This is a background blog which will support the release of my Fantasy Budget 2013-14, which will be part of Crikey’s Budget coverage leading up to the delivery of the Federal Budget on May 14, 2013. This blog provides some general principles that should govern the design of a budget.
The complete suite of Fantasy Budget blogs are as follows:
- The indecent inconsistency of the neo-liberals
- Australia output gap – not close to full capacity
- Daily macroeconomic income losses from unemployment
- The Australian labour market – 815 thousand jobs from full employment
- What is a Job Guarantee?
- Investing in a Job Guarantee – how much?
- MMT Fiscal Principles
- The Fantasy Budget 2013-14
In this blog, we consider the principles that might inform a government in determining what its fiscal policy strategy should be.
I provided a detailed framework in this blog – The full employment budget deficit condition
Other recommended sources of information and analysis include:
- Deficit spending 101 – Part 1
- Deficit spending 101 – Part 2
- Deficit spending 101 – Part 3
- Fiscal sustainability 101 – Part 1
- Fiscal sustainability 101 – Part 2
- Fiscal sustainability 101 – Part 3
- Functional finance and modern monetary theory
More discussions of Modern Monetary Theory are to be found at this location – Debriefing 101.
Responsible fiscal policy requires two conditions be fulfilled:
1. The discretionary budget position (deficit or surplus) must fill the gap between the savings minus investment minus the gap between exports minus imports.
In notation this is given as
(G – T) = (S – I) – (X – M)
Which in English says for income to be stable, the budget deficit (G – T) will equal the excess of saving (S) over investment (I) – which drains domestic demand, minus the excess of exports (X) over imports (M), which adds to demand.
If the right-hand side of the equation: (S – I) – (X – M) – is in surplus overall – that is, the non-government sector is saving overall then the only way the level of national income can remain stable is if the budget deficit offsets that surplus.
A surplus on the right-hand side can arise from (S – I) > (X – M) (that is, the private domestic sector net saving being more than the net export surplus) or it could be associated with a net exports deficit (draining demand and adding foreign savings) being greater than the private domestic sector deficit (investment greater than saving) which adds to demand.
2. Most importantly, the prior discussion focused on the level of income remaining stable but as we have seen doesn’t necessarily define a full employment condition.
We can define a full employment level of national income as that which is generated when all resources are fully utilised according to the preferences of workers and owners of land and capital etc.
Given that S, T and M are all positively related to the level of national income, there is a unique level of each of these flows that is defined at full employment. Changes in behaviour (for example, an increased desire to save per dollar earned) will change that “unique” level but for given behavioural preferences and parameters we can define levels of each.
So lets call S(Yf), M(Yf) the corresponding flows that are defined at full employment income (Yf). We also consider investment to be sensitive to national income (this is outlined in the so-called accelerator theory) such that higher levels of output require more capital equipment for a given technology.
So I(Yf) might be defined as the full employment flow of investment. We consider export spending to be determined by the level of World income.
Accordingly, to sustain full employment the condition for stable national income is written more specifically:
Full-employment budget deficit condition: (G – T) = S(Yf) + M(Yf) – I(Yf) – X
The sum of the terms S(Yf) and M(Yf) represent drains on aggregate demand when the economy is at full employment and the sum of the terms I(Yf) and X represents spending injections at full employment.
If the drains outweigh the injections then for national income to remain stable, there has to be a budget deficit (G – T) sufficient to offset that gap in aggregate demand.
If the budget deficit is not sufficient, then national income will fall and full employment will be lost.
If the government tries to expand the budget deficit beyond the full employment limit (G – T)(Yf) then nominal spending will outstrip the capacity of the economy to respond by increasing real output and while income will rise it will be all due to price effects (that is, inflation would occur).
In this sense, Modern Monetary Theory (MMT) specifies a strict discipline on fiscal policy. It is not a free-for-all. If the goal is full employment and price stability then the Full-employment budget deficit condition has to be met.
Are budget deficits or surpluses good or bad?
The budget balance has no meaning as a standalone aggregate. What does a $A30 billion federal deficit mean? Nothing in itself. What does a deficit of 2 per cent of GDP mean? Only that the deficit is 2 per cent of current price GDP. Is a deficit that is 2 per cent of GDP better or worse than one that is 4 per cent of GDP? The answer it that it all depends.
