Inflation: where does the buck stop? Part 2

Many of the comments on my previous posting have been about the monetary effects of budgets. While not dismissing the significance of money supply, I prefer to look at inflation in real demand terms and hence I like to focus on the Budgets effects on aggregate demand pressures. I believe that if the RBA decides to raise interest rates it will be because it believes that current demand pressures are unsustainably high. Howards argument is also based on the same premise. He believes a budget surplus is an indication that his Government is dampening down demand while the States are doing the opposite.

My argument is that the Prime Minister is mistaken. The impact on net aggregate demand of a budget strategy is best measured by the CHANGE in net borrowing (not its level) and the CHANGE in government spending.

Drawing on Budget Papers (12-6), one finds that the Commonwealth Budget surplus was 1.5% of GDP in the 2005-6 Budget and projected at 0.9% in 2007-8 thus delivering a stimulus to the economy of 0.6% of GDP. The States had a surplus of 0.4% of GDP in 2005-6 and a projected deficit (net borrowing) of 0.4% in 2007-8 delivering a stimulus to the economy of 0.8% of GDP. There is not much here for Mr. Howard to boast about. All levels of government have been adding to demand pressures.

Turning to government spending, one finds that in 2005-6, Commonwealth spending (expenses) were 21.3% of GDP and are projected to be 21.5% of GDP for 2007-8 a net stimulus of 0.2%. At the State/local level, spending levels were 15.7% of GDP in 2005-6 and are projected to be 15.3% of GDP in 2007-8 a net deflationary effect of 0.4%. On such spending comparisons, and having regard to the fact that the increase in State spending is being driven by infrastructure spending, thus adding to supply in the medium-term, the Commonwealth has done more to stimulate the economy than the States.

As noted in my previous posting, part of the surge in private spending can be attributed to the tax cuts of the Howard Government.

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Jc
Jc
14 years ago

“As noted in my previous posting, part of the surge in private spending can be attributed to the tax cuts of the Howard Government.”

And the levels of consumer debt that keeps on rising because people still find interest rates relatively cheap is whose fault exactly?

Fred, I still have this question that needs to be answered tnat I left on the previous thread:

“If inflation was caused by tax cuts you why want to explain those surplus dollars were created in the first place?” Where did those dollars come from?

One other thing. If you thought the Feds are driving consumer demand etc. maybe another solution would be to mitigate an increase in demand with a drop in spending. Do you think that would help?

Bring Back CL's blog
Bring Back CL's blog
14 years ago

Fred,

This is an interesting variation of the structural budget influence. I would have thought the deterioration has been there for sometime but covered up by the commodities boom.

what will the budget look like when the commodities boom is over. I suspect that Ken Henry has a large paper on this for the Annihilator and Swanee when they enter office. This will give them the excuse to not do a number of things they will promise.

Fred Argy
Fred Argy
14 years ago

JC the ‘surplus dollars’ that have given Costello a huge revenue windfall stem from the big improvement in export prices relative to import prices. The terms of trade boost was reflected in corporate profits which in turn benefited Costello’s coffers. He was able to give away all these tax cuts and increase spending while leaving his budget surplus around 1% of GDP (albeit declining a little as I noted).

The resources boom ‘windfall’ was new money coming into the system without any counerpart reduction in demand anywhere. He should have put away most of it into his Future Fund to prepare for the inevitable shift in the commodity price cycle.

Jc
Jc
14 years ago

Fred

“JC the surplus dollars that have given Costello a huge revenue windfall stem from the big improvement in export prices relative to import prices.”

Through taxes etc., right?

Where did those “dollars come from in the first place? They were’t created through the foreign exchange market because there is no government intervention to speak of in the currency markets these days.

No one can create the “Dollars” except the cental bank. It’s a monetary issue as it see it.

Jeremy
Jeremy
14 years ago

Fred,

So the government’s injection into the economy is 0.6% or GDP, and you’re holding it responsible for higher inflationary outcomes?

Meanwhile, private sector borrowing, as indicated by the current account, is injecting about 6% of GDP of new spending power into the economy each year.

And we’re experiencing a commodity price shock.

In the face of this, do you still want to blame inflation on Howard and Costello and their miniscule change in the budget balance?

I agree with JC: I can’t see how giving people back via tax cuts the wealth that they themselves have created in the previous year can induce an imbalance between demand and supply. Private borrowing of money can, but tax cuts can’t.

