23 November 2008

Are Fiscal Deficits Really That Bad?

We've been hearing a lot in the media about this subject at the moment. The Prime Minister, the Treasurer and the Opposition Leader are forthright that budgets should not slip into deficit.

Yet we heard the other day from the governor of the Reserve Bank, Glenn Stevens, that we probably shouldn't be so concerned should it actually happen, provided that increased government expenditure was being made in the right places. Presumably, his definition of "public investment" is a reference to increased expenditure in the regions covered under the heading, "infrastructure".

After this seal of approval from Stevens, it wasn't then, a real surprise that the Treasurer and the Opposition Leader voiced their disapproval of such moves. Deficits are seen by the electorate as a sign of fiscal irresponsibility and are considered political dynamite for an incumbent government, even if they can be defended on prudent economic grounds.

So, for the layman, why might a fiscal deficit be defensible and when might a government use it?

The answer lies in the government itself. Governments are traditionally the biggest business in a national economy. In most places, anyway - I know about countries like Finland where the domination of companies like Nokia almost relegates government involvement to "minor player" status.

Governments make money through taxation and then spend it through government expenditure. How much and where the government spends then becomes rather powerful as it can turn entire economies.

The power that government expenditure has was really only realised towards the end of the 1930s during the Great Depression, when an economist named John Maynard Keynes worked out that if people and businesses weren't spending, then governments had to pick up the slack.

Governments then went berzerk, borrowing and spending. In fact, the Australian Federal Treasury did not post a single fiscal surplus between the thirties and the late eighties. I was surprised that it took this long, given that Keynesianism fell almost entirely out of favour in the late seventies as stagflation thanks to rising oil prices took hold, and increasing importance was places on interest rates to sort economies out. This, incidentally was single-handedly due to the work of another economist in the sixties, Milton Friedman, who predicted the events of the seventies, and was lauded as an economic prophet of sorts, as a result.

The discarding of Keynesianism and the adoption of Monetarism was merciless. But the strange thing was that as interest rates started to play a greater role in regulating economic activity, a kind of reverse-Keynesianism crept in in a number of places, in particular, the US and the UK where Ronald Reagan and Margaret Thatcher launched a dual assault on the role of government spending. Consequently, in these places, the end result of cutting government services and slashing taxes was that more money was free to pump up these economies. This actually led, in parts, to the record inflation of the eighties, followed by the crash of 1987. And the resulting recession, which was a fierce one. Strangely though, Reagan and Thatcher are lauded by conservative politicos as visionary.

What a bunch of twats.

Reagan and Thatcher were reducing government participation in the economy and increasing reliance on interest rates which pumped more money into economies that eventually overheated as a result. The recession of the early nineties cost Thatcher and her successor John Major their jobs, as well as eventually ensuring defeat for George HW Bush.

Keynesian economics has a time and place. Using fiscal power to fuel the fires of booming economies is not it. Reducing the role of government fuels economies and is thus, despite what conservative economic pundits will tell you, Keynesian.

Over twenty years since the crash of 1987, it appears that the role played by government expenditure is back as a viable tool for getting economies moving again. In Australia, we're now in a position where we're seeing major economies like the US and the UK, possibly even Europe, moving into recession once more, and having to resort to spending their way out of the mess.

Australia isn't yet obviously moving into recession, hence the obstinacy on the part of the government and opposition, however, Stevens has a point, which he spoke about in another part of the same speech: If our economy slips downhill as a result of us talking our way into another recession - Stevens isn't the first to notice this - can't fiscal deficits be used by Australia as a sort of pre-emptive strike?

I don't see why not.


Anonymous said...

well, it seems there are two issues here. One is the role of automatic stabilisers in the budget- the more unemployment, the more the government spends on unemployment benefits because more people are getting them.

Then there are discretionary increases in government expenditure. Such as the recent "economic security strategy payments" to pensioners and people receiving Family Tax Benifit A.

Then again, there are so called 'expenditures' on the revenue side of the budget when the government reduces the amount of tax it collects. These can be automatic, ie if less people are working, less tax is usually collected, and discretionary, ie the Budget tax cuts in recent years by both sides of politics.

My own view is that both automatic and discretionary changes which either reduce the budget surplus or create a budget surplus, will in an economy that is not running at full supply capacity, lead to greater employment. A good thing.

The question for Australia is what happens in an economy that is supposedly near full capacity but experiencing a slow down in economic growth.

I lean to the view of Stevens. If the spending increases the supply capacity of the economy as well as demand, by boosting productivity, it is a good thing.

The politicians tend to fudge things a bit, by overlooking that changes in the size of the surplus and deficits have effects as well.

If this were not so, the recent spending initiatives would have no point to them other than to redistribute income. (Which in itself may not be a bad thing either).

I reckon Keating got it right when he described those fixated on producing only surplus budgets as "deficit Daleks". A deficit, provided it avoids a recession, and provided it avoids reigniting inflation (which the last government did through it's tax cuts) by increasing the supply capacity of the economy, is nothing to worry about.

Dikkii said...

The way I see it Simon, by only ever budgeting for surpluses, you're robbing yourself of a potent economic tool, or even totally misusing that tool.

Liked Keating's call about "deficit daleks", by the way.

Anonymous said...

Yes. I would expect a budget deficit to grow the economy and this is a useful tool.

One thing that is missing from the debate, at least in the newspapers, is the so-called effect of the multiplier.

That is, if the government spends money, that money get's re-spent by households, and then re-spent again,etc and therefore, for each dollar of government spending there is a multiple effect on national income.

And some of this will end up back in the hands of the government through consumption tax and income tax.

So although the government may spend $20 billion dollars, a good proportion of this spending ends up in government coffer's again directly through the GST and indirectly as the economy grows.

Maybe this is why the government seems confident it can keep the budget in surplus!

Incidently Keating's comments came from when he was PM and we had the recession in the early 90's "that we had to have". I prefer the idea of a pre-emptive strike thanks very much. :-)

Dikkii said...

I'm not sure that the government is sure that it can stay in surplus. I think that they have a "problem" - having said that the problem is in the eye of an electorate that has been sold a message suggesting that anything other than a surplus is bad, full stop.

Agree with your comments re the multiplier - however, such an effect is not usually instantaneous, to say the least. But it's worth considering.