The higher deficit figure might be the exemplar of fiscally responsible policy choices whereas the lower outcome might indicate fiscally irresponsible decisions. Or, the opposite might be the case, depending on the circumstances.
There is nothing intrinsically good or bad about any specific budget outcome.
In response to the 1982 attempt by conservative politicians to pass a Balanced Budget Act in the US Congress, the revered macroeconomist Gardner Ackley said:
My own position on deficits has always been, and remains, that deficits, per se, are neither good nor bad. There are times when they are not only appropriate but even highly desirable, and there are times when they are inappropriate and dangerous. During a recession or a period of “stagflation”, deficits are nearly unavoidable, and are likely to be constructive rather than harmful.
This blog – A voice from the past – budget deficits are neither good nor bad – has more discussion about Gardner Ackley.
To add meaning to the discussion we have to relate the budget outcome to the circumstances in the economy rather than be side-tracked by some pre-conceived notion that some balance is desirable and another is not.
It is not the government’s role to run deficits or surpluses. We want governments to make policy choices that will maximise the potential of the people to enjoy their lives and contribute the best they can, given their own circumstances to the well-being of society and the planet.
We might call this goal one of public purpose. An essential element of that goal, given current cultural morays in most nations, will be to ensure that everyone who wants to work has a job and for those that are unable to work, for whatever reason, have adequate income support so they are not alienated and socially-excluded.
That goal is constrained by the availability of real resources that the nation commands – labour, capital, land, etc – but not by the financial capacity of the currency-issuing government.
In most budgetary discussions, it is erroneously assumed that the national government has a financial constraint and has to budget like a household.
The analogy neo-liberals draw between household budgets and government budgets is false. Households use the currency and must finance their spending.
However, government issues the currency and must first spend (i.e. credit private bank accounts) before it can tax (i.e. debit bank accounts). The claim that governments must tax or borrow to ‘finance’ its spending is false under a fiat-currency system.
The Euro nations are an exception to this rule. They surrendered currency sovereignty, and thus have to borrow to cover deficits. This makes them dependent on bond markets (in lieu of European Central Bank support) and exposes them to solvency risk. The current Euro problem lies in the flawed design of its monetary system, which was a neo-liberal ploy to limit the capacity of these governments to borrow and spend.
The restrictions on government spending are the quantity of real goods and services available for sale in its own currency, including all the unemployed labour. Neo-liberal claims that bond markets limit government spending are false.
The fact is that the only constraint that a currency-issuing government, such as the Australian government faces, are how many real goods and services are available for sale in $A. When there is mass unemployment, for example, we can conclude that the government has no real constraint at that point in time and can bring those labour resources into productive use through higher spending.
Despite the collapse of the convertible currency system (in 1971), most fiat-currency-issuing governments impose voluntary constraints on themselves that resemble the spending constraints under the gold standard. These ideologically motivated fiscal rules are designed to limit the capacity of government to run deficits or borrow from the non-government sector (or both).
These rules render fiscal policy subservient to monetary policy, which continues to echo the failed monetarist approach. The fiscal rules represent a denial of the opportunities that a fiat monetary system offers an elected government; in addition, they are undemocratic (e.g. making an unelected ‘Budget Commission’ responsible for fiscal policy).
A decision to restrict real public spending growth to 2 per cent might be suitable at some specific time, given the need to ensure that nominal aggregate demand does not exceed real capacity and cause inflation. At other times, such a decision would be irresponsible; for example, when nominal demand is weak and unemployment is rising. Therefore, it is not sensible to make such a restriction a fixed rule.
Something that is often misunderstood is that the budget outcome is determined by the state of overall activity, and is largely beyond the control of government. If private spending is weak, then the budget deficit will typically rise as tax revenue declines, irrespective of what government does.
Thus, by trying to operate within false thresholds and limits (e.g. a 3 per cent deficit-to-GDP rule), governments too easily fail and the pressure for fiscal retrenchment increases. But when private spending collapses and the deficit rises, the correct response is to increase discretionary net public spending, not cut it.
