MICHAEL KEATING. Covid-19 and Future Fiscal Policy

Covid-19 will have a big impact on fiscal policy over the next few years. The Budget balance is estimated here to show a deficit equivalent to 4½ per cent of GDP this year and as much as 10 per cent next year. But overall the size of the Government’s fiscal response seems appropriate, and it should be manageable in the future.

In the absence of an up-to-date consolidated statement from the Government, I estimate that the total cost to the Australian Government Budget of the Government’s various economic and health responses to the Covid-19 virus is of the order of $200 billion. By any standards this is a massive fiscal intervention.

Of this total cost, $62 billion will impact the current, 2019-20, Budget, and $132 billion will impact next year’s Budget in 2020-21. Almost all this assistance is on the outlays side of the Budget, and it represents an unprecedented increase on the Government’s previous estimate for Budget outlays for 2019-20 and 2020-21 of 13 per cent and 25 percent respectively.

On the other hand, this assistance is intended to be very time-limited, and if all goes according to plan, after 2020-21 the cost of the Government’s various packages in response to the Covid-19 virus should have a negligible direct impact on the Budget.

But in addition, the Budget will also be further impacted by the economic downturn that Australia is currently experiencing as a result of Covid-19. In particular, tax revenue is very sensitive to changes in nominal national income.

As I discussed in my preceding article, MICHAEL KEATING. Covid-19 and the Economic Outlook, assuming the Government’s present plans are realised, I estimate that in 2019-20 real GDP will fall by 1 per cent compared to the previous year, and by another 2 per cent in 2020-21. As a result, I estimate that the further impact of the recession on the Budget (almost all on the revenue) will add another $28 billion and $70 billion to the Budget deficits in 2019-20 and 2020-21 respectively.

After allowing for both these negative impacts on the Budget, and taking the Government’s Mid-Year Economic and Fiscal Outlook as my starting point, I estimate that, on present policies, the Budget balance for the next few years will deteriorate as set out in the Table below.

Fiscal impact of Covid-19 ($billion)

Financial Year MYEFO Budget Balance Gov’t Response Package Economic impact on Budget* Forecast Budget Balance
2019-20 5 -64 -28 -87
2020-21 6.1 -132 -70 -196
2021-22 8.4 -6 -86 -83
2022-23 4 1 -93 -88

* These estimates of the impact of the recession on the Budget cannot be all that accurate, but the figures for the Budget balance do give an idea of the size of the overall impact of Covid -19 on the budget.

These forecasts for the Budget deficits in 2019-20 and 2020-21 would represent as much as 4½ per cent and 10 per cent of GDP respectively. This swing to deficit is much greater than the responses to previous economic shocks, when the Budget deficit amounted to 3.3 per cent of GDP in 1982-83, 4.1 per cent in 1992-93 and 4.2 per cent in 2009-10.

On the other hand, a key feature of this Budget deficit is that most of the deterioration is currently meant to be strictly temporary. Thus, although the continuation of present plans and policies cannot realistically be expected to return the Budget to surplus in the next three years, nevertheless the size of the deficits in 2021-22 and 2022-23 will most probably substantially contract to around 4 per cent of GDP.

Because of this short-term surge in the Budget deficit, the gross debt of the Australian Government will increase in the current financial year by about 4½ per cent of GDP to a level equivalent to 32 per cent of GDP. Over the medium-term, Australian Government gross debt is now forecast to reach almost 40 per cent of GDP by 2022-23.

Those who are accustomed to rail against debt and deficits are now asking is this level of debt sustainable and how will it be repaid? They argue that “there is no such thing as a free lunch” and that the increase in spending that the Government has embarked upon will eventually have to be paid for by someone – namely taxpayers, either by increased taxes or fewer services and less social assistance.

The first point to make is that the amount of debt might have been much greater if the Government had not taken action to limit the spread of the Covid-19 virus and to maintain the capability of the economy during the lockdown. A longer recession, where no action was taken to subsidise the continuation of employment and business capability, would have risked a bigger economic downturn and even more debt accumulating.

Furthermore, there should be no rush to get the Budget back to surplus. As always, the size of future Budget deficits should represent the amount that is deemed necessary to balance the expected difference between private investment on the one hand, and the combination of private domestic saving plus net foreign capital inflow on the other hand. A premature tightening of fiscal policy that defies this rule, risks prolongation of the recession and thus will prove to be self-defeating.

The extra borrowing now required by the government should be seen as an investment in maintaining the capability of the economy during the downturn in demand. This borrowing is not really different from governments borrowing to finance new physical infrastructure during a recession, which people do not have a problem with. In this case, however, the borrowing is to finance the continuing capability of firms and their workforces, and that sort of capital is typically even more vital to supporting an economy’s future growth.

There should also be no difficulty in financing this borrowing by the Australian Government. First, the gross debt of all Australian Governments (State as well as Federal) only represented 41 per cent of GDP in 2019 – much less than in the UK (112%) and the US (108%), and an OECD average of 109%. Despite the usual misguided mumblings from the so-called ratings agencies, it might well be asked which other country than Australia will be more credit worthy?

Second, prior to Covid-19, auctions for Australian Government bonds were typically over-subscribed and it can be expected that private demand for these bonds will continue. But to the extent necessary, the Reserve Bank can be expected to support the bond market. Indeed, with almost zero interest rates, the Reserve Bank (RBA) had already started to buy Australian Government bonds on the secondary market as a key part of its monetary policy before the advent of Covid-19.

