I have been down in Tasmania today (Hobart) doing some workshops and press interviews about a Report that my research centre prepared for the public sector unions to help them design a policy response to the announcement by the state Labor government that they plan harsh cuts in net public spending which will include the loss of 2300 FTE public sector jobs and concomitant loss of service delivery capacity. As part of the day I met with the leaders of the Greens (part of the minority government with Labor) and the Opposition Liberals (conservative) who wish to understand the technical issues involved in cutting fiscal support at a time when the state economy is still ailing after taking a beating during the financial crisis – largely due to loss of federal revenues. It is also the day the Federal Budget comes out. So I have some comments on each part of the day although I haven’t had that much time to write. The overriding message from the Federal Budget is that we are now entering the land of the mythical “fiscal contraction expansion”. Ireland has been in it for some time and the UK is now entering it. The overriding lesson from the Federal Budget is that despite the Government’s claims to the contrary – more is not less.
Fiscal battles in the State of Tasmania
As background you may like to read this blog – When governments are financially constrained.
The fact is that the State government of Tasmania is like all below-national level governments in any federal system (so in this respect it is no different to say California) – it faces a financial constraint and has to fund its spending via taxation and then if that is insufficient with debt. Of-course, it can run down assets (privatisation) but that undermines its revenue capacity, generally does not transfer risk to the private sector and leaves the state government vulnerable to having to “buy the asset back” when the private supplier defaults on service delivery standards (often by going broke).
So it is very clear that a national government is never revenue constrained if it retains the capacity to issue its own currency under conditions of monopoly but a state-level government is revenue constrained and so has to manage its budget in a careful way.
What principles might apply to a state government in this respect?
The argument I presented today was simple.
State accounts distinguish between the Operating Balance (which is really recurrent spending and current taxation) and the Fiscal Balance which adds capital spending on public infrastructure to the Operating Balance.
Budget sustainability requires that recurrent expenditures are financed by recurrent revenues over the full economic cycle. The Government can support economic activity by running deficits in periods of slow economic growth when revenues are lower and the demand for services is higher. Conversely when revenues recover and the demand for Government services declines, in periods of strong economic growth, surpluses assist the Government to achieve a net Operating Balance of zero.
But significantly, budget sustainability for a state-level government does not require a surplus on the overall the Fiscal Balance or that the General Government Sector remains net debt free. Certainly, the capital account which records infrastructure investments should typically be in deficit unless the state economy is at full capacity and a withdrawal of public spending overall is considered appropriate to control aggregate spending.
Capital investments provide long-term benefits that span several generations. On equity grounds alone, the burdens of the provision of public infrastructure should be matched against the generations that enjoy the benefits. The only funding vehicle that can achieve that matching is debt.
This requires that the government seek to “balance” the recurrent account over the cycle (issuing short-term debt to cover any cyclically-induced deficits) and fund the capital infrastructure spending via long-term debt to prorate the burden across the beneficiaries.
Unfortunately, the popular “Treasury” narrative is that recurrent surpluses should be used to pay for capital expenditure. That would only be sensible if the economy needed a fiscal drain because it was at full capacity. Given that is rarely the situation encountered, and certainly not the situation that the state governments find themselves in at present, it is a gross violation of generational equity to squeeze the current generation to pay for goods that will provide benefits to their children and grandchildren.
The other aspect of the discussion today surrounded the issue of what to do if the forward estimates pertaining to the recurrent balance suggest there is a long-term structural imbalance between revenues and spending. When should the government seek to redress that imbalance given it is prudent to achieve as best as possible a balance over the cycle?
The specific context in the Tasmanian situation is that the Labor government (yes, the party for workers!) is proposing severe cuts in public employment because it claims the budget outcome has deteriorated.
The advice I gave was two-fold. First, you have to properly assess the budget position and eliminate the cyclical component. The reality is that the Tasmanian budget outcome like most states was significantly impacted by the global financial crisis. The state lost significant amounts of revenue.
It was obvious at the various briefings today that most in attendance didn’t fully appreciate that the final budget outcome for any government (at each level) is a complex result of cyclical factors and discretionary policy choices. The budget balance can fluctuate significantly without any change in government fiscal policy.
The State Government’s Fiscal Balance which is published in the Budget Papers each year is the difference between total state revenue and total state outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. Many observers and politicians use the actual reported Fiscal Balance to indicate the fiscal stance of the government. So if the budget is in surplus they conclude that the fiscal impact of government is contractionary (withdrawing net public spending) and if the budget is in deficit they conclude that the fiscal impact is expansionary (adding net public spending).