Typical fiscal rules create a bias towards spending restraint; this damages public infrastructure development, reduces the volume and quality of public goods such as education and health, and maintains high rates of underuse of labour.
In the current crisis, such rules have resulted in pro-cyclical policy changes, which are anathema to responsible fiscal management. Governments should not cut public spending when the economy is plummeting into recession.
The blogs listed in background material contain more detailed conceptual or empirical analysis that expand on the points made in this section of the document:
Structural and Cyclical Budget Balances
The government budget balance is the difference between total revenue and total outlays. So if total revenue is greater than outlays, the budget is in surplus and vice versa. It should be appreciated however that movements in the final budget balance do not provide a reliable indication of the intent of the government.
We cannot conclude that if the budget is in surplus then the fiscal impact of government is contractionary (withdrawing net spending) and if the budget is in deficit then the fiscal impact is expansionary (adding net spending).
This uncertainty arises because there are so-called automatic stabilisers operating as a result of swings in economic activity, which are, in part, influenced by the discretionary shifts in government fiscal policy.
To see this, the most simple model of the budget balance we might think of can be written as:
Budget Balance = Revenue – Spending.
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 GDP growth falls and the former rises with GDP growth. These components of the Budget Balance are the so-called automatic stabilisers.
In other words, without any discretionary policy changes, the Budget Balance will vary in a pro-cyclical manner 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.
So just because the budget goes into deficit doesn’t allow us to conclude that the Government has suddenly become of an expansionary mind.
At full employment, it is entirely possible (and likely) that the budget will still be in deficit (given the propensity of the non-government sector to save).
The point is that we have to measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output, so that we can decompose the budget balance into that component which is due to specific discretionary fiscal policy choices made by the government and that which arises because the cycle takes the economy away from the potential level of output.
This decomposition provides (in modern terminology) the structural (discretionary) and cyclical budget balances. The budget components are adjusted to what they would be at the potential or full capacity level of output.
So if the economy is operating below capacity then tax revenue would be below its potential level and welfare spending would be above. In other words, the budget balance would be smaller at potential output relative to its current value if the economy was operating below full capacity. The adjustments would work in reverse should the economy be operating above full capacity.
If the budget is in deficit when computed at the “full employment” or potential output level, then we call this a structural deficit and it means that the overall impact of discretionary fiscal policy is expansionary irrespective of what the actual budget outcome is presently. If it is in surplus, then we have a structural surplus and it means that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual budget outcome is presently.
So you could have a downturn which drives the budget into a deficit but the underlying structural position could be contractionary (that is, a surplus). And vice versa.
The difference between the actual budget outcome and the structural component is then considered to be the cyclical budget outcome and it arises because the economy is deviating from its potential output level.
The point is that structural budget balance has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work for all of us to advance public purpose.
In this context, one of the most important elements of public purpose that the state has to maximise is employment. Once the private sector has made its spending (and saving decisions) based on its expectations of the future, the government has to render those private decisions consistent with the objective of full employment.
So then the national government has a choice – maintain full employment by ensuring there is no spending gap which means that the necessary deficit is defined by this political goal. It will be whatever is required to close the spending gap. However, it is also possible that the political goals may be to maintain some slack in the economy (persistent unemployment and underemployment) which means that the government deficit will be somewhat smaller and perhaps even, for a time, a budget surplus will be possible.
But the second option would introduce fiscal drag (deflationary forces) into the economy which will ultimately cause firms to reduce production and income and drive the budget outcome towards increasing deficits.
Ultimately, the spending gap is closed by the automatic stabilisers because falling national income ensures that that the leakages (saving, taxation and imports) equal the injections (investment, government spending and exports) so that the sectoral balances hold (being accounting constructs). But at that point, the economy will support lower employment levels and rising unemployment. The budget will also be in deficit – but in this situation, the deficits will be what I call “bad” deficits. Deficits driven by a declining economy and rising unemployment.
So fiscal sustainability requires that the government fills the spending gap with “good” deficits at levels of economic activity consistent with full employment.
Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end).
The blogs listed in background material contain more detailed conceptual or empirical analysis that expand on the points made in this section of the document:
The Government’s 2012-13 Fiscal Shift – doomed to fail from the start
As noted in my commentary on the May 2012-13 Budget – the planned fiscal retreat is unprecedented in our history.
