Why is Australia so opposed to debt?

In the USA, Lawrence Summers tells us that the case for a fiscal stimulus is stronger than at any time in my professional lifetime. And most people other than a few crazy republicans agree with him. Paul Krugman and Greg Mankiw both add their voice: counter-cyclical measures are needed immediately. The same applies to the UK and Europe.

So why is the Australian Political Left and so much of the popular media still so debt-allergic? Why do our fiscal authorities refuse to respond to the imminent threat of a recession? And why are they so reluctant to finance new infrastructure investment at a time when new private investment has a very high risk premium? And why do we fail to recognize that monetary policy faces a breakdown in trust, irrespective of the lending rate?

Is fiscal policy effective?

Fiscal expansion can be effective in stimulating activity if the income effects outweigh the crowding out effects. Crowding out occurs through various channels:

– physical crowding out, which stems from demand pressure on productive resources; this only applies when the economy is operating close to full employment; it does not apply to the expected outlook over the next few months;
– direct interest rate responses by the central bank; this assumes a non-accommodating monetary policy, which now seems unrealistic;
– financial/crowding out, which occurs through indirect effects on financial markets and business confidence;
– exchange rate movements (with secondary effects on net exports); and
– some forward looking consumption smoothing by private agents (Ricardian equivalence effects where people are smart enough to recognize that higher deficit spending will lead to higher taxes later on ).

Extreme monetarists play up these leaks, especially the last three. But such extreme circumstances are unsupported by the evidence.

A recent US academic review of the empirical literature on how best to craft fiscal stimulus (authored by Elmendorf and Furman, January 10 and available in Greg Mankiws blog) concluded that, provided a discretionary fiscal stimulus is seen as temporary, it would boost economic activity more quickly than monetary policy and would usefully supplement and reinforce any monetary stimulus.

How to overcome implantation lags?

Well used, fiscal policy can clearly be effective as a contra-cyclical tool. But its biggest stumbling block is implementation lags, especially in periods when governments do not control the Senate.

To overcome the reluctance to increase tax rates in boom times, an independent body could be given the power (a la Gruen) to make small upward or downward adjustments to tax rates without the need for Parliamentary approval.

But another rewarding idea would be to have a number of sensible ready to go infrastructure projects for quick implementation. The advantages of such a proposal are potentially large.

First, spending increases on infrastructure projects produce a more effective contra-cyclical demand effect per dollar than tax changes – because it initially raises aggregate demand in the economy dollar for dollar, whereas a share of the tax cut is saved.

Secondly, the benefit-cost ratio on any new infrastructure project is much more favourable if it is started at a time when there is a lot of spare capacity in the engineering and construction industry and if it were sensibly cut off soon as soon as private building finance becomes more readily available (which point to the need to target low-gestation infrastructure).

Thirdly, investment spending has much bigger spin-offs for the economy in the long term than increased transfers and consumer spending e.g. it offers an opportunity to rectify the past neglect of social and environmental investment such as in education, health, public transport, low-cost housing, urban roads, rivers and water.

But governments need to be institutionally prepared. For investments to be well timed and productive there needs to be prior federal state coordination and a national audit to determine priorities. This is currently being done through coordinate federal-sate bodies such as COAG or the new Infrastructure Australia body.

The rules of the game

So why is Australia so different from the rest of the world in its stance on fiscal debt?

It cannot be simply the rules of the game. These clearly define the fiscal target as being “to maintain budget balance, on average, over the course of the economic cycle”. Formally, this gives governments scope to run budget deficits or surpluses depending on the economic circumstances. Nor have our rules changed much relative to the Hawke and Keating period.

Yet our fiscal advisers seem to make a distinction between automatic stabilizers and discretionary spending the former is tolerated (subject to some attempt to cushion its effects) but the latter is not.

I think the reasons must lie in

1. Costellos constant harangues against government debt, forcing new state governments to avoid incurring new net fiscal borrowing;
2. The fiscal conservatism of people like Carr and Rudd;
3. The political objections of the far right, who always prefer a tax cut;
4. Ongoing fears of the risk of a debt downgrading (which makes little or no sense);
5. And a degree of reluctance to run fiscal surpluses in the face of our stubbornly large current account deficit (which is illogical as private borrowing to fund infrastructure has exactly the same effect on the current account deficit).

