This is not the time to turn to Keynes

As budget season gets under way, the key issue for federal fiscal ­policy is sadly the same as it has been since the end of the 2008-09 global financial crisis - the need to reduce the budget deficit.

The reality is, whatever is in the federal budget, it will most likely be negative for the economy, as part of the price to be paid for past fiscal excess.

Doing too little to address the deficit means continued growth in public debt, which would further jeopardise Australia's AAA credit rating, currently placed on a negative outlook by Standard and Poor's. A question therefore ­arises: What is the biggest risk to the economy - a credit rating downgrade, higher taxes or reduced government spending?

The threat to Australia's credit rating stems directly from the string of large budget deficits, originally misdirected at "stimulating" the economy during the GFC that should have been staunched years ago by governments from both sides of politics. But this has not happened because of a lack of political will to tackle government spending growth as it outpaces revenue growth.

A credit rating downgrade is a Damoclean sword that continues to hang over the Australian economy. It should not be under­estimated given Australia's high private and fast-rising public debt levels, reflecting large-scale borrowing from abroad.

Australia's heavy dependence on foreign money is peculiar by OECD standards. The macroeconomic vulnerability this implies means it is better to be in company with ­Germany, The Netherlands and Singapore with their AAA credit ratings than France and Britain with their AAs.

It is worth recalling what a ­credit rating downgrade could do. First, the increase in domestic interest rates across the board because of a higher interest risk premium would increase the debt-servicing costs of federal, state and local governments, firms and every household - this in the context of rising world interest rates.

Second, it could lead to loan rationing by traditional foreign providers of funds, directly affecting economic activity.

Third, it would be a blow to local consumer and business confidence, as well as deterring foreign investment in its many forms. It is not inconceivable that a credit downgrade could induce an economic downturn or ­shallow recession if these effects combined.

Although there is general recognition that deficit reduction is necessary, in following public policy debate on this issue you could be fooled into thinking it doesn't matter what kind of budget repair occurs, so long as it reduces the deficit. Even some credit rating agencies seem to think this way.

But how different budget measures influence the wider economy is critically important. Raising taxes - for instance, via increased capital gains tax or higher marginal tax rates - is the most widely canvassed budget repair option. But higher taxes damage incentives to work and invest and, if drastic enough, could possibly have as bad an effect on the economy as a credit rating downgrade. Even according to much-flawed Keynesian thinking, higher taxes reduce total private spending in the economy.

That brings us to the most contentious budgetary option of cutting government expenditure. By crude Keynesian closed economy logic, enthusiastically embraced by Kevin Rudd, Wayne Swan and federal Treasury during the GFC, reduced spending can be recessionary. But this is debatable in theory for an economy like Australia that is open to international trade and capital flows. It is also at odds with real world evidence.

Economic history is replete with examples of "expansionary fiscal contraction". For instance, there were no economic downturns following the significant spending cuts undertaken by treasurers Paul Keating and Peter Costello in the 1980s and 90s; quite the contrary. More recently, Ireland has emerged as one of the ­strongest performing economies in Europe after severe public spending cuts.

It's hard to think of a more contentious economic policy issue than the role government spending plays in influencing the economy's overall performance. The consensus academic view has oscillated on this issue since Keynes's The General Theory of Money, Interest, and Employment was published in 1936. Keynesianism peaked in the 60s and 70s but was largely discredited by monetarist and new classical economists in the 80s and 90s. More Nobel prizes have been awarded to non-Keynesians than to Keynesians over this time.

Yet crude Keynesian thinking has always held sway in government circles, and a clear fault line exists between academic and official thinking about using fiscal policy as a macroeconomic policy instrument. Policymakers are naturally drawn to the Keynesian emphasis on government spending as it puts government in charge of the economy, provides a rationale for spending on anything, and affords unelected ­bureaucrats power and influence.

Hence Keynesianism is as much a political doctrine as an economic one. For that reason it has significantly politicised fiscal policy since the GFC. This has biased government thinking against undertaking budget repair via spending cuts at the cost of Australia's long-run economic performance.