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Fiscal policy: the ideological war

By Fred Argy - posted Wednesday, 4 March 2009

Over the long term - i.e. over the business cycle as a whole - economists do not agree on whether the “structural” budget should aim for a surplus or a deficit. This is understandable as several issues arise, such as whether governments can at times be more efficient than private enterprise, whether it is sound public finance for governments not to borrow, whether higher taxes are bad for economic growth, the equity premium puzzle and so on.

But, until today, we thought we had wide agreement on whether governments should be trying to iron out cyclical differences - through fiscal stabilisers (such as automatic changes in unemployment payments or in tax revenues) or through discretionary counter-cyclical fiscal measures (such as deliberate changes in tax rates or new expenditure initiatives). We no longer have such agreement.

At the political level, Australia is now fighting two ideological wars. First, Malcolm Turnbull (leader of the Opposition) is attempting to stir up an aversion to big deficits (“the Prime Minister is plunging our nation into enormous and unprecedented debt”). Second, whatever the size of the deficit, Turnbull favours general tax cuts in preference to the Government’s policy of upfront cash grants and various other forms of spending.


The deficit

During the Howard years, resources were booming and most households were actively building up their debt. The government did the “right” thing by running budget surpluses of 1 to 1.5 per cent of GDP. In fact, Howard did not do enough: it should have been running much bigger surpluses.

With the end of the resource boom and with households seeking to drastically reduce their debt levels, the economy was faced with the prospect of a deep recession. In those circumstances, public debt needed to rise to sustain the economic recovery. Critics of deficits worried that if governments decided to borrow it would simply be draining resources from productive uses in the private sector. They forgot that much of the private sector’s resources were idle and actively looking for alternative productive uses. Turnbull is hoping the economy will recover quickly. This is a forlorn hope. We are simply trading off short-term unemployment for fiscal prudence.

What of the risk that public debt levels will become too high? We have to make a choice between falling GDP and rising public debt. The official forecast is for public debt to rise to about 5 per cent of GDP. If the downturn lasts a few years it might even rise to about 10 per cent. This will still be a very manageable level, when compared to the much larger public debt levels in the USA, UK, Europe, and Japan. Debt levels should then start to decline in the better years.

What of the fear that rising public debt will lead us into a further increase in foreign debt, which is already very high - at around 60 per cent of GDP?
The truth is that external debt is promoted just as much by private sector borrowing as by public debt. Public debt will substitute for private debt levels, leaving total foreign debt levels broadly unchanged - and indeed the change in the mix of public-private debt could enhance overall saving if it increases the national investment-consumption mix (see later). In short, this argument does not apply to contra-cyclical interventions which are later corrected over the economic cycle (leaving a “balanced budget” over the whole of the economic cycle).

Nonetheless, New Zealand, with a current account deficit of 7 per cent of GDP - 2 per cent points higher than ours - has received a warning from Standard and Poor’s that it is “on watch for a credit downgrade”. There is a possibility this contagion could spread here to Australia. Any prospective decline in our risk premium would only be small; our history shows that we had a higher risk premium for the same external account deficit back in the 1980s and 1990s and that financial markets are becoming increasingly aware of our long record of responsible economic management and fiscal management. The alternative to public debt would be to put up with an output decline - which is a far worse outcome.


That said, governments clearly need to encourage savings incentives in the long-run (such as offering automatic, reciprocal grants to low income people who can add additional money to their superannuation).

The choice between expenditures and general tax cuts

One group of economists - mostly libertarians like Robert Lucas, John Cochrane, Robert Barro and John Taylor - argue that the government should go for tax cuts. Malcolm Turnbull - in many ways a social progressive on issues like abortion, gay rights, the republic etc. - has now lined up with the economic libertarians. Not only has he disowned the 10.4 billion package (even though he heartily commended it back in October), but he also rejects the $42 billion package.

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About the Author

Fred Argy, a former high level policy adviser to several Federal governments, has written extensively on the interaction between social and economic issues. His three most recent papers are Equality of Opportunity in Australia (Australia Institute Discussion Paper no. 85, 2006); Employment Policy and Values (Public Policy volume 1, no. 2, 2006); and Distribution Effects of Labour Deregulation (AGENDA, volume 14, no. 2, 2007). He is currently a Visiting Fellow, ANU.

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All articles by Fred Argy

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