Monday, June 13, 2011

Govt gets it wrong on spending

The political orthodoxy is that budget spending cuts should be avoided as they cause widespread economic pain if implemented. 

According to standard Keynesian macroeconomics, government expenditure is a key component of aggregate demand and so any given spending cut would lead to a greater than proportionate fall in economic activity.

However subsequent developments in economic thinking raise legitimate doubts about the allegedly damaging effects of spending reductions.

First it is necessary to consider the financial market implications of fiscal policy.

In a simple model a reduction in government spending leads to a reduction in output but also an easing in interest rates as the demand for real balances falls.

If sustained, the interest rate reduction would in itself encourage additional private sector investment, counteracting the adverse effect of reduced government spending on output.

In the early 1960s economists Mundell and Fleming augmented the analysis by illustrating the effects of fiscal policy under floating exchange rates and capital mobility.

As mentioned, a reduction in government expenditure leads to a reduction in interest rates.  However in an open economy lower interest rates leads to an outflow of capital and, through it, depreciation of the exchange rate.

This exchange rate depreciation will have a crucial effect on the tradeable goods sectors of the economy by promoting the international competitiveness of exports.  An increase in our export trade counteracts the output effect of reduced government spending.

It is possible to extend the macroeconomic analysis further still by considering the crucial role of expectations held by economic agents such as consumers and private investors in response to changes in government policy.

The famed ''Ricardian equivalence'' proposition suggests that an increase in public sector savings will lead to an increase in private consumption to some extent, as individuals perceive that future taxation burdens will decline.

In addition, it is necessary to consider some potentially beneficial effects of government spending cuts for the supply side of the economy.

If spending cuts are accompanied by a reduction in distortionary taxes then productive economic activity will expand as people becoming willing to work more hours and investors purchase extra capital.

The reduction or elimination of public sector spending that detracts from the capacity of the economy to add value will induce economic growth as scarce resources are freed up for higher valued uses.

It is for these reasons that the Federal Government's ''tough as tofu'' approach to budgeting is inappropriately designed for our economic landscape of a very strong Australian dollar, internationally high interest rates and price inflation threats.

Treasurer Wayne Swan has extolled the Government's $22 billion of budget savings as a virtue and a strategy that will, depending on economic forecasts playing out exactly as planned, lead to a $3.5 billion surplus in 2012-13.

However, there is more than meets the eye when it comes to the nature of the announced savings over the next four years.

The budget fine print shows about $6 billion of the savings measures are, in fact, tax increases whereas the proceeds of most of the actual expenditure cuts will be reallocated towards other programs.

To add to this, the budget contained $19 billion in new spending over the next four years including election commitments.

The Gillard Government's tepid approach on expenditure rationalisation should be contrasted with that undertaken by the Howard government in its first term.

In 1995-96 the federal budget was in deficit to the tune of $11 billion with the government weighed down by net debt totalling $96 billion, figures which were concealed during the 1996 election campaign.

In government, prime minister John Howard and treasurer Peter Costello announced a range of sweeping expenditure reductions to return the budget to balance.

A range of decisions were made to reduce certain areas of expenditure, including cuts to ineffectual labour market and industry programs, tighter welfare means testing provisions and outsourcing public service functions.

Targeting the running costs of government, including through a reduction in public service numbers from 146,000 in 1995 to 121,000 in 1998 and 113,500 in 2000, was pivotal to the success of fiscal consolidation.

By 1997-98 the budget was in surplus with the proceeds of asset sales, particularly Telstra, used to eventually eliminate public sector net debt.

The Howard-Costello fiscal consolidation contributed to economic outcomes predicted by the more sophisticated macroeconomic theories.

A reduction in the government's call on national savings enabled the official interest rate to fall from 7.5 per cent in the first half of 1996 to 4.75 per cent by the end of 1998, fuelling an increase in private investment.

The Australian dollar also depreciated from 76c in March 1996 to 61c by the end of 1998 improving our trade competitiveness.

The budget cuts certainly did not prevent the national economy from growing and, if anything, assisted Australia in absorbing the economic shock of the Asian financial crisis.

With opinion polls showing that perceptions of wasteful spending are turning into a political negative, the Gillard Government should heed the lessons of the late 1990s and instigate deeper cuts to bolster private sector activity.

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