Of razor gangs, budget cuts and the policy mix

In the Channel Nine series Underbelly Razor – as in real life – Sydney’s criminal matriarch Tilly Devine did not hesitate to wield the razor to keep her motley empire in line and protect it against incursion by rival gangs. It appears Julia Gillard approaches the task of achieving a budget surplus in 2012-13 with a similar ferocity of intent.

A high-level group within cabinet, chaired by the Treasurer, Wayne Swan, called the expenditure review committee, last week signed off on a range of budget savings measures to ensure the surplus target. They will be revealed in the coming week with the regular end-of-year federal budget update, known as the Mid Year Economic and Fiscal Outlook. MYEFO, to those in the know.

This year’s update will reveal a downgrade to the Treasury’s economic growth forecasts since the May budget, but still show the economy growing at about trend, not falling off a cliff.

However, smaller-than-expected revenue collections mean that, left alone, the budget would still be in deficit by a billion or two in 2012-13. And make no mistake, by hook or by crook, Gillard, Swan and Co are getting their surplus (intervening dramatic European events permitting, of course).

The government says that by pulling on the fiscal reins it is giving the Reserve Bank more room to cut interest rates. Picture Gillard as razor maiden, the Reserve Bank governor, Glenn Stevens, as Santa Claus.

This is significant, representing a continuing shift in what economists call Australia’s “policy mix”: the relative responsibility of fiscal policy (government’s spend and tax decisions) and monetary policy (interest rates) in influencing the level of aggregate demand in the economy.

In previous episodes – think mining boom mark one under Howard – puritanical economists were always complaining that the two arms of economic policymaking were working against each other. By lifting interest rates in 2007, the Reserve Bank had its hand on the brake, trying to reduce aggregate demand in the economy, and hence control price rises.

At the same time, the Howard government was merrily spending on cash handouts for pensioners and tax cuts for all before the 2007 election (cuts that Labor also adopted and implemented), effectively putting its foot on the economic accelerator by adding to demand.

When the global financial crisis hit, the policy mix changed dramatically. The government and the Reserve Bank acted in concert to stimulate demand, delivering multibillion-dollar fiscal spending and interest rate cuts. In a speech in late 2009, senior Treasury official David Gruen hailed “the return of fiscal policy”.

Since early 2010, the government has in fact been quietly putting its foot on the brake. Because the government went from stimulating activity a lot to stimulating it by less, this change in stance means government budget decisions have actually been subtracting from the rate of economic growth.

These new spending cuts indicate the government wants fiscal policy to continue to be contractionary. The advantage of running tight fiscal policy rather than tight monetary policy – that is, high interest rates – is that it limits upward pressure on the dollar, in turn relieving some pressure on struggling manufacturers and tourism operators.

The same puritanical economists are now running around arguing the government is putting its foot on the brake while the Reserve Bank is, if anything, tapping the accelerator with its interest rate cut last month.

But let’s keep this in perspective.

The estimates are that the government will need about $4 billion in savings to secure a surplus in 2012-13. Out of total spending of $381 billion forecast for that year, that’s not huge. Europe may well fall over the edge, triggering another economic downturn, but it hasn’t yet. With Australian economic growth at trend, it remains prudent for the government to keep a firm hand on the purse strings.

Moreover, let’s not look this gift-horse in the mouth. How often do you get politicians desperate to cut spending rather than squander it on appealing to special interests (like pre-election handouts for old people). Let them go for it, I say.

In the long term, the budget faces a significant shortfall in revenues due to the ageing of the population. In the shorter term, money must also be found for a $2 billion pay rise for low-paid social and community service workers and to fund a comprehensive national disability insurance scheme.

As always, it’s the quality of the spending cuts that matters, not their size. It would be quite possible to fudge the figures to create a surplus in 2012-13 by simply pulling forward spending into earlier deficit years, or delaying spending until the out-years of the budget.

But the government has also indicated “structural” spending cuts to the big budget items of welfare, health, education and defence are in the offing. Specifically, the ballooning cost of pharmaceutical subsidies and dentists who over-claim under a limited publicly funded dental scheme are reportedly in the firing line.

Will it be enough to convince the Reserve Bank it could step in with another cut in interest rates next month? That, of course, depends on the size of the cuts the government unveils. But at $4 billion – or roughly 0.3 per cent of GDP – it’s unlikely.

Dramatic events in Europe could well convince the Reserve board of the need for another pre-Christmas interest rate cut, as could any signals in economic reports that Australian consumers and businesses are more worried about Europe than they had previously been letting on.

For the time being, however, the bank is sitting pretty, having returned interest rates to “neutral” – their historic average. It continues to watch for a sign that it needs to flick the monetary policy switch to stimulatory by cutting interest rates to below neutral. But it hasn’t happened yet.

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This entry was posted in Budget, Gillard Government, Global Financial Crisis, Interest Rates, Mining Boom, Reserve Bank. Bookmark the permalink.

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