23 February 2006

Symposium: A Decade of Howard Government

The uses of fiscal policy and the role of monetary policy

Tony Aspromourgos, The University of Sydney

APPROACHES TO FISCAL POLICY

The role of fiscal policy—the national government’s planned, discretionary balance between its outlays and recurrent revenues (broadly, spending and taxes)—has long been a subject of debate and controversy in modern times. During the 20th century, for a time at least, a ‘Keynesian’ view of the role of fiscal policy supplanted the more traditional conservative view. The latter view took as its benchmark a rather thorough-going commitment to the maintenance of a balanced budget—aggregate spending being restricted to the size of aggregate recurrent revenue—with a view to the objective of sound management of the government sector’s ‘balance sheet’. Or to put the same point differently, budgets were to be framed with a view to prudent management of the State’s assets, financial liabilities and net worth—generally with a presumption in favour of ‘small government’.

This approach does not inexorably lead to the policy conclusion that there ought to be continuous annual balancing of outlays and recurrent revenue: it is consistent, for example, with balancing the ‘current’ budget (recurrent expenditures equal to recurrent revenues), while funding capital expenditure with issue of financial liabilities (government debt). For in this way, at least if sensibly done, the value of assets would increase with the extent of financial liabilities, with no deterioration in the public sector’s net worth. Nevertheless, in practice the credo of the balanced budget was the common mantra. And in truth, the illiquidity of government assets, and their commonly non-revenue-generating character, means that funding assets with debt is not a straightforwardly viable financial exercise.

In practice the credo of the balanced budget was the common mantra.

Against this traditional view, in the aftermath of the Great Depression, following the lead provided by the British economist and public intellectual, John Maynard Keynes, many within and without the economics profession took the view that the primary purpose of the annual fiscal balance was not so much to ‘balance the books’ of the public sector, but rather, to ‘balance’ the economy as a whole; that is to say, to set expenditure in excess of revenues to offset unemployment and insufficiency of demand in the private sector, or to set revenues in excess of expenditure to offset excess demand pressures in the private sector.

While these two approaches proceed from distinctly different conceptions of how the economy (and government) work—or can be made to work—the qualitative difference as to budget outcomes is not really so dramatic. Even under circumstances in which annual budgets are strictly balanced, the irregular character of the within-year flow of expenditures and of revenues inevitably means that for some shorter periods within the annual time period, there will be ‘deficits’, albeit offset by ‘surpluses’ during other shorter periods, within the annual cycle. To the extent that the annual budget time-frame is ultimately arbitrary, this means that those who are committed to strict annual budget balance, in fact, as much acquiesce in the acceptability of temporary budget deficits, as do those who would argue instead for allowing some annual budget deficits, to be offset at other times by annual budget surpluses. How different are the propositions, ‘budget balance over one year’ versus ‘budget balance over five years’?

It is also possible to argue further, that a cumulative outcome of persistent deficit, even over an indefinite sequence of years, is quite feasible for contemporary governments. Consider, on the one hand, that growth in private sector demand for government securities can only be met by positive public sector deficits. Consider on the other, that a government security is a promise by the government to make future payment in outside money—an asset that government can create ex nihilo.

WHAT THE GOVERNMENT’S FISCAL POLICY HAS NOT BEEN

In the light of this broad background, how does the role of fiscal policy during the decade of conservative government appear? In short, it appears at first glance very much more in the traditional mould of fiscal policy as the instrument of balance sheet management than as the pursuit any wider purpose of balancing the economy as a whole. There has been no use of fiscal policy in the Keynesian sense, except that there remain ‘built-in stabilisers’ in the fiscal structure, though they have not been much needed. (2001–02 is the notable exception: see Table 1.) The built-in stabilisers are elements of the fiscal structure which automatically offset, to some extent, movements in private sector demand as the growth rate of the economy varies; for example, automatic falls in tax revenues and automatic rises in social security transfer payments, as the growth rate of the private sector falls.

There has been no use of fiscal policy in the Keynesian sense during the decade of conservative government.

One could respond to this lack of Keynesian macroeconomic purpose for fiscal policy by saying that this is unimportant, benign, or even desirable. One could say that there has been—and increasingly so over the decade—no macroeconomic problem of unemployment in Australia, and so, no need for Keynesian-style fiscal policy. And further, or alternatively, one could say that to the extent that there has been any need to target the overall level of economic activity or employment, this has been satisfactorily undertaken by another arm of government policy, monetary policy.

