Interest rate pressures: are the states to blame?

On August 8, the Reserve Bank decided to raise the official cash interest rate. In the lead up to that decision, the Prime Minister, John Howard, argued that the blame for any interest rate rise should be sheeted home to the states as Mr Costello is running a budget cash surplus whereas state budgets are in cash deficit. Is the Prime Minister right?

The bank’s decision reflected concern that aggregate spending was growing too fast relative to domestic productive capacity and posing a threat for inflation. So have the states been contributing more to demand than the Commonwealth?

The first thing to be said is that the combined state and local general government fiscal deficit is quite small - about 0.5 per cent of GDP - and projected to remain at these low levels in the years ahead.

Second, it is wrong to assess the impact of a budget on net aggregate demand (and hence on inflationary pressures) by looking solely at whether it is currently in surplus or deficit. The inflationary effect in any one year is determined by the change in fiscal position relative to the previous year. On this criterion, the Commonwealth and states have delivered roughly the same stimulus to aggregate demand over the last two years.

The 2007 Budget Paper No. 1 (p.12-6), tells us that the Commonwealth budget surplus was 1.5 per cent of GDP in the 2005-6 Budget and it is projected to be 0.9 per cent in 2007-8: thus delivering a stimulus to the economy of 0.6 per cent of GDP over the two years. The states had a surplus of 0.4 per cent of GDP in 2005-6 and are projecting a deficit (net borrowing) of 0.4 per cent in 2007-8: delivering a stimulus to the economy of 0.8 per cent of GDP.

The figures on general government spending (excluding capital investment) tell a similar story. In 2005-6 Commonwealth spending (“expenses”) was 21.3 per cent of GDP and is projected to be 21.5 per cent of GDP in 2007-8: a net stimulus of 0.2 per cent. At the state and local level, spending levels were 15.7 per cent of GDP in 2005-6 and are projected to be 15.3 per cent of GDP in 2007-8: a net deflationary effect of 0.4 per cent. In addition, the Howard Government’s generous tax cuts are adding to the surge in private sector spending.

While more refined assessments are needed, for example, to weed out cyclical and structural effects, these figures suggest prima facie that the Commonwealth has contributed as much or more to demand pressures as the states. This boost to demand is partly why the labour market is so strong. Does Mr Howard want to share the credit for Australia’s low unemployment with the states?

Third, one needs to look at the composition of the increase in spending to assess its longer term inflationary implications. Mr Howard’s increased spending has been mostly in the form of transfer payments, including a good deal of middle class welfare. In his eleven years, his government has done very little to relieve the growing skills shortage and infrastructure bottlenecks in Australia. Furthermore, he has been spending at record levels on government advertising, much of it for party political purposes. The states have not always been judicious with their spending but at present their increased spending is mainly on productive infrastructure, which will in turn reduce future inflationary pressures.

Incidentally, it is ludicrous for the Prime Minister and Mr Costello to say that private financing of new infrastructure is OK but public sector financing is not. They both have exactly the same impact on interest rates.

Finally, how can Mr Howard blame the states for over-spending when he is at the same time obstructing their efforts to rationalise their public services? Mr Howard recently decided to invest over half a billion dollars in new Technical Colleges instead of upgrading existing state technical schools, causing considerable economic waste and duplication. And now, with his Mersey hospital intervention, Mr Howard is thwarting Tasmania’s attempts to rationalise its hospital system and improve its efficiency.

The interest rate rise is largely a result of the resources boom and strong world economy. To the extent that any of our governments are to blame, Mr Howard needs to accept more than his share of the blame. Responsibility for overall demand management rests with the Commonwealth - not the states.