Can you think of other reasons?

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jimormerod
jimormerod(@jimormerod)
13 years ago

History and a collective case of mistaking correlation for causation.

In Victoria, the economic recession of the early 1990s, and the financial institution collapses of the State Bank and the Pyramid Building Society, seem rather strongly associated in the public mind (not least, by Kennett’s effective wedging it in there) with the level of deficits the Kirner government ran.

The links are, of course, pretty dubious, but that’s what we’ve been sold.

Similarly, federally, economic times were indeed good during the Howard era for reasons that didn’t have that much to do with his government. The Howard government ran surpluses built on the back of increased tax revenues.

Thus, people think that running a surplus means economic growth, running a deficit means a recession, when of course it’s in large part the other way round.

NPOV
NPOV
13 years ago

Fred, on what basis would you claim that the “Australian Political Left” is “reluctant to finance new infrastructure investment”?

Sure, the ALP might be, but that long stopped being even vaguely representative of the political Left. Most serious Left-wing commentators and certainly the Greens party have long been arguing for the government to invest more in infrastructure, even if it means borrowing to do so.

tim watson
tim watson
13 years ago

Judging by recent comments from John Brumby in Victoria, I think there will be an ever so slight move back towards public indebtedness in the coming years.

Especially considering the growing unpopularity of public private partnerships for the provision of essential infrastructure.

Current events overseas will surely see a resurgence in the popularity of Keynsian economics, and I think that will flow over into more public support for government debt in the Australian polity.

Thersites
Thersites
13 years ago

“Governments can boast about capital works programs extending out five, 10, 15 years. But essentially what you’re boasting about is the level of debt you have.”

Perhaps this quote in todays Sydney Morning Herald from NSW Premier Nathan Rees is very topical as he also signals cuts in capital spending …..

Andrew Norton
Andrew Norton
13 years ago

Fred – I think much of this has been making a political virtue out of surpluses that were often much larger than expected, and then could not be returned to taxpayers because in its last budgets the Howard government was spooked by claims that tax cuts would be inflationary.

But while not strictly accurate from a purely intellectual perspective, if a public debt averse culture has been entrenched it will help save us from the fiscal mess that so many other countries now find themselves in. You think deficit financing would be well spent, but this seems very optimistic.

The argument about infrastructure is largely a separate one – we can’t really link major projects that require years of planning and construction to tweaking of the economic cycle.

NPOV
NPOV
13 years ago

Andrew, if you’re concerned about deficit financing being well spent, would you be prepared to argue for stronger laws governing what deficit funding can be used for? Indeed, are there any such laws at all? I assume your primary concern is that governments might borrow money simply for pork-barrelling purposes. But surely to a certain degree we can trust the lenders involved to make a reasonable assessment of whether such borrowing is economical sensible? A government presumably can’t simply go banks and expect to get billions of dollars in funding for whatever fanciful project they care to dream up: after all, their ability to raise taxes in order to fund repayments if necessary is not unlimited.

Michael Kalecki
Michael Kalecki
13 years ago

Fred,
The reason why Larry, Kruggers and Mankiw believe Fiscal policy is necessary is because monetarty is next to impotent.

This is why Keynes actually wrote the General Theory.

I do not see that at work in Australia as yet

Andrew Norton
Andrew Norton
13 years ago

NPOV – There are no laws governing what deficit funding can be spent on; indeed given that money is fungible they would be pointless, as the ‘deficit’ component would just be categorised to something within the law. And lenders ask no questions, assuming that with government’s power to tax the quality of their spending is irrelevant. Only if the government looked likely to default would lender resistance set in.

NPOV
NPOV
13 years ago

I wouldn’t say pointless Andrew – if there is a law stating that before applying for deficit funding, the Government must at least have a budgeted proposal to build infrastructure costed at that quantity, and are then held to go ahead with building that infrastructure once the funding is available, it may help prevent them from deficit funding for any arbitrary purposes. But to be honest I’m not too convinced there’s a serious history of “borrowing for questionable purposes” anyway.
Would lenders really consistently automatically approve basically every loan that the Austalian federal or state governments apply for?