Both these responses have some truth; and with regard to the latter, certainly monetary policy has become the macroeconomic policy instrument. This has come about without the general public much noticing—except for the widespread fear across a debt-laden public, of interest rate rises. Responsibility for simultaneously balancing the economy at a desirable growth rate of GDP and employment, while at the same time suitably containing inflationary pressures, has shifted to monetary policy and a quasi-independent Reserve Bank of Australia (RBA). In fact, this has worked out reasonably well, but that has been largely due to fortuitously benign economic conditions.

In essence, those benign conditions under which this ‘policy assignment’ has proceeded are the combination of sustained, reasonably strong growth and an absence of any severe adverse ‘supply’ shocks. This has enabled monetary policy to pursue a target of low inflation without endangering the real growth of GDP and employment. To be clear, by ‘policy assignment’ is meant the resolution of the following three issues. What are the policy objectives of government? What policy instruments are to be employed? Which instruments are to be assigned to which objectives? In effect, the conservative government has assigned monetary policy to inflation and unemployment—though there are also structural and microeconomic policies aimed at structural or supply-side unemployment. Fiscal policy has been assigned to balance sheet objectives—the latter, connected to some political purposes (more on this below).

What could have brought all this unstuck, mightily testing this policy regime—and what may yet do so, if the conservatives remain in government long enough—is a dramatic adverse supply shock of some kind: a shock to the economy such as to simultaneously place upward pressure on inflation and impose contractionary pressure on real growth and employment. (A sharp rise in the world supply-price of oil is the most obvious candidate.) This is where ‘the assignment problem’ would start to bite. In general, to solve the policy assignment issue, there must be at least as many instruments of policy as there are objectives. To put the point intuitively, in the face of a serious adverse supply shock, monetary policy might find itself having to walk north and south at the same time, on one pair of legs. The upward pressure on inflation from such a supply shock would signal a need for monetary policy to raise interest rates; the downward pressure on demand, on the other hand, would signal a need to lower rates. The difficulty of pursuing two objectives with one instrument, when the objectives are pulling policy in different directions, would be exposed.

Stand-alone monetary policy is better able to handle aggregate demand shocks.

In this situation, the abandonment of fiscal policy as an instrument of macroeconomic adjustment and stabilisation, aimed at or about full employment would become more clearly problematic. As a corollary of this line of argument, the single-handed success of monetary policy as the instrument of macroeconomic policy over the last decade is considerably indebted to the absence of any such serious adverse supply shocks during that period—though that is not to deny that the wisdom and skill of the RBA leadership is to be given credit for the success of policy. It was not all just good luck. Apart from oil price rises not having had any significant adverse consequences for the Australian economy since the second US-Iraqi war, the only supply-side concerns have been in relation to domestic infrastructure constraints and skills shortages, raised by the RBA last summer; but little has so far come of this issue.

LIMITATIONS OF MONETARY POLICY

It is not, however, just adverse supply shocks which would test the efficacy of monetary policy as the singular instrument of macroeconomic stabilisation, and the associated abandonment of fiscal policy as a tool of stabilisation. Stand-alone monetary policy is better able to handle aggregate demand shocks, since they imply moving the interest-rate instrument of policy in one direction rather than two: upward pressure on inflation is then associated with strengthening demand and employment growth, and vice versa. Indeed, our economy is one in which more and more of the private sector agents’ expenditure-versus-saving decisions are sensitive to their net wealth or net worth. Furthermore, private sector net worth (assets net of liabilities) has become increasingly sensitive to interest rates, due to the growth of interest-bearing liabilities (debt). In these circumstances, interest rate variations are becoming more potent in their influence on aggregate demand. The bad news is that there is a downside to this greater potency of monetary policy: the risk of policy error is heightened, particularly with regard to tightening policy (raising official interest rates).

There is likely to be an asymmetry here: the demand management task of monetary policy over the last decade has been almost exclusively about avoiding excessively fast growth, not bolstering excessively slow growth. A tightening of monetary policy fairly directly takes money out of the pockets of households and firms that are carrying debt, and therefore can quite powerfully constrain their disposable income and their expenditures. On the other hand, an easing of policy leads to an increase in the disposable income of net debtors, but cannot force them to spend the difference. In a situation of economic contraction or falling growth, those net debtors may think it prudent from an individual point of view, to save the difference rather than spend it. (The same can apply to a policy of tax cuts.) This asymmetry has traditionally been called the problem of monetary policy easing ‘pushing on a string’ (whereas, asymmetrically, monetary policy tightening is pulling on a string).