Now, given the depressed economic outlook, these bond purchases by the RBA are likely to continue for some time. Those who worry about this monetising of the Government debt need to remember that this increase in the money supply is unlikely to result in increased inflation in the foreseeable future. In addition, interest rates are therefore likely to stay low, and the cost of the additional debt to the Budget will be very small.

Accordingly, this obsession with continuing budget deficits as measured by the cash balance is frankly misguided. Most firms maintain some permanent debt, just rolling their debt over whenever payment is due. Governments are no different. Indeed, given the ease with which other countries have been financing much bigger government borrowing programs, it is not credible that Australia will have a problem.

Finally, it is important to emphasise these economic and budget forecasts depend upon all going to plan and the Covid-19 virus being brought under control and present restrictions on movement being relaxed in the time scale presently envisaged by the Government. Thus, it represents a “best case” scenario, and it is possible that further policy initiatives, which come at a cost to the Budget, will prove to be necessary in due course.

For example, the health system may well require more funding for some time, while tourism and education have been especially hard hit by the restrictions on people movement and may take longer to recover. In particular, the business model of universities will probably have to change, requiring a permanent increase in government funding, and the airline industry is also asking for more government support.

Most importantly, the economy was very sluggish before the pandemic, and there is a good case for new policy initiatives to enhance Australia’s longer-term growth rate. The key problem has been the stagnation of wages and household incomes, and the consequent lack of growth in aggregate demand.

Accordingly, options that should be considered are:

  • reviewing the proposed future income tax cuts to make them more generous and more equitable,
  • increasing the amount of assistance to unemployed people and rental assistance, even if understandably the Government doesn’t wish to maintain the recent doubling of Newstart,
  • increased funding for social housing and the support of homeless people,
  • improving the funding of education and training, which is vital to the future capability of workers to adopt and adapt to technological change.

For these various reasons, any future austerity program should be avoided. Of course, all expenditure should be reviewed in terms of its equity and value but getting the Budget back into the black at whatever cost never made sense, and it makes even less sense now.

Michael Keating is a former Head of the Departments of Prime Minister & Cabinet, Finance, and Employment & Industrial Relations. He is presently a Visiting Fellow at the Australian National University.

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Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations.  He is presently a visiting fellow at the Australian National University. 

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3 Responses to MICHAEL KEATING. Covid-19 and Future Fiscal Policy

  1. Avatar Vicky Batten says:

    I really appreciate the measured tone and easy explanations regarding Government budgetary policy. Many people I know are concerned that this LNP Government will use the Covid-19 spend as a way to further cut programs and assistance to those most in need of them – eg. Newstart recipients and those vital industries such as tourism and aviation as just a few examples. With a focus on mental health and the impacts on it of such a stressful time, I will definitely be recommending Michael’s well written and frankly reassuring articles to others that are in my online support group for anxiety and depression.

  2. Avatar Wayne McMillan says:

    Michael we all need to get over over the misplaced preoccupation with budget deficits and surpluses once and for all. The economy isn’t like a household, where if we don’t have the income to buy goods or services, we have to borrow the money or sell an asset.
    Sovereign federal governments that are currency issuers with a floating exchange rate, can NEVER run out of funds and they can spend without taxes to cover any expenditure.

    Economies need to be balanced NOT budgets. The nonsense that we need to borrow to cover a deficit has been proven technically incorrect by Modern Monetary theorists for many years now. This crisis has only reinforced macro-monetary reality and astute macroeconomists across the world now recognise the valuable insights that have been gleaned from modern monetary theory (MMT).

    From a macro economic point of view we are in a new era and new policies are going to be crafted, gained from the macro monetary lens that has been given to us from MMT .

  3. Avatar Cameron Leckie says:

    I agree with Michael that the case presented case is a best case scenario. I also think it is the least likely scenario.

    The elephant in the room is the key question of whether the global economy has reached the limits to economic growth?

    The response to the GFC may have saved the global economy from seizing up at the time but it did not fix the underlying problems. Problems that led to the ‘sluggish economy’ prior to the pandemic despite ‘unprecedented’ intervention in world markets by central banks.

    The response to the COVID-19 pandemic will make the response to the GFC look rather mild in comparison. There is a trend here; the responses in terms of quantitative easing/money printing, are getting (exponentially) bigger with each crisis. This highlights that the underlying problem IS the financial system.

    The financialisaton of the economy over the last 30 or 40 years has led to an increasing disconnect between the financial economy and the underlying ‘real’ economy. We seem to have forgotten that financial instruments do not represent wealth but are rather a call on wealth. Unfortunately we are now in a situation where the call on wealth is orders of magnitude greater than the underlying real wealth. In a game of musical chairs it is like for every 10 players there is only one chair.

    With constraints increasing year by year on virtually all of the primary inputs into the economy (water, arable land, a stable climate, declining quality of mineral ore’s, literally scraping the bottom of the oil barrel etc), growing the economy to reduce the debt burden is a response with diminishing prospects for success. The alternative, deflating the debt balloon to bring the financial system back in alignment with the real economy, also appears politically unacceptable.

    Nature bats last; it is going to be a rocky ride into the future!

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