MICHAEL KEATING Budget Deficits: Good or Bad

Jun 12, 2019


Returning the Budget to surplus has been an article of faith in most Australian political dialogue for the last decade. However, with stagnant economic growth and the Government’s proposed tax cuts, there is a real risk that Budget surpluses cannot be sustained. On the other hand, some people who are concerned that more public spending is needed to maintain services, have argued that these can be deficit funded. Instead this article argues that in the long run Australia will need to augment its taxation revenue if it wants to maintain the public expenditure required to achieve reasonable economic growth and welfare.

In the recent election the Coalition proudly trumpeted that it would (finally) be returning the Budget to surplus. Labor responded by claiming that its policies would result in an even bigger surplus.

Clearly only a few weeks ago Budget surpluses were deemed to be an almost mandatory target for economic policy.

Last week, however, the Reserve Bank (RBA) acknowledged that there was too much economic slack and lowered the official interest rate. But the RBA also considers that there are limits to what can be achieved by lowering interest rates – which are approaching their lower bound and are already negative in real terms.

Most significantly, the RBA therefore called for fiscal policy to do more. Apparently, the RBA is prepared to envisage further Budget deficits, and the commentariat seems to treat such pronouncements from the RBA as “gospel”, so we can expect that budget deficits will soon be back in favour.

Similarly, the relative economic stagnation which has affected almost all the advanced economies since the Global Financial Crisis (GFC) has led some leading economists to argue for fiscal policy to do more. For example, early this year, Olivier Blanchard, the former Chief Economist at the IMF, in his Presidential Address to the American Economic Association argued that the fiscal and welfare costs of budget deficits are much less than often assumed.

As Blanchard points out, there is no fiscal cost (that is no long-run deterioration in the budget balance as a share of GDP) if the interest rate at which the government borrows is less than the growth rate of nominal GDP. This is the current situation in most of the major economies, and currently it is also true in Australia.

Furthermore, there are good grounds for thinking that this situation might continue for some years ahead, if there is a continuing excess in global savings. For example, in the extreme case of Japan, its excess savings has resulted in continuing budget deficits for thirty years, with public debt now amounting to more than 200 per cent of GDP, but Japan has no difficulty financing those budget deficits and interest rates remain very low.

Equally Blanchard concludes that “in the current environment …. the welfare effect of public debt is probably negative, but not large”. This is because the rate of return to capital is probably only a little higher than the nominal growth rate of GDP, so any welfare loss from a switch from private investment to public investment would at most be small.

But I think that, in the present range of experience, the main determinant of private investment is aggregate demand rather than the rate of return. In that case if aggregate demand is insufficient to justify more private investment, then additional debt-financed public expenditure can readily be justified.

Furthermore, there is the example of America where the large fiscal stimulus enacted in 2017 and 2018 is believed to be the main reason why economic growth has picked-up from 1.6 per cent in 2016 to 2.9 per cent in 2018. On the other hand, in the absence of further fiscal stimulus, US economic growth is forecast by the OECD to fall back to close to 2 per cent in 2020.

The problem is that no real attempt has been made to address the underlying reasons for the poor performance of the US economy over an extended period. Over the longer-term US economic growth will continue to stagnate until more specific policies are developed to address the structural deficiencies in the US economy that are leading to low wages, low productivity and low aggregate demand.

And this has lessons for Australia, which I would now like to address.

Australian Fiscal Policy

Until very recently the RBA was on record as stating that an unemployment rate of 5 per cent was consistent with full employment. Last week, however, the Governor revised that assessment and stated that “our judgement is that we can now do better than this – that we can sustain an unemployment rate of 4 point something”.

It is on this basis that the RBA argues for more fiscal stimulus. Nevertheless, I would counter that this additional room for fiscal stimulus is not large when we are talking about the difference in an unemployment rate of say 5 per cent and a rate of say 4¾ per cent.

In addition, the RBA, and others like Blanchard, propose that this fiscal stimulus should come from increased investment in infrastructure, on the assumption that this investment is warranted and will therefore add to future economic capacity. However, the Grattan Institute found that in the 2016 Federal election “The proportion of the promised money that was for projects that had been assessed [by Infrastructure Australia] as nationally significant and worth building ranged from 15 per cent for the Coalition to 3 per cent for the ALP to none for the Greens”. As the Grattan Institute further comments: “Sadly, there is no reason to expect anything different in the 2019 election campaign”. In short, if we only invested in infrastructure that would yield an economic return, we would spend less better and not more badly.

Nevertheless, my most important reservation about the RBA’s proposal to increase debt by spending more on infrastructure is that it fails to deal with the real problem facing the Australian economy. As the RBA has previously acknowledged: “The crisis really is in real wage growth”.

In my view it then beggars belief to assume, as the RBA appears to assume, that a small further reduction in unemployment brought about by a modest increase in debt-financed infrastructure investment, will sufficiently restore wage growth.

Instead, as I have argued in my book, Fair Share (co-authored with Stephen Bell), and also in previous posts on this blog, the main reason for low wage growth in Australia (and elsewhere) is not primarily because of a cyclical shortfall in demand; rather the main reason for low wage growth is structural changes impacting on the labour market because of the nature of technological change.

Accordingly, a relatively small and presumably temporary fiscal stimulus is not going to fix the underlying problem of low wage growth and thus ensure that demand growth is sustained over the long run. Instead, the solution to low wage growth requires much more government intervention to support the increased education and training which is required to provide the skills to enable workers to adapt and adopt the new technologies that are becoming available. Furthermore, this increased investment in human capital needs to be broad-based, encompassing all phases of education from pre-schools to better opportunities for mid-career adults to return to education and gain new skills. Similarly, increased public expenditure will also be required to improve access to health care and to finance health prevention.

Frankly, I think any reasonable assessment of the scope of the additional public expenditure needed to sustain economic growth and provide a reasonable quality of life for all Australians would show that it cannot be sustained by going into a budget deficit. The necessary amount of this expenditure would more than exhaust any present slack in the Australian economy.

In fact, public expenditure is lower as a share of GDP in Australia than in almost all the other advanced economies, even including the US. Nevertheless, per capita economic growth is faster in many of these economies than in Australia, suggesting that their higher levels of taxation allow their governments to spend more on the provision of better quality public services, especially for education, training and research.

In short, ensuring future wage and economic growth in Australia will require a considered policy to increase the amount of expenditure and taxation relative to GDP. That is what Labor was offering in the last election and it would be a great set-back if Australia turns its back on that fundamental choice that Labor proposed, even if some of the details are varied in the future.

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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