Also, you mentioned yesterday that:

“the Commonwealth has been getting a lions share of the huge increases in revenue stemming from the resources boom. Costello needed only a small portion of that revenue bonanza to run a budget surplus. The rest he spent or handed out in tax cuts!”

Could you please quantify that huge increase in revenue stemming from the resources boom. I suspect that the large surpluses of recent years have less to do with the resources boom than with a tax system designed for the high unemployment seventies, eighties and nineties ripping far more money out of the high-employment naughties economy than the government requires.

Fred Argy
Fred Argy
14 years ago

Jeremy, I have three responses.

First, it was the Prime Minister who accused the States of creating the conditions for an interest rate rise. I am simply pointing out that the pot should not call the kettle black.

Secondly, I agree that adding 0.6% to aggregate demand is not too frightening but if Costello had done the right thing (as I suggested in my posting) he would have taken 0.6% OFF demand. So his budget strategy has caused aggregate demand to be 1.2% higher than otherwise! Not insignificant.

Thirdly, the RBA Governor yesterday indicated that the higher export prices and lower import costs have boosted national income by some $80 billion ( i.e. some $4000 per capita I think) since 1999. Most of that has been reflected in higher corporate and personal income. This has been worth several hundred billion dollars to Costello’s coffers over that period. Hardly chicken feed.

Jc
Jc
14 years ago

The idea that tax cuts cause inflation needs to be sent to the roach motel where that sort of idea never ever sees the light of day again. I saw Terry OBrien trying that line with Costello who much to his discredit didnt send it out of the ballpark.

People can be influenced with this type of this wrong thinking and its important we clear the deck.

Inflation is a monetary problem first and foremost. Fiscal policy has nothing to do with it unless of course the government tries on that pre-nazi Germany trick of writing an IOU to the central bank to be monetized that is through the printing presses.

However saying that tax cuts are inflationary is to ignore the obvious. Inflation can only be created through by the government giving the central bank an IOU and they in turn use that IOU to print money, or do a permanent add through the bond and credit market by buying paper for cash.

What is the effect of a tax cut? A tax cut obviously puts money into the hands of the public with which they can do two things. They can spend it or save it. Now it is obvious that a sudden demand shock will affect prices of goods and services when the tax begins to work through the economy. However the upward tendency for prices is actually what you want because it is the price signal producers need that more goods are demanded. In other words an upward move in prices in this case should not be considered inflation and is more along the lines of a change in relative prices.

I would be pleased if you can tell me where Im wrong on this Fred..

Jc
Jc
14 years ago

Fred

In the past you’ve said you want to see more government funding of infrastructure etc. Should that also be considered inflationary after all it is increaseing aggregate demand through the economy? In fact it has a harder punch than tax cuts seeing people have a propensity to save. Aren’t we confusing personal preferences here rather more than anything else.

Re The state governments.

Collectively they are carrying a deficit equal to the the federal governments. This is pretty amazing since their receipts have also run at record levels. It’s also amazing that we are short of water in the south. It’s even more amazing that their public service rolls and salaries have increased faster than any other group. Perhaps, if the labor market is so tight, they could release some this surplus labor and let them help out in the private sector.

Jeremy
Jeremy
14 years ago

Fred,

On the evidence of what has happened in recent years, tax revenues will accrue so quickly that the actual outcome this year will probably be a net subtraction from, rather than the expected addition to, GDP.

As regards the commodities boom, is that $80 billion per year, or over 8 years? I can’t find the Stevens quote, I’m sorry.

Andrew Reynolds
14 years ago

Fred,
One issue I have with your methodology is that, using your calculations, a move from a budget deficit of (for example) 100% to a deficit of 50% would be contractionary. Sorry – but I just cannot follow the logic of that. The government is still spending more than it is receiving and I cannot see that this would do other than expand the economy.

Fred Argy
Fred Argy
14 years ago

Yes Jeremy, national income is $80b per annum higher today than it would have been if the terms of trade had stayed at their 1998/9 level. This terms of trade boost has happened gradually over the 8 year period and the gains have been cumulative e.g. in the first year it may have added 15b, the second year 25b and so on until now when it is adding $80b. I am guessing as the only firm figure is the for the latest year: I have not done the calculations for each year. You can do that yourself by comparing GDP with Net National Disposable Income (NNDI) which adjusts for the terms of trade. For example, in the year to March 2007 GDP increased in real terms by 3.5% but NNDI increased by 4.3%.

[By the way the estimate of $80b was not made by the RBA ‘yesterday” as I incorrectly said. It was made some weeks ago.]