The most significant contractionary demand shock of the last decade was the Asian Crisis of 1997. The resilience of the Australian economy in the face of that is testament to how much the strength of the economy since the mid-1990s is attributable to the structural changes wrought by the previous Labor governments. A future possible adverse demand shock could come from a number of sources. The two which appear most possible in current international and Australian circumstances are: 1) a sudden and sharp correction in the United States imbalance of foreign payments on its current and capital accounts; and/or 2) a sharp adjustment in household saving versus spending, in response to an adverse wealth effect emanating from further unravelling of house prices. It would be poetic justice in a way, if the latter problem were visited on the conservative government (but not on the rest of us): its policies are partly culpable in the unsustainable rise of residential housing prices.

The most significant contractionary demand shock of the last decade was the Asian Crisis of 1997.

Neither of these possibilities is looming ominously, but neither is impossible either. In any case, one may seriously doubt whether a future contractionary demand shock could be adequately addressed by way of only monetary easing, without recourse also to discretionary fiscal expansion (and not just the automatic fiscal stabilisers). But if the current Treasurer and other members of the Government really mean what they frequently say about fiscal policy and budget balances, then in the face of a severe downturn one might expect them not to turn to fiscal stabilisation—and perhaps even to seek to counteract the operation of the automatic fiscal stabilisers, with discretionary fiscal policy changes of a contractionary kind. The currently proposed further deregulation of the labour market (if it survives judicial review) also will come into play here, likely changing the balance between unemployment impacts and wage reduction impacts of such a shock.

CONSERVATIVE FISCAL PURPOSES

What principles or objectives have governed the conduct of the conservative government’s fiscal policy? It may be emphasised, first, that by ‘fiscal policy’ one does not mean all and every element of government expenditures and government revenue raising. Its meaning rather should be limited to policy as to the overall balance between total government outlays and recurrent revenues—though one may include as well, policy towards the share of government expenditure and transfers in GDP, and the share of tax revenue in GDP. Note that the choice as to the balance of outlays and recurrent revenues is consistent with a wide range of values for the shares of outlays and recurrent revenues in GDP. There is a ‘degree of freedom’. Hence, for example, a policy of balanced budgets is consistent with a high or a low tax share, so long as accompanied by equally high or low total government outlays as a share of GDP. Once policy as to outlay and revenue shares is determined, a vast range of economic, social and political objectives will enter into deciding how revenue should be raised and how outlays should be allocated.

At first glance the conservative government’s fiscal policy might appear to have been concerned with debt management. The government has made much of its reduction in the stock of outstanding Commonwealth Government debt, to the point where at one stage (2002–03) it was—at least in its public posturing—toying with the possibility of retiring all government debt. This, remarkably, would have led to the extinguishment of the market for Australian government bonds. But the total reduction in Commonwealth debt which has actually occurred is in considerable measure matched by the government’s sale of assets, so that only a fraction of debt reduction is attributable to genuine public sector saving in excess of public sector investment. Over the period 1996 to 2004, the reduction in net Commonwealth debt was approximately $73 billion; the cumulative value of asset sales over the same period appears to be around $49 billion; and the cumulative underlying cash balances (budget surpluses) amounted to about $34 billion. Hence debt reduction to a considerable extent has really been about a shift in the composition of the Commonwealth’s assets and liabilities, rather than an increase in net worth. Nevertheless, there have been genuine fiscal surpluses, and increases in the ‘structural’ surplus. (The structural surplus removes the impact on budget balance arising from cyclical fluctuations in the economy, which influence the budget via the built-in stabilisers.)

The conservative government’s fiscal policy might appear to have been concerned with debt management.

Table 1 shows the budget balances (underlying cash balances) for most of the decade. It also shows the decline in the Commonwealth tax share in GDP—and of course, almost inevitably associated with these two trends, the decline in Commonwealth outlays as a percentage of GDP. This could be read as an expression of conservative or liberal ideology, shifting resources from public use to private use. But the GST revenues are not included in these figures (because the GST is treated as if it were a state tax). The consolidated revenues of all three tiers of government taken together, as a percentage of GDP, seem to indicate little shift in the overall tax share—and hence, not exactly an anti-socialist counter-revolution in the overall balance between public and private income in Australia (see Australian Bureau of Statistics 2005).

The conclusion to be drawn from this is that the impact of conservative or liberal ideology is probably more interesting and significant in relation to the distribution of the tax take and of government outlays, rather than in relation to overall fiscal outcomes. It is certainly arguable, just from a narrowly economic point of view, that more substantial public investment—for example, in economic infrastructure and technical and vocational education—would have been justified over the last decade. But even if this is so, it doesn’t go to the question of fiscal balance (or public sector net asset growth): such expenditures could have been funded either by higher taxes (or less tax cuts), or by issuing debt. Furthermore, while counter-cyclical fiscal policy has hardly been needed, significant long-term unemployment (at the low-skill end of the workforce) and hidden unemployment persists.