However, the complication is that we cannot then conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty is that there are automatic stabilisers which are in-built into the budget outcome and vary with the level of economic activity independent of discretionary policy changes.
Why? We can decompose the budget balance in this way:
Budget Balance = (Tax Revenue + Other Revenue) – (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when growth in State Product falls and the former rises with growth in State Product. These components of the Budget Balance are the so-called automatic stabilisers. In other words, without any discretionary policy changes, the recorded Budget Balance will vary over the course of the business cycle.
When the economy is weak – tax revenue falls and welfare payments rise and so the Budget Balance moves towards deficit (or an increasing deficit). When the economy is stronger – tax revenue rises and welfare payments fall and the Budget Balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the budget in a recession and contracting it in a boom.
As a result, we cannot conclude that a rising budget deficit indicates that the State Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers makes it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time. Any statements that suggest the budget deficit is “too large” and that program cut-backs are required to address the situation thus have to be assessed with considerable caution.
To overcome this uncertainty, economists use the concept of a Structural Balance which is a hypothetical budget balance that would be realised if the economy was operating at potential capacity or full employment. In other words, we would calibrate the budget position (and the underlying budget parameters) against some fixed point (full capacity) and thus eliminate the swings in the budget balance that arise from variations in the business cycle. These cyclical swings in activity around full employment or capacity would be separated out from the underlying budget position which would reflect the discretionary fiscal stance chosen by the government.
If the structural component of the budget outcome is balanced then it means, conceptually, that total outlays and total revenue would be equal if the economy was operating at total capacity. If the budget was in surplus at full capacity, then we would conclude that the discretionary structure of the budget was contractionary and vice versa if the budget was in deficit at full capacity.
In this way, it is important to understand that the actual budget balance is to a major extent out of the control of any government because the cyclical component reflects the variations in the spending decisions of private sector agents (household, business firms, external relations). As a result, it is often counter-productive for a government to attempt to cut back the budget outcome with discretionary spending cuts and/or taxation increases because it fears the budget balance is excessive.
In these circumstances, the imposition of austerity may then cause State Product to contract and the automatic stabilisers (principally, tax revenue at the State level) to push the budget further into deficit. It also follows that a growth strategy underpinned by discretionary stimulus spending and/or tax cuts can drive reductions in the budget deficit outcome as the level of economic activity increases and tax revenues recover.
I thus urged that the State government in Tasmania exercise caution when dealing with decisions surrounding what they perceive to be the dynamics of the State budget. Our work for the unions revealed that the current budget balance was significantly influenced by the downturn in the cycle associated with the GFC. The proposal by the State government to cut back the budget now while the State economy is still lagging is highly contractionary once you calibrate the outcome at the “full employment” benchmark.
In other words, they are proposing (without really knowing it) to hack into the cyclical budget deficit component by tightening the discretionary net spending component. If the economy was to return to growth under this scenario, the actual budget would be in significant surplus and adding fiscal drag to the economy.
My second piece of advice concerned the timing of any adjustments to bring the average recurrent budget into balance over the course of the business cycle. I argued that a thorough review of State spending and revenue was needed before any understanding of the structural balance could be achieved. The State government has not done that analysis. Moreover, even if (hypothetically) there was a structural deficit outstanding once economic growth had restored revenue to its full employment potential, it was critical to get the timing of any adjustment to net public spending correct.
At present the Tasmanian economy is lagging behind the modest national growth average. It is taking much longer to recover from the downturn. Also the significant fiscal stimulus support that was provided by the Federal government to the states to ward off the GFC is now being withdrawn.
Under these circumstances, cutting net state spending now would certainly cause the fragile growth process in that state to stall and perhaps would send the state back into recession. The State government plans to hack 2300 FTE jobs out of the public sector.
We estimated the regional spending multipliers associated with those direct cuts and concluded within a broad (reasonable) range of estimates that the 2300 jobs that were directly cut by the state government would likely lead to between 900 and 2500 private sector jobs as the income losses multiplied out through the economy. The 900 is based on the most conservative assumptions and is probably unrealistic. The upper figure is more likely to result.
Please read my blog – Spending multipliers – for more discussion on this point.
We also identified a number of other negative factors associated with spending cuts of this magnitude including the likelihood of net migration to other states, significant loss of front-line service quality and loss of business confidence.
