A surplus for its own sake is a dangerous thing

April 24, 2013

By Stephen Koukoulas

The current body language from those in the know is that the budget bottom line will be in deficit, not only for 2013-14, but also in the forward estimates out to 2016-17.

Treasurer Wayne Swan will be handing down his sixth budget on May 14 amid signs of low inflation, weak nominal GDP growth and, with that, ongoing weakness in government revenue.

While there will no doubt be a welter of criticism that the Government is not doing enough to bring the budget to surplus, the question for those truly interested in economic management is, does it matter?

For now, given the current economic conditions, the answer is a resounding no. Over time, of course, the question of whether there should be a deficit or a surplus is dependent on the economic cycle.

While the real economy is doing well, with GDP growth holding around 3 per cent and the unemployment rate stuck a few tenths around 5.5 per cent, the intended return to budget surplus is being undermined by low inflation and the softness in the terms of trade which are leading to weak growth in tax receipts. Barring a range of austerity spending cuts or unwelcome tax hikes, the return to a budget surplus is likely to be slow.

Of course, anyone can deliver a surplus at almost any time – the issue in striving for a hard to get surplus is the cost to the economy of cutting spending or hiking taxes to deliver that surplus.

If the deficit projection for 2013-14 is, for example, around $12 billion of 0.75 per cent of GDP, the government could cut programs totalling that amount or hike taxes to pull that cash out from the private sector (households or companies) so that it can present a surplus. It is that simple.

But having the government pulling 0.75 per cent of GDP out from the economy when it is only growing at around trend, when the unemployment rate is drifting upwards, when the global economy is fragile, would be economically irresponsible. Some simple economic modelling suggests that this sort of fiscal austerity would cut employment by around 40,000 people.

Despite the significant change in the economic circumstances over the past year, some may argue that it is entirely reasonable to stick with the surplus objective and give it a higher priority than economic growth and unemployment. It is entirely open for these views to be expressed and for these beliefs to exist, but the trade-off must always be acknowledged.

Which circles back to the fundamental question of whether a budget surplus is a means to an end or an end in itself.

The answer to that, when Australia has not had the ratio of net government debt to GDP above 20 per cent in over 50 years, is simple – the budget is a means to an end.

What is the point of running a surplus if the economy is kneecapped? Turning this concept on its head to highlight the crux of the matter, why run a deficit if the economy is overheating, there are rampant inflation pressures, and interest rates are being hiked? That latter example would be as irresponsible as pursuing fiscal austerity when an economy was slowing and the unemployment rate was rising.

The other thing to recall about the obvious fiscal shortfall that is likely to show up in the budget is that financial markets and the credit ratings agencies are aware of the fiscal outlook. It has been front page news for some time and it was back in December that Treasurer Swan acknowledged that the revenue shortfall made the surplus objective just about impossible to achieve.

And what has been the reaction?

The ratings agencies retain the triple-A rating and the Australian dollar has jumped to a fresh 28-year high. The stock market is maintaining its strength and at the same time, government bond yields have remained close to 50-year lows. Clearly, this is a complete acceptance of the circumstances that are leading to the deficit projections.

Then, of course, there is the question of just how big the projected deficits will be when the budget is handed down.

It is unlikely that any budget deficit in the out-years will be much more than 1 per cent of GDP. More likely, the deficits will be nearer 0.5 per cent of GDP which means that net government debt levels will hold around 10 per cent of GDP, a trivial amount.

The key point is that the budget is and should be used to manage the economic cycle and that when the economy is booming, it should move to surplus, reduce government debt and take some of the heat out of the economy. This action builds a pool of reserves that can be used when the economy slows which is when tax receipts weaken, government spending is boosted and the budget returns to deficit and government debt rises.

This is exactly what has happened in Australia for the last 35 years and hopefully will happen over the next 35.