Andrew Norton
Andrew Norton
13 years ago

NPOV – The issue isn’t so much borrowing for questionable purposes as the quality of spending overall. The Budget is already full of programs that have never been evaluated to see if they represent value for money, because the incentive structure is to get re-elected, not to spend other people’s money wisely. If there was a worthwhile project it could be funded by reallocating existing resources.

NPOV
NPOV
13 years ago

“The Budget is already full of programs that have never been evaluated to see if they represent value for money, because the incentive structure is to get re-elected”

I could certainly believe that was the case in an election year for a government that was struggling at the polls. But it’s rather harder to see why that would be the case for the current budget. Can you list some specific examples?

Patrick
Patrick(@patrick)
13 years ago

NPOV – yes of course they would, up to the point of anticipated default. What could make you think otherwise?

In practice, most of the lending would be Treasury bills, which are brought (or not) by a diverse range of people none of whom are imagining the money to be in way linked to any specific project – they are just buying Australian debt.

Of course, the overall spending mix will affect (if not a lot especially at first) the price, but that is about it.

Andrew – I hear you, I really do, but practically, if we assume that we do need further infrastructure and that the existing political system is more or less what it is, isn’t borrowing a reasonable means to finance it? And ideally, won’t borrowing, and the resultant debt service costs, act (perhaps only to a tiny degree) as a disciplinary measure in and of itself?

NPOV
NPOV
13 years ago

Patrick, thanks for that explanation – so government can basically get itself into as much debt as it can, so long as there is anyone out there prepared to buy up T-bills. In that case it does seem to me that there should be laws that govern the approval process for deficit spending. Do any other countries have such laws? I know the U.S. has a law controlling the maximum about of debt the government is allowed to hold, which I understand the TARP bill will necessarily cause an increase in.

Andrew Norton
Andrew Norton
13 years ago

NPOV – Specific examples: Baby bonus, scrap it completely. FTB – one of the biggest items in the budget – massively scale it back. There is no evidence that most higher ed tuition subsidies make any difference. Subsidies to the car industry; indeed industry subsidies generally.

NPOV
NPOV
13 years ago

Well no argument from me about the baby bonus, and I fully agree that family payments can be done more efficiently in general than they are currently. Are you honestly claiming that you believe all tertiary education should be fully user pays? As in, you don’t accept that countries likes Finland where tertiary education is basically fully subsidised have better quality outcomes than countries like the U.S. where is it fairly poorly subsidised?

Patrick
Patrick(@patrick)
13 years ago

NPOV, yes, that’s how Japan got to almost 200% of GDP and even Singapore to 100%, according to this Wikipedia table. I’m comfortable with Japan and Italy, for example, but I wonder about Singapore’s.

As Jacques’ point illustrates, though, I can’t imagine effective laws against it.

Unrelatedly, I wonder about this statement:

As in, you dont accept that countries likes Finland where tertiary education is basically fully subsidised have better quality outcomes than countries like the U.S. where is it fairly poorly subsidised?

Doesn’t every US State have free State universities, most of which are quite respectable? And whilst I know that America’s primary and secondary education systems are patchy, I actually thought that their tertiary system was regarded as basically the best going.

NPOV
NPOV
13 years ago

It’s the quality of the institutions that’s at question, rather the quality of the outcomes, which depends as much as anything on the ability of students to afford attending them.

NPOV
NPOV
13 years ago

BTW, great image map on that wikipedia site. It certainly suggests that Australia should be able to comfortably manage somewhat higher levels of public debt than it has currently.

NPOV
NPOV
13 years ago

(Er, missing “not” after “it’s” in the last post but one”)

dickinson.ma
dickinson.ma(@dickinson-ma)
13 years ago

How can opening the Future Fund for infrastructure development not be seen as the political left taking positive action in the country’s best interests? Surely no-one believes that such funding will cease when that fund is drained? Surely no-one believes the fund will be drained at all?