VCTA Student Revision Lectures
September 12, 2010
The economy has been on a roller-coaster ride from resource boom to global financial crisis to recovery from the mildest of recessions to the likelihood of an early return to the resources boom and an economy at near full employment. Monetary policy played its accustomed role in all this and Keynesian fiscal policy returned to the fore. But did we have a recession? And just what was the role played by fiscal/budgetary policy?
Yes, we did have a recession
The widespread belief - encouraged by the Rudd government - that Australia avoided recession is based solely on the notion that a ‘technical’ recession occurs when real GDP contracts for two quarters in succession. But though this rule is widely used by the media, it’s merely rule of thumb with no status among economists. It’s quite arbitrary, and doesn’t always give the right answer. A better definition of recession was given by Dr David Gruen of Treasury: ‘a sustained period of either weak growth or falling real GDP, accompanied by a significant rise in the unemployment rate’.
The evidence that we did have a (very mild) recession is clear: we saw the collapse of various local fringe financial institutions, a 0.7 per cent fall in real GDP in the December quarter of 2008 and weak growth in later quarters, a rise of 230,000 (1.8 percentage points) in unemployment and a bigger rise in under-employment, much tougher borrowing conditions for small business, and weakness in retail sales and home building as the effects of budgetary stimulus wore off.
The reasons why the recession was so mild and short-lived were many: our banks didn’t get into difficulties, the continued strength of our exports to China, the strong growth in the population, the reluctance of employers to retrench their skilled staff and the dramatic cuts the official interest rate. But much of the credit must go to the fiscal stimulus, which was particularly effective in turning around the collapse in business and consumer confidence following the US and European banking crisis.
Fiscal policy
Definition: the manipulation of government spending and taxation to influence the strength of demand.
Instruments: variation of the size and composition of government spending and taxation.
Objective: to serve as a backup to monetary policy in achieving internal balance - low inflation, low unemployment and a relatively stable rate of economic growth. It is conducted in accordance with the government’s ‘medium-term fiscal strategy’: to ‘achieve budget surpluses, on average over the medium term’.
This strategy, which the Rudd government essentially took over intact from the Howard government, was carefully worded so as to fully accommodate a Keynesian approach to fiscal policy. It implies that fiscal policy will support economic growth and jobs by allowing the budget to move into temporary deficit during an economic downturn. So it was deliberately framed in a way that permits the automatic stabilisers to respond to a downturn by turning the budget balance from surplus to deficit. But it also permits the Government to apply discretionary fiscal stimulus, provided the budget balance is brought back into surplus once the economy recovers. In this way, the deficits in the bad years will eventually be offset by surpluses in the good years, thus causing the budget to be balanced (or even in surplus) on average over the full cycle. In other words, the strategy is constructed to permit what I call ‘symmetrical Keynesianism’.
The fiscal stimulus
During the boom, fiscal policy was given a limited role to play in the policy mix, with the heavy lifting left to monetary policy. Once the economy turned down, however, fiscal policy came to fore. The Government announced its first fiscal stimulus package (worth $10 billion) in October 2008, then a second package (worth $42 billion) in February 2009. And it announced a $22 billion national infrastructure program in the 2009 budget.
The measures included in the various packages were intended to comply with three principles enunciated by Treasury and known as the ‘three Ts’: measures needed to be timely, targeted and temporary. Timely meant they should take effect as soon as possible; targeted meant the spending should go to those people or activities most likely to involve spending rather than saving; temporary meant they should involve only a one-off cost to the budget (eg cash bonuses, specific capital works) rather than a continuing cost (eg tax cuts, pension increases).
Some people have the impression that most of the stimulus spending went on cash bonuses. In fact, they cost about $22 billion, less than a third of the Government’s total stimulus spending of $74 billion over the four financial years to2011-12. The remaining two-thirds went on ‘shovel-ready’ minor capital works (road black spots, level crossings, public housing, roof insulation and primary schools) and major infrastructure projects (roads, rail, ports and broadband).
Whereas in May 2008 the government was projecting a long run of budget surpluses, it is now projecting large budget deficits, leading to an increase in the Australian Government’s net debt. It is important to understand, however, that most of this deterioration has been caused by the operation of the budget’s automatic stabilisers, rather than by the Government’s explicit spending decisions. Lower prospective tax collections required the Government to write down its projected revenue by $110 billion over the five years from 2008-09 to 2012-13. Higher prospective dole payments would also have contributed to the deterioration in the budget balance.
The latest estimates suggest the government is expecting the budget deficits over the four years to 2011-12 to total $135 billion. Thus discretionary fiscal stimulus accounts for only a bit over half of the accumulated deficits, with the automatic stabilisers accounting for the rest.
Stimulus spending by governments is intended to have ‘multiplier effects’. Empirical research shows, however, that, particularly because of leakages to saving and imports, the multiplier effects are much smaller in real life than in textbooks. In the Treasury’s calculations for the budget it used highly conservative (pessimistic) multipliers of 0.6 for the Government’s cash bonuses and 0.85 for capital works spending. It now seems clear that the fiscal stimulus has been far more successful than even its promoters expected. That is, the multipliers seem to have been greater than expected.
