Swan's Zero-Sum Surplus


Is Wayne Swan about to blow up the economy?

It sounds like a silly question, and yet that suddenly is what many economists and business figures are warning us about.

With much of the economy in the south-eastern states still in the doldrums, the high Aussie dollar hurting exports and Australian interest rates a lot higher than many other rich economies, there’s plenty of ammunition for the Cassandras forecasting an imminent recession.

Housing construction is in a serious downturn while export industries like tourism and manufacturing are struggling against the headwinds of the high dollar. If Treasurer Wayne Swan goes ahead with the roughly $40 billion of government spending cuts required to return the federal budget to the black this May, many worry that this sudden subtraction of government demand will flow on to the rest of the economy. The worst-case scenario would be a recession.

As Rob Burgess pointed out on recently in Business Spectator, "the danger for both sides is that cutting back public demand by cancelling or scaling back public services runs the very real risk that there will be no private sector demand to replace it."

The incoming boss of the Business Council of Australia, Tony Shepherd, warned last week that "there shouldn’t be a surplus at any cost." He cautioned against achieving a budget surplus by making cuts to productivity-enhancing government spending programs, like tax breaks for research and development. "You shouldn’t strive to achieve a surplus by putting into place policies which in fact hamper the productivity and competitiveness of Australian business," he told a business function.

The Institute of Company Directors mounts a similar case. According to the Institute’s John Colvin, 90 per cent of the company directors it recently surveyed think infrastructure spending is too low. "My surmise would be that they would think that a budget surplus is the right thing to do, but trying to do it all at once or in a very quick manner rather than staggered over time can be hurtful in the short term," Colvin told the ABC’s Peter Ryan.

Many economists agree. RBC Capital Market’s Su-Lin Ong told The Australian this week that "we have a situation at the moment where the RBA is going to order more cuts in the next few months and the government is tightening fiscal policy and not just slightly, we are talking about nearly 2.5 per cent of GDP, depending on the final numbers". Merrill Lynch’s Saul Eslake adds that the scale of the fiscal consolidation is "a bigger positive movement from one year to the next than we’ve seen in any of the 57 years for which we now have internally consistent data."

So is Swan being crazy-brave — or just crazy? The macro-economic theory behind the Treasury’s thinking is all pretty conventional stuff. It comes down to this: by pulling back on government spending, the government will allow the Reserve Bank room to lower interest rates. That’s certainly what Wayne Swan has been telling us. The spending cuts required to get a surplus are an "economic imperative", he writes in his latest Economic Note. This will eventually stimulate private-sector demand, for instance in housing construction, which in turn will keep the economy out of recession. "Just as it was right to step in and support demand when it was needed," he writes, "it’s right now to be stepping back to provide space for the private sector to grow and to ensure the Reserve Bank has the flexibility to cut interest rates further if it thinks that is necessary."

Some dovish economists think Swan is on the right track. Stephen Koukoulas has, rather ambitiously, called it a "near perfect application of economic policy". Koukoulas argues that tighter fiscal policy will build Australia’s national savings. This "allows for a lower interest rate structure and therefore a lower Australian dollar".

You can see the logic. By pulling back on government spending, Labor hopes the private sector will be able to pick up some or all of the missing demand. In the meantime, lower interest rates will reduce the carry-trade currently inflating the value of the Aussie dollar, which will in turn help the pressures on exporters and import-competitors in the trade-exposed sectors of the economy. Swan is therefore aiming to repair the fraying edges of the patchwork economy, in this analysis.

Few doubt that fiscal and monetary policy can, in theory, balance each other out. As Greg Jericho points out in a column for The Drum, the idea that fiscal policy and monetary policy offset each other dates back to Keynes. The concept is often illustrated by a mathematical formula called the "IS-LM" model (here’s Nouirel Roubini’s lecture on the model, for the economically inclined).

That’s not to say there aren’t risks. The problem here is that it is entirely possible that lower government spending and lower interest rates could still result in lower GDP. "The risk," Jericho writes, "is that the stimulus from monetary policy won’t be able to fill the gap in the economy left by the withdrawal of government spending — especially when you consider that the RBA cuts the cash rate, but for monetary-policy stimulus to work the banks need to match it, and they haven’t been so desirous of doing so recently."

The problem, as usual, lies in the politics. In fact, it’s now painfully obvious that the reasons Labor is scraping so hard to return to surplus have nothing to do with economics, and everything to do with politics. And if the economic risks are manifest, the political ones loom even larger. The politics of the budget are simply awful for Labor. This week’s Essential poll tells us that voters comprehensively blame the budget deficit on the government. They’re wrong, of course: the budget deficit is almost wholly due to lower tax revenues in the wake of the GFC. And yet, even though Labor is actually levying less tax as a percentage of the economy than John Howard was, many voters still believe the rhetoric that Labor is a high-taxing government.

Making a carbon tax the centre-piece of your second-term agenda can’t have helped there, but the melancholy truth for Labor is that voters simply don’t believe the government is a good economic manager, despite Australia’s stellar performance in comparison with our cousins in the northern hemisphere.

This means that, even if Wayne Swan and Penny Wong do manage to return a surplus on budget night, this remarkable feat is unlikely to rapidly lift the government’s fortunes.

On the other hand, if the government delivers a deficit, the government will be seen to have miserably failed. That’s the thorny logic of Labor’s electoral reality. Politically, therefore, all the government can do is push ahead with the cost-cutting, and hope like hell Glenn Stevens comes through with some interest rate cuts.

Swan and Labor have painted themselves into a corner, and they’re putting the broader Australian economy at risk as a result.

Ben Eltham is New Matilda's National Affairs Correspondent.