Andrew, I am indeed saying that a move from a deficit of 100% to a deficit of 50% would be contractionary, as achieving it would require a bigger increase in revenue than in spending. Similarly, a move from a surplus of 10% to one of 5% would be expansionary as achieving it would require a bigger increase in spending than in revenue. It is the turnaround which impacts on the economy.

It is in my view incorrect to look at the LEVEL of net borrowing or lending in any one year when assessing the impact on the economy.

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Tax cuts are not inflationary, increases and decreases in the price of things is purely a supply issue, a supply of the asset, the goods, the services, the amount of currency. Tax cuts will not affect the amount of any of these things in the economy, so how exactly are they inflationary?

This is, as JC puts, bad thinking, and I can’t help but think that there is an element of bias against personal preferences here. More money in taxpayers pockets give them two choices, consumption or saving. Increased consumption may lead to an increase in prices, but this provides an indicator to suppliers to produce more and to consumers to value future consumption (savings) more than present consumption, once suppliers have adjusted to the new conditions. This does not represent a change in the value of the currency, merely a change in the value of the goods or services until the new status quo is achieved. Since suppliers are respeonding to multiple variables, the new status quo is never achieved, and price stability of goods and services is neither desirable or acheivable. Without price instability, consumers and suppliers will not have the indicators required to make informed choices.

Inflation is, and always will be a monetary phenomenon. M3 should only adjust to meet the demand for money, not the demand for bread, milk and innner city appartments.

Jeremy
Jeremy
14 years ago

Thanks Fred. I’ll have a look at the figures.

Fred Argy
Fred Argy
14 years ago

Brendan and JC sorry, I don’t fully understand your points about taxation. Let me explain mine better.

A government can do three things with a revenue windfall from booming export prices. It can (a) increase spending (b) reduce taxes or (d) stack the money away in the Future Fund or other ‘financial’ vehicle.

IN THE SHORT TERM (which is what this post is about), the most expansionary of the three is option (a) and the least expansionary is option (c) – which I claim deserved more attention than it got. Tax cuts are somewhere in the middle: some of the tax cuts are saved or invested in financial assets (so they have a fairly neutral effect on real aggregate demand) but some are spent (the latter is most likely to happen with low-paid income earners). The increased consumption puts added pressure on already-strained productive resources and probably leads to higher prices.

IN THE LONGER TERM, there are supply side effects to consider. In the case of spending, the outcome for supply-demand (demand pressures) depends on whether it takes the form of transfer payments, consumption or infrastructure investment. In the case of taxes it depends on what tax cuts do to work incentives and innovation. In the case of the Future Fund it depends on the effects it has on financial markets and secondary wealth effects.

My posting was focused only on the short run.

By the way, if the present share market decline turns into a rout, we wont need to worry about short term demand pressures.

jc
jc
14 years ago

Fred
The Dollars the Feds return are not created a second time by the RBA. They are simply being returned to the rightful owners. If you have a problem with those dollars being expansionary they should never have been created n the first place.

Graeme Bird
Graeme Bird
14 years ago

“Many of the comments on my previous posting have been about the monetary effects of budgets. While not dismissing the significance of money supply, I prefer to look at inflation in real demand terms and hence I like to focus on the Budgets effects on aggregate demand pressures.”

But thats a total waste of time Fred.

Real demand has nothing to do with anything. Nominal demand is what is important. Money supply growth determines nominal demand. So you can hardly acknowledge it and forget about it again in the space of just a few words.

The other thing is that THERE IS NO MONETARY EFFECTS OF BUDGETS.

None.

Monetary effects come from the printing press, the banking sector and the governments regulation OF the banking sector.

There is no way to cheat reality here. You create more money you get more spending.

Alphonse
Alphonse
14 years ago

On ABC radio’s Insiders this morning, Gerard Henderson spoke about the Labor States’ deficits, no ‘journalist’ on the panel questioned it, and Barry Cassidy acknowledged the ‘truth’ of it in a preamble to a later question. Just another collective media swallow worth noting – from the ‘left’ end of the dial, at that.

Joshua Gans
Joshua Gans(@joshua-gans)
14 years ago

The impact on net aggregate demand of a budget strategy is best measured by the CHANGE in net borrowing (not its level) and the CHANGE in government spending.