The point is that just as Ireland, Greece, the UK and other nations are finding (the hard way) – austerity doesn’t come with a silver lining. Reduced economic activity due to expenditure cuts have dampening effects on revenues. This will be amplified to the extent that other States and/or the Australian Government implement similar contractionary policies and will likely prove to be counter-productive – in the sense of reducing the budget outcome.
Remember, a government’s budget outcome is largely beyond its control. The actual budget balance is the outcome of spending decisions by businesses and individuals. Decisions to impose austerity through large cuts to government expenditure or increases in taxation will influence spending decisions in the private sector and can prove counter-productive by causing Gross State Product to contract and thereby reduce State revenues and worsen the budget balance. The alternative strategy of fostering growth by discretionary stimulus spending and/or tax cuts can drive reductions in the budget deficit outcome as the level of economic activity increases and tax revenues recover.
There were other aspects of our work that the politicians and press found interesting including re-estimating the budget forward estimates which showed that the Treasury had overestimated the budget deficit and were actually planning to create very large (contractionary) surpluses while holding out to the public that they were just reducing the deficit.
Why would they do that? Politics triumphing over economics.
Which brings me to the Federal Budget. I am sitting in the Melbourne Airport terminal awaiting a flight back to Newcastle. The Federal Treasurer is about to get up and present the 2011-12 Budget Speech. I plan to download as much of the documentation (it is being released at 19:30) so that I can read it on my flight back north (which goes at 19:45).
Australian Federal Budget – 2011-12
Fiscal policy is often discredited because it is used to advance a political rather than an economic strategy. Clearly all governance is about politics and governments use their policy settings to advance their political agendas. That is unavoidable.
Further, the requirements of democracy mean that our elected officials should be responsible for major policy decisions and not out-source them to so-called “independent commissions”, which are never independent (in terms of ideology) and do not provide voters with a target.
That combination thus means that the use of fiscal policy can become seriously compromised by political considerations at the expense of sound economic management. The way the two are brought together in the public space is that governments first and foremost worry about their own longevity and reconstruct th eeconomic narrative to allow them to take decisions that advance their primary objectives.
I have a different view about the way governments should operate. My feeling is that if the government truly advances public purpose – which after all is the only reason we would want to hand over our freedom to an external authority – then they should not struggle politically. Sure defining what public purpose means is a challenge. But full employment and income security should tough enough “voting” bases for the other more contentious policy areas to be less damaging should division occur.
Further, I see the role of the government to provide leadership and to shape the opinions of the electorate through education and demonstration. The current political system in Australia (and elsewhere) has descended into a game of managing the 24 hour news cycle and responding on a daily basis to polling that is constantly being taken.
We now see major policy announcements materialise as if overnight in repsonse to some opinion poll or another. The latest fiasco about the way the government proposes to manage the miniscule number of boat people trying to land on our shores is a (pathetic) case in point. The problem – minute in relative terms – has been magnified by the media into being seen by the electorate as being the largest threat to our sovereignty. The government gives oxygen to that mis-perception by constantly coming up with ever more draconian ways to corral these unfortunate people.
The Australian government has chosen a course of action that promotes the pursuit of inflexible fiscal rules ahead of prudent management.
In several recent blogs I have provided contextual analysis that frames my reaction to the Budget tonight. Please see – Time for progressives and unions to abandon Labor – When ideological blinkers lead to denial – It is getting ridiculous.
Here are some comments sketched on the plane after reading the Budget Papers.
The Treasurer used the term “the Asian Century” to describe what he says is a “seismic shift in global economic power, which positions us as a prime beneficiary of tremendous economic growth in our Asian region”. I have some sympathy with that view. It is clear the Europe is bogged down in ideology on top of a dysfunctional monetary system. The US – the largest economy in the world – is similarly bogged down by ideology that is denying the monetary system it enjoys.
The growth centre of World is now to be found in China and India and as a primary commodity exporter with favourable trade associations with this “centre” the Australian economy is well placed. The terms of trade are in our favour and allow us to gain significantly increased access to real goods and services for less sacrifice of our own resources.
The question remains however as to whether the external sector will play a sufficiently large growth role to both allow the private domestic sector to continue to run down its overall levels of indebtedness and the Government to run a highly contractionary fiscal position.
The Government is banking on that.
The reality is that this Budget is framed at a time when the business cycle is still undermining the Government’s capacity to take in revenue. The Budget Papers forecast that the on-going effects of the financial crisis has lopped more than $A20 billion from its revenue forecasts made in the Mid-Year Review (6 months ago).
