really cut the deficit much yet, but we have to cut the budget in the medium term.

“We will outline a path back to surplus but, yes, you may have noticed that we are now arguing things are getting better because we are hoping that the deficit won’t be larger,” the argument goes. “And that’s only if we measure it as a percentage of GDP, rather than in dollar terms.”

This is where the real story of the budget lies. The glib version of what is at stake with next Tuesday night’s budget is it is the crucial test that will determine Tony Abbott’s future, Joe Hockey’s future, and the country’s.

In fact, the political and economic task facing the government is truly gargantuan. It is not just a question of righting the political wrongs of last year’s budget. Abbott, Hockey and the expenditure review committee have to turn around both a political and policy aircraft carrier.

The government has to escape and rewrite the whole direction and message of the Coalition for the past five years in all its inflexible, overly simplistic glory, about getting back to surplus at the end of a first term.

…If there is an inflexion point where the Coalition’s debt and deficit rhetoric meets the softening economy, it is that the Abbott government is sliding towards a moment when it may be forced into making a major choice between preserving the AAA credit rating at all costs or preventing a serious downturn.

A good effort but it still doesn’t go far enough. What is at stake here is much greater than a cyclical and political choice between fiscal easing, a sovereign downgrade and a slowing economy. The question before the government – of which it is either blissfully unaware or cynically dodging – is whether or not it can save Australia’s contemporary economic model. To understand this we need a little history.

For the past forty years, two schools of thought have vied for the hearts and minds of Australian economic policy-makers.

The older of the two holds that running current account deficits to grow your economy is a bad idea because sooner or later you will run into an external crisis. It argues that competitiveness is of utmost importance and elevates productivity as the key driver of prosperity.

The second school is younger and was birthed in the time of Paul Keating’s “Banana Republic” debate. Known colloquially as the “Pitchford thesis” it holds that current account deficits don’t matter so long as the debt is accumulated in the private sector by “consenting adults”. As such it is really an offshoot of the “rational markets hypothesis”.

The first school held sway through the eighties and nineties but the second school has dominated policy since the late nineties. The economy has transformed accordingly, from a productivity and reform driven model to an offshore debt-accumulation and asset inflation model.

There have been times when the Pitchford model has faced a reckoning but each time it has been saved by good fortune. In 2003 the model would have hit a wall as the housing bubble of the day was popped by the MacFarlane RBA. But a housing crash in Sydney was rescued by the greatest commodity and income boom in Australian history, and the bubble instead went national.

In 2008, as the rational markets hypothesis was smashed to pieces by the GFC, Australia’s Pitchord thesis policy-making retreated for a time as the RBA and APRA sought to rebuild Australia’s banks with local deposits rather than the offshore borrowing that had necessitated a government guarantee in the crisis. What made this possible was the serendipity of a second round and even larger commodity boom.

But, sadly, these near misses, rescues and rational interludes did not kill the Pitchford school. Rather, good fortune was misinterpreted as good management and, so, as the second mining boom began to go bust in late 2011, rather than challenge itself and wonder if the old school of focusing on competitiveness and productivity was worth revisiting, the Pitchford school said to itself “let it rip”, and deliberately blew another offshore-funded property bubble, which is where we find ourselves today.

The problem, however, is this. The Pitchford model was always an illusion. With banks borrowing heavily offshore to pump debt into mortgages and not business lending at home, there is no productive economy to support the borrowing over time. When the offshore debts were called in in the GFC, the government was forced to guarantee the borrowing and that finally described the limits of the model. Credit rating agencies made the link explicit and the Budget was henceforth forced to maintain surpluses to guarantee the giant private debt pile, or the sovereign rating would be stripped and the Pitchford model unravel via more expensive offshore debt for the banks.

Which brings us back to tomorrow’s Budget and national discussion about it. The media is still trapped in the Pitchford model of thinking. It sees Budget choices as political, between fiscal stimulus and a lower sovereign rating on one hand and fiscal discipline and lower growth on the other.

This is true only within the business cycle, which is rapidly maturing and likely to end in the next several years.

The much bigger choice for this Budget is whether or not Australia’s wastes its last clip of fiscal ammunition on keeping another high-risk Pitchford cycle alive or it instead begins a reform process that aims to change the economic model to the old way of thinking, by improving competitiveness and productivity.

Very obviously it will be the former, given the Abbott Government wither understands none of this or just wants to get past the next election. Joe Hockey sums it up today:

Mr Hockey sought to defuse the recession warning on Sunday, saying no economists were “stating in numbers” that Australia “is facing an economic downturn”.

“Australia is on the threshold of its greatest-ever era, but we have to earn, and we are earning that era,” he said in Canberra.

…Mr Hockey described the Reserve Bank’s outlook as “upbeat”.

“We are going to have strong economic growth this year; we want it to be stronger,” he told Channel Nine. “We’re keeping unemployment below the 6.5 per cent level.”

This may reassure the Pitchford pundits for a while, and who knows, perhaps a third rainbow will smack ’em in the arse as India rises to a boom dwarfing that of China and iron ore heads for $500 per tonne. As Pitchford doyen, Michael Pascoe, once wrote at the very peak, “you ain’t seen nuthin’ yet”.

But here on planet earth, where commodity prices will very likely keep falling on monumental oversupply, a Budget that is not by design shifting the nation towards a managed structural change is really just inviting markets to force the same adjustment via a violent dislocation a bit further down the track.

The proximate trigger is the loss of the AAA rating. If it happens soon the pain will be delayed as the global chase for yield continues. But when the next end-of-cycle shock brings with it higher interest rates for nations of questionable credit quality, just as Australian public debt stock rockets above 50% of GDP virtually overnight (sorry Tony, not by 2050-60), sovereign downgrades will rain down, triggering a private sector credit crunch that finally ends the Pitchford model by driving it head first into a brick wall.

That is what is at stake in this Budget. It’s not Tony Abbott’s nor Joe Hockey’s last chance, it is Australia’s.

Houses and Holes

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