At the time of the May 2012-13 Budget the planned budgetary shift was estimated to be at least $A38.5 billion. In the latest MYEFO the proposed fiscal shift is now $A44.1 billion or 3.1 per cent of GDP. That sort of shift towards surplus has never been achieved in known history.
The following graph shows annual fiscal shifts since 1972-73 in terms of proportions of GDP.
The shift into deficit in 2008-09 saved the economy from a major recession and growth was supported in the following year by a further shift to stimulus, although some of the shift in both years was the result of the automatic stabilisers reducing tax revenue and pushing out welfare payments (based on existing policy settings).
The Government’s take on this appears on Page 35 of the MYEFO:
Importantly, the economic impact of the fiscal consolidation in 2012-13 is much smaller than the 3.1 per cent of GDP turnaround in the underlying cash balance. This is because the surplus is being achieved through a combination of targeted and responsible savings and the natural increase in tax receipts associated with a growing economy, assisted by policy measures in this MYEFO to improve the operation and integrity of the tax and superannuation systems.
Of-course, one can ensure the growth assumptions and underlying tax elasticities (the response of tax revenue to growth for a given tax rate structure) are such that the budget outcome moves towards and/or into surplus. But a fiscal contraction has to undermine spending growth overall unless the non-government sector more than offsets the cuts (no matter what degree of contraction is finally endured).
On the same page (35) of the MYEFO this is what the Government actually assumes.
But like all austerity-seeking governments who have assumed the private sector prefers smaller deficits or surpluses and will increase spending as a consequence of a government pursuing such a fiscal shift, the Australian government is in denial of not only the objective circumstances that exist at present (rising unemployment; outstanding and massive private debt overhang from the pre-crisis credit binge; declining terms of trade which is undermining $A export revenue but also discouraging further investment growth in the mining sector, etc), but also basic psychology.
The non-mining economy is in near recession at present with unemployment undermining income growth and non-mining investment very weak. Basic psychology tells us that in those situations private spending binges of the size required to “more than offset” the public cutbacks will not be forthcoming.
However, there is also some dishonesty in the way the government is presenting the data to us.
In the May 2012-13 Budget statement it was obvious that at least $A8.5 billion in spending that will flow this year was shifted to be recorded against the 2011-12 outcome. So the deficit in 2011-12 was artificially inflated, which just happened to allow them to record a paper surplus despite the degree of contraction associated with the 2012-13 fiscal position being less than would be forthcoming if there really had have been a 3.1 per cent of GDP withdrawal in one year.
In other words, the degree of contraction this fiscal year is actually less in 2012-13 than the nominal figures suggest. How much less is a guess but if we subtract the $A8.5 billion from last year and add it to this year then you are talking a $A27 billion fiscal shift, which is about 1.8 per cent of GDP.
More importantly, this means the underlying fiscal position in 2012-13 is not a surplus at all but a deficit of some $A7.4 billion (0.5 per cent of GDP).
Whatever the actual numbers are (and turn out to be) and the deviousness aside, the direction of fiscal policy is completely wrong. Even if it ends up being a 1.8 per cent of GDP contraction that scale of fiscal shift i one year is also unprecedented historically and is totally unsuitable at a time when non-government spending will not offset the loss of public net spending.
The question that has to be asked is under what circumstances would a Government be responsible in taking out net spending equivalent to 1.8 per cent of GDP in one year (when inflation is forecast to be constant or falling)?
You have to ask this question in the context of actual real GDP growth is running at around 2.5 per cent at present and trending downward and the main growth engine – private investment slowing as a result of the slump in commodity prices.
The answer to the question is that the economy would have to be pushing well above trend and straining the inflation barrier – with full employment and zero underemployment – and private growth would have to be very strong and becoming even stronger during the forecast period.
There have never been conditions like that in the last 40 years. Nor will there be in the next 12 months.
That is why this scale of fiscal withdrawal is an act of vandalism and driven by misguided (miscalculated) political machinations and is devoid of any economic rationale. That is why it will fail.
The current budget position does not reflect macroeconomic realities and is undermining the pursuit of public purpose.
(c) Copyright 2013 Bill Mitchell. All Rights Reserved.