The changing policy mix
The Opposition’s calls for the stimulus spending to be curtailed now the economy has begun to recover fail to take account of the originally planned phase-down as the T-for-temporary spending programs expire. According to Treasury’s calculations, after the December quarter of 2009 the stimulus spending’s contribution to GDP growth swung from positive to negative. This occurred because, though more stimulus money was spent in the March quarter, it was less than the stimulus money spent in the December quarter. And this meant it subtracted from the rate of growth in GDP (even though it still added to the level of GDP). In other words, from the end of December the stance of fiscal policy switched from expansionary to (mildly) contractionary as the stimulus was withdrawn. To hasten this planned withdrawal would make fiscal policy more contractionary.
By contrast, the various increases in the cash rate we’ve seen, taking it to 4.5 per cent, merely represent moves to take the stance of monetary policy from stimulatory to neutral.
What we have to show for the fiscal stimulus
The Opposition runs hard with the line that, thanks to all the fiscal stimulus, we’re left with nothing to show but a lot of deficits and debt. This isn’t true. Clearly, we’ll be left with all the shovel-ready capital works - rail crossings, fixed black spots, social housing, school buildings and ceiling insulation - and major infrastructure.
But that’s not all - though you have to be an economist to see it. Even the money spent on the cash splashes and unneeded assembly halls has left us with something to show. All the spending - discretionary and automatic - reduces the time it will take for the level of real GDP to return to its previous peak. And that leaves us better off than we would have been in two respects. First, the smaller the rise in unemployment and thus the fewer people unemployed - and the shorter the time they spend unemployed - the less the atrophy (wasting away) of individuals’ skills. Reducing this problem, which economists call ‘hysteresis’, is a benefit not just to the individuals involved, but also to the community.
Second, the milder the recession, the fewer viable businesses go bust, thus avoiding the destruction of various forms of tangible and intangible capital. Some capital equipment - and some understandings, networks and arrangements the firms have made - that could have been used to produce goods and services in the upswing is destroyed. So the milder the recession, the less the loss of productive potential because of the destruction of human, physical and intangible capital.
The opposition opposed all but the first stimulus package and has been continually finding fault. At first it argued the measures - particularly the cash splash - wouldn’t work. But it’s clear from the economic indicators - for retail sales, home loan approvals, new home building approvals and business investment in equipment - that the measures were highly successful in leading to increased private spending. It’s true some of the cash was saved rather than spent, but the marked improvement in business and consumer confidence at the time suggests this saving made many people less anxious about their debts and so less keen to cut back their spending as a precautionary measure.
Later the opposition switched to claiming much of the stimulus - particularly the spending on ceiling insulation and school buildings - had been wasted. It’s true the insulation program should have been much more carefully administered and that there was a degree of waste in the school building program. However, an official inquiry received complaints from only 2.7 per cent of schools, suggesting the extent of waste had been greatly exaggerated by the opposition and sections of the media. Stimulus spending always involves a difficult trade-off between conflicting objectives: the macroeconomic objective (getting the money spent as soon as possible so as to limit downturn in activity) and the value-for-money objective (making sure we have something of lasting value to show for the spending). The way to avoid waste is to take as long as necessary to ensure the money is spent well. So when speed is a high priority, some degree of waste is inevitable. Note, too, that even when spending is wasted on classrooms no one wants, it still creates jobs.
The tax reform package
The main measure announced in this year’s budget was a tax reform package, in partial response to the report of the Henry review of the tax system. After its amendment by Julia Gillard, the package consisted of a minerals resource rent tax, expected to raise about $10 billion in its first two years, the proceeds from which would be used to cover the cost of reducing the company tax rate from 30 per cent to 29 per cent, plus tax concessions for small business, superannuation and individuals. Note that the new tax won’t take effect until July 2012, so the measures it pays for will be phased in from that date. Note, too, that the package is roughly revenue neutral, meaning it’s wrong to imagine the resource tax will play a significant part in returning the budget to surplus.
Mr Swan is now expecting a budget deficit for the old financial year (2009-10) of $57 billion (or 4.4 per cent of GDP), falling to a deficit in the present financial year of $40 billion (2.8 per cent). With the cessation of most stimulus spending programs, this means the stance of policy adopted in the budget is mildly contractionary.
The budget is projected to reach a small surplus in 2012-13 for three reasons: First, the effect on the budget’s automatic stabilisers of the economy’s expected return to strong growth; second, the always-planned completion of the government’s temporary stimulus measures; and third, the government’s adherence to its ‘deficit exit strategy’ of allowing the level of tax receipts to recover naturally as the economy improves (ie avoid further tax cuts) and holding the real growth in spending to 2 pc a year until a surplus of 1 pc of GDP has been achieved. The fact that the government now expects the return to surplus to occur three years’ earlier than it expected in last year’s budget is explained by the much milder recession than it expected and the much stronger forecasts for the next four years.