Fred, you need to distinguish actual and structural deficits too. If there is a surge in consumer sentiment or exports, this may indeed change the budget balance and the PSBR, but you can’t attribute that change to the government. You can only legitimately say the government has added to or subtracted from aggregate demand if they increase discretionary spending or change the (net) tax regime. You could, I suppose, blame the government for failing to offset a spontaneous increase in private spebding, but that’s not quite the same. (I raved on about all this href=”http://clubtroppo.lateraleconomics.com.au/2007/05/13/a-macroeconomics-tutorial/”.)

Joshua Gans
Joshua Gans(@joshua-gans)
14 years ago
Brendan Halfweeg
Brendan Halfweeg
14 years ago

Fred,

All you are saying is that giving people back their wealth through tax cuts can lead to price rises. I agree. These price rises are not inflation though, they are merely the market responding to the new situation. If the government spends it on building roads, the cost of road construction will rise. Price rises due to natural changes to where supply meets demand is not inflation. Inflation is the devaluing of a currency, not the rise in price of goods and services.

So, since tax cuts do not change the status quo on the amount of money in the economy and do not change the amount of assets, goods and services avalaible to purchase, the money has not devalued, only the people whose preferences dictate the use the money have changed. It is either the preferences of the politicians and bureaucrats, or those of the individual taxpayers. Blaming consumers for demanding more of a thing is not reason enough to withold tax cuts, and indicates a mistrust in the personal preferences of taxpayers.

It is disingenious to claim that taxpayers are smart enough to earn $30,000+ a year, but not smart enough to be be able to make decisions for more than 70 cents in the dollar. Faith in the taxpayer’s ability to make consumption versus savings decisions perversely decrease as the ability of the taxpayer to earn income increases. Price rises (not inflationary) due to tax cuts are emininently preferrable than price rises due to politician’s pork barrelling, since the state has little incentive to change their consumption/savings mix in the face of price rises.

It is paternal in the extreme not to trust taxpayers to use their own wealth in the way they best see fit. Blaming price rises on people’s consumption choices and using this to justify not giving them back their money is a false argument and must be shot down as it is a smokescreen for paternalism.

Inflation will always be an increase in the money supply faster than the demand for money. Tax cuts do not increase the money supply.

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Fred,

All you are saying is that giving people back their wealth through tax cuts can lead to price rises. I agree. These price rises are not inflation though, they are merely the market responding to the new situation. If the government spends it on building roads, the cost of road construction will rise. Price rises due to natural changes to where supply meets demand is not inflation. Inflation is the devaluing of a currency, not the rise in price of goods and services.

So, since tax cuts do not change the status quo on the amount of money in the economy and do not change the amount of assets, goods and services available to purchase, the money has not devalued, only the people whose preferences dictate the use the money have changed. It is either the preferences of the politicians and bureaucrats, or those of the individual taxpayers. Blaming consumers for demanding more of a thing is not reason enough to withhold tax cuts, and indicates mistrust in the personal preferences of taxpayers.

It is disingenuous to claim that taxpayers are smart enough to earn $30,000+ a year, but not smart enough to be able to make decisions for more than 70 cents in the dollar. Faith in the taxpayer’s ability to make consumption versus savings decisions perversely decrease as the ability of the taxpayer to earn income increases. Price rises (not inflationary) due to tax cuts are eminently preferable than price rises due to politician’s pork barrelling, since the state has little incentive to change their consumption/savings mix in the face of price rises. Even if you believe that they do have an incentive to plan better, why are the preferences of politicians and bureaucrats better than individual taxpayers?

It is paternal in the extreme not to trust taxpayers to use their own wealth in the way they best see fit. Blaming price rises on people’s consumption choices and using this to justify not giving them back their money is a false argument and must be shot down as it is a smokescreen for paternalism.

Inflation will always be an increase in the money supply faster than the demand for money. Tax cuts do not increase the money supply and therefore not inflationary.

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Can someone delete #20 and this post, it is a repeat, my server went haywire. Sorry for the repeat.

Fred Argy
Fred Argy
14 years ago

James thanks. You are of course right that, technically, one should also distinguish between structural and actual deficits and thanks for drawing my attention to your interesting piece. Unfortunately, I am retired and no longer equipped or eager to do that kind of refined analysis. I suspect that if it were done, it would still show the Costello budget to be moderately expansionary.

The two main points I am trying to make are that
(i) the methodology used by Howard in condemning the states – comparing the budget balances rather than changes in the balances – is technically faulty and
(ii) the Howard budget was irresponsible because although it was only mildly expansionary, it should have been contractionary.

Reading your piece, I don’t think you would disagree with either of these propositions, would you?