That should have sent the Government a message – the economy is weak and will weaken further if the fiscal support is further withdrawn. The Government’s reaction is opposite. Its reaction is to cut spending even further. Why? Because it has become fixated on its surplus by 2013 target and has lost sight of the fact that the Budget is an economic document. Politics is dominating this Budget and the Nation is the worse for it.
I actually do not think it will help the Government politically anyway.
My examination of the Forward Estimates revealed that despite the fact that we are meant to be going through the “once-in-a-lifetime” mining boom and record terms of trade, the forecasted surplus three years out is miniscule. They even estimate that unemployment will rise a tad to 5 per cent by 2013-14.
Why? Because the rest of the economy is dragging along the bottom. I do not believe that an economy that is so imbalanced in its growth projections (and reality) will deliver the bonuses that the Treasurer is claiming will be there for all Australians.
This is the fourth budget that the Treasurer has delivered and is his worst. As the ABC Report – Swan makes jobs his budget mantra – notes the mantra was “Jobs, jobs, jobs” and he repeatedly claimed that this was a “back-to-work-budget”.
The bottom line is this: they have a budget deficit of $A45.7 billion (3.3 per cent of GDP) in 2010-11. They plan in this budget to more than halve that deficit (to $A20.3 billion or 1.4 per cent of GDP) this coming financial year before delivering a surplus of $A4 billion (0.3 per cent of GDP) by 2012-13 as promised.
My bet two years out is that the growth forecasts upon which these estimates are based are too optimistic (4 per cent real GDP growth, for example is forecast in the next financial year) which would amount to an almost doubling of the current growth rate.
They plan to do this by cutting $A22 billion out of public spending while private spending is flat and business confidence is in decline (as per data we received yesterday).
There was bright economic news today with the Trade Balance being in surplus for March 2011. The surplus was driven by strong growth in metal ores and coal (production of which had been disrupted earlier in the year by natural disasters).
Further, primary commodity export prices continue to edge up in our favour.
The trade balance however is volatile and was in deficit last month. I agree that the outlook for trade is solid.
The question is whether this will ensure the external sector becomes a positive contributor to growth. The income drain on the current account would have to sharply reverse itself for that to be the case. The Government’s hype is built around that assumption and historically you would have to be dubious.
The problem is also that if commodity prices continue to rise the central bank (RBA) will probably presume an inflation spike is just around the corner and hike interest rates again. With households still holding record levels of debt the sensitivity of aggregate demand to interest rate rises is increasing.
So the combination of fiscal retrenchment and monetary tightening will worsen the imabalances that are already evident in the Australian economy. The mining export sector is booming but the train is leaving the rest of the economy behind at the station.
The press called this the “less is more” budget (for example, Labor banks on less-is-more) but do not take that analysis far enough.
Where there are new spending initiatives announced they are in areas that I predict will not achieve much. The supply-side labour market rhetoric – the OECD Jobs Study line – that the responsibility of the Government is no longer to ensure there are enough jobs but rather to adopt the diminished goal of full employability has failed since it became the dominant approach to long-term unemployment in the early 1990s.
The neo-liberals are a one-trick pony in this respect. All the evidence suggests that churning the unemployed through a relentless stream of training exercises divorced from a paid work environment is not an effective use of public funds. All it has done is create a new private industry that “manages” the unemployed.
Combined with the harsh – read pernicious – rules that are associated with this “management” (fines for failing “activity” tests etc) and you have a policy framework that is a waste of public money.
The Government would have been far better off if it had announced broad job creation programs with essential on-the-job training opportunities embedded.
In my view the only way to test the “shirker” hypothesis (that is, that the long-term income support recipients) do not want to work is to offer them a job. It is not sufficient to force them to look for work that is not there.
Employment growth is no-where near strong enough to ensure that all those who want to work (the hours desired) can find those opportunities. The Australian government keeps faith with its neo-liberal leanings and just goes into denial by assuming that we are full employment when unemployment is at 5 per cent and underemployment is over 7 per cent.
By adopting this pathetic benchmark the whole public debate is aborted and they get away with their tough on the dole recipients mantra. Just for that they deserve to lose office – not to say that the Opposition would be any better in this regard.
It is now very late and I promised some journalists my Budget commentary once I got back home from Hobart (nearly 5 hours of travel).
But given I started out today at Melbourne airport at 5.30 and it is now 22:35 odd I think …
That is enough for today!