Table 1: Commonwealth Government Revenues, Outlays and Budget Balances, 1997–98 to 2004–05*
 
  Receipts Payments Underlying
Cash Balance 		Tax Non-Tax
1997–98 24.3 24.1 +0.2 23.4 0.9
1998–99 24.8 24.1 +0.7 23.9 0.9
1999–00 26.6 24.5 +2.1 24.2 2.4
2000–01 24.1 23.2 +0.9 21.9 2.2
2001–02 22.8 22.9 –0.1 20.7 2.1
2002–03 23.2 22.2 +1.0 21.2 2.0
2003–04 23.0 22.0 +1.0 21.2 1.8
2004–05 23.5(e) 22.4(e) +1.1(e) 21.6(e) 1.9(e)
 
Source: Budget Paper No. 1 (Budget Statement No. 13), 2005.
* All magnitudes are percentages of GDP. Changes in accounting procedures between 1998–99 and 1999–00, and other accounting changes, make comparability through time problematic. Columns 4 and 5 divide receipts into tax and non-tax revenue. The underlying budget cash balance is the first column minus the second column.

RETURN OF THE ‘BANANA (OR IS IT “WHEAT”?) REPUBLIC’?

Two potential sources of an economic downturn were suggested above, such as might expose the need to employ fiscal policy for macroeconomic stabilisation. There is perhaps also a third candidate: a sharp correction of the now historically high Australian deficit in the balance of foreign payments on current account (more than 6 per cent of GDP). But such an eventuality would almost certainly not allow the choice of an expansionary fiscal response. At least in the short run, policy would have to acquiesce in the implied structural weaknesses in external economic performance and the associated maximum ‘balance-of-payments-constrained GDP growth rate’; that is to say, acquiescence in constrained growth rates that would make import growth better aligned with export performance.

Commonwealth debt reduction, funded by asset sales, is irrelevant to the external deficit.

In fact, a policy of avoiding public sector deficits and public debt growth in the Australian context could be justified by reference to Australia’s persistent recourse to external deficits. If external balance, in some sense (for example, the current account deficit as a percentage of GDP), is regarded as a macroeconomic policy objective, then fiscal restraint could be seen as a necessary offset to the private sector’s chronic tendency to generate a deficit with the rest of the world. But here it must be kept in mind that Commonwealth debt reduction, to the extent that it has been funded by asset sales, is irrelevant to the external deficit, since to that extent it does not reflect higher net saving by the public sector, partly offsetting private sector dissaving (the sum of the two being the external current account balance).

If fiscal restraint is accepted on this ground, then any desirable new public expenditure initiatives (for example, to address long-term and other unemployment, or public infrastructure and education and training inadequacies) must come from redistribution of current expenditures, or higher taxes. But also here, recourse to financing new public expenditures via higher taxation will only avoid deterioration in external balance if it reduces private expenditure by at least the same amount (rather than reducing private saving). (The possibility of an external balance policy objective also links to interest rates via the possibility of a currency-risk premium being built into Australian interest rates, with potential spillovers to all borrowers.) To the extent that the policy response to external imbalance is public sector austerity on the expenditure side (rather than higher taxes and/or higher private saving net of private investment), this involves a political and social value judgment about the appropriate balance between private and public production and expenditures.

CONCLUSION

As a matter of fact, the great fiscal reform of the current prime minister’s first decade in office was of course a new tax, the GST. And it is rather paradoxical, in a way, that those to the left of the political centre opposed such a magnificent source of tax revenue—and hence such a robust means to long-run growth of the public sector. It is also not a politically insignificant fact that the GST effected increased centralisation of fiscal power in the hands of national government. Taken together with his industrial relations legislation (which also centralises power, if it survives judicial review), these two measures could possibly end up making the current prime minister the politician who has made the greatest contribution to the prospects for social democracy and Left politics in Australia since Gough Whitlam. But after all, in truth the current government is neither conservative (rather, radical), nor liberal (rather, authoritarian).

REFERENCES

Australian Bureau of Statistics 2005, Taxation Revenues, Australia, 2003–04, Cat. no. 5506.0, ABS, Canberra [Online], Available: http://www.abs.gov.au/Ausstats/abs@.nsf/0/ACE2B395A8657B91CA256A6800820742?Open [2006, Feb 16].

Tony Aspromourgos is Professor of Economics in the School of Economics & Political Science, The University of Sydney. The author is indebted to Jasmin Argyrou, John O’Mahony and Graham White for comment and advice, without thereby implicating any of them in the final product.