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Kenneth Davidson
May 18, 2009

Turnbull is wrong, it is not the size of the deficit that matters, but how it is used.

THE political debate about the budget is bizarre. The fiscal strategy is not rocket science. As the budget papers say, the task of budgetary policy is “supporting the economy and jobs now while investing in infrastructure for the future”.

The prime short-term objective of budgetary policy (reinforced by monetary policy) is to balance the economy. In other words whether the budget should be in balance, surplus or deficit depends on the rest of the economy. There is no particular virtue in a surplus budget unless the surplus is designed to offset a potential inflationary gap between expenditure plans and economic capacity.

Today there is a deflationary gap which can be measured by rising unemployment. As the world is experiencing the biggest recession since the 1930s, it isn’t surprising that Australia is running the biggest deficit since the end of World War II. It is also at least arguable that the reason the world is unlikely to experience another Great Depression is because of the willingness of the industrial nations to “pump prime” demand to offset the crisis in consumer and business confidence.

Because the budget accounts for about a third of gross domestic product and sets expenditure and revenue-raising priorities, it is also the major direct government influence on income distribution and the allocation of resources. This in turn influences the growth in living standards.

Yet all the Opposition can do is bleat about the size of the budget deficit. In a truly pathetic budget reply in Parliament last week, the Leader of the Opposition, Malcolm Turnbull, said: “Australians are now paying the price for Labor’s reckless spending” and he contrasted this with the record under the Howard government when “… the Coalition, together with the Australian people, (took) 10 years to pay off $96 billion of Keating Labor debt”.

The Howard government paid off the debt by a slash and burn policy on higher education, public schooling, training and hospitals, as well as the privatisation of Telstra, airports and virtually all government office buildings.

Arguably, the net sale of the overwhelming majority of these assets generated no net benefit to the nation.

The Howard government undermined support for CSIRO and independent university research. The bureau of manufacturing industry was abolished, meaning the future of manufacturing was left to the tender mercies of the Treasury and the Productivity Commission.

This contributed to the destruction of manufacturing know-how and capacity and the blow-out in foreign debt from about $150 billion in 1996 to about $600 billion now.

And, despite the erosion in services that added to household expenses, there was no tax relief. The tax burden rose from 22 per cent of GDP under Labor to a peak of 25 per cent between 2004 and 2006. The diminution of public services, which led to higher private costs in health and education and the rise in the tax burden, was a major factor in the rise in household debt to a record 160 per cent during the Howard era. It is household debt and foreign debt that is the real burden on Australians.

Government debt raised domestically is largely owed to ourselves. If it is borrowed from the Reserve Bank, the interest charged becomes part of the profit of the RBA, which is owed to the Government.

The money borrowed from the public is a burden on us as taxpayers but it is an asset to us as superannuants and as depositors in financial institutions.

Part of the debt will be borrowed offshore. But these borrowings will be largely associated with the necessity to finance the foreign debt burden that grew out of the Howard government policies that undermined Australia’s balance of payments in the first place.

If the budget reply by Turnbull can be taken at face value, he would impose a smaller deficit on the economy than the Government.

This is the path to the Great Depression Mark 11. The budget is already deflationary. The impact of the budget on the economy is measured by the change in the surplus or deficit, not its size.

The net injection into the income-expenditure flow this financial year is equal to 4.4 per cent of GDP (from 1.7 per cent in 2007-08 to -2.7 per cent in 2008-09).

In 2009-10, the net injection from the budget into the income-expenditure flow will be halved to 2.2 per cent of GDP according to the budget papers (from -2.7 per cent in 2008-09 to -4.9 per cent in 2009-2010).

In 2010-11 the forward estimate suggests the budget deficit will contract from 4.9 per cent of GDP to 4.7 per cent, resulting in a cut in the contribution to the income expenditure flow of 0.2 per cent.

Just because the stock of debt will be increasing over the two years, it doesn’t mean fiscal policy is contributing to an expansion in consumer demand and job creation.

One of the oldest confusions in economics is between stocks and flows and there always seem to be plenty of politicians happy to exploit this, rather than educate themselves and the public. This is reinforced by financiers whose prestige and profits would be diminished by a more active fiscal policy underpinned by financial reregulation.

By maintaining the fiction that responsible fiscal management demands balanced or surplus budgets, the opportunity for profit from “innovative financial products” that got the world into the present financial mess is maximised.

Whatever. Both sides of this political debate are reluctant to embrace deficits of the scale necessary to support employment, even though there is little risk that this would promote inflation.

While the cynicism on both sides of this debate is palpable, I don’t think either party is aware that the greatest danger to the prospect of an above trend 4 per cent growth rate after 2011-12 is not the level of debt— which is forecast to be a piddling 13.6 per cent of GDP with an interest burden of 0.6 per cent of GDP — but questionable infrastructure projects such as the $4.3 billion express rail project from West Werribee to Southern Cross Station.

It is not the size of the deficit that matters in terms of the burden on future generations, but how it is used. Households and corporations use debt to enhance their long-term wealth. The same principles apply to government debt. Providing the debt yields a higher rate of return than the cost of borrowing, there is no burden on the future.

Conversely, where governments sell productive assets for a price that yields a lower return to the taxpayer than if the assets and the dividends were kept in public ownership, then the nation is impoverished.

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