Photo Depression revisited. futureatlas.com/blog. flickr cc.
4 June 2020.
Australia’s present budget deficit is unprecedented, but it represents an appropriate response to the recession. The resulting debt does not present a future problem, and the deficit should only be unwound as private demand recovers.
Clearly Australia is in a deep recession. But with interest rates already as low as they can get, monetary policy has essentially been sidelined. Instead, and unusually, the government is totally reliant on fiscal policy to stimulate the economy, although the Reserve Bank continues to play an important role in ensuring the availability of credit to business and households.
The key fiscal initiative has been JobKeeper and without it, unemployment would be much worse. This success in ameliorating the severity of the recession has, however, come at a substantial cost to the Budget deficit.
Somewhat to the surprise of many of us, the Coalition Government has been prepared to put aside its previous sloganising against “debt and deficits” and has adopted Keynesian stimulus policies. But looking ahead that still leaves questions about how big a budget deficit can we expect, and how concerned should we be about the accumulating debt?
The size of the expected budget deficit
No official answer about the size of the future budget deficit is yet available, although the government has promised to release updated Budget figures from the Treasury next month. In the meantime, however, we have to rely on private forecasts about the size of the budget deficit, both now and in the future.
On 14 April I posted projections for the budget deficit that showed a deficit for this financial year of around $87bn, and as much as $196bn next financial year. Of course, much of this increase in the budget deficit is temporary, as it mainly reflects the impact of the time-limited JobKeeper and JobSeeker programs.
Nevertheless, the impact of the recession on budget revenue is more enduring. Thus, according to my projections, on present policies the budget deficit would still be as high $96 billion two years later, in 2022-23.
There is inevitably considerable uncertainty attaching to these budget projections; not least because we do not know how long the virus will last. But on my figures the budget deficit could be as much as 10 per cent of GDP in 2020-21; a huge stimulus compared to the deficit of 4.2 per cent of GDP incurred in 2009-10 in response to the GFC.
In addition, there are good reasons to think that these projections may turn out to be an understatement of the size of future budget deficits. The present projections assume that spending on the present major programs, JobKeeper and JobSeeker, will cease as legislated at the end of September. However, realising the full extent of this saving is likely to have quite damaging consequences.
Many industries will still be feeling the effect of the recession, even if most of the restrictions have been removed. Increased debt will make businesses and consumers very cautious and the economy will likely remain depressed for some time.
It would therefore be counter-productive to wind the JobKeeper and JobSeeker programs down and tighten the budget too quickly. In particular, higher education, international tourism, and the arts and entertainment industries may well require further assistance. In addition, there are good social reasons why it would not be fair to return to the previous rate of $40 per day for unemployed persons under Newstart.
In sum, it seems desirable that the budget deficit next year should increase a bit further above the present projection of 10 per cent of GDP, and that will have consequences for the deficits in subsequent years as well.
Can Australia afford the increase in public debt?
Perhaps it is not surprising that the government’s reversal of its previous ideology about budget deficits is concerning some of its backbench members who are already calling for savings to be made, starting with JobKeeper.
The important point to remember, however, is that the budget deficit is not and should not be an objective of economic policy. Instead, the budget deficit is an instrument which can be used to achieve the true objectives of full employment and improved living standards.
Accordingly, a budget deficit is appropriate if it balances any shortfall between aggregate demand and the supply capacity of the economy. Equally, if there is excess demand relative to supply, then a budget surplus is called for; otherwise interest rates and the exchange rate will tend to rise, and we would become more dependent on imports to service the excess demand. Only in that case would the country then be living beyond its means.
However, a budget deficit which offsets a shortfall in aggregate demand relative to the economy’s supply capacity should not put any upward pressure on real interest rates. This is because this deficit can be financed out of the excess private savings which are available, as any shortfall in aggregate demand is (by definition) equal to the excess of private savings over actual investment.
Also, as the total of public debt represents the sum of previous budget deficits, then if each of these deficits has offset the excess of private savings, there should not be any problem in financing the debt out of the surplus savings that are available.
Indeed, the problem for many advanced economies over the last decade prior to Covid-19 was secular stagnation caused by inadequate private demand. Unfortunately, however, too many of these countries implemented austerity policies in response to the pressure on their budgets following the GFC. These austerity policies just prolonged the agony and were largely unsuccessful in meeting their ostensible objective of reducing the debt.
On the other hand, a country, like Japan, continued to run budget deficits to equilibrate demand, without any pressure on interest rates, notwithstanding that its public debt was high as 225 per cent of GDP in 2019.
By comparison, Australia’s public debt in 2019 was only 41 per cent of GDP, and is not expected to rise much above 50 per cent, so it is hard to see that we will have a problem financing the present budget deficit that corresponds to a shortfall in aggregate demand. Indeed, last week the government conducted the biggest sale of ten-year bonds in Australia’s history – $19 billion – and received bids for more than twice as many.
Furthermore, history shows that when demand is low because there are excess savings, then interest rates are typically less than the nominal rate of growth in GDP. This means that unless the economy deteriorates much further, and with a ten-year borrowing rate of less than 1 per cent, there is a reasonable chance that the ratio of public debt to GDP will fall over time as the economy grows, without even running future budget surpluses.
Of course, as private demand and consequently economic growth recovers, it can be expected that interest rates will rise again, but that is when it will be appropriate to tighten the budget to achieve a surplus, and not before.
Some people, however, only seem to be happy if the public debt is incurred to finance infrastructure. Their argument is that infrastructure investment is analogous to private investment. It will therefore add to productive capacity and thus eventually pay for itself.
But much public infrastructure investment is presently not subject to proper cost-benefit appraisal and there can be no such guarantee that it will eventually pay dividends. While the charges for even economically justified infrastructure projects frequently do not fully recover their costs over their lifetimes.
On the other hand, assistance that supports demand will help retain the productive capabilities of both employees and their businesses, whereas if they were to close for an extended period, those capabilities may well be lost forever. Similarly, investment in education will enhance human capital, and increased expenditure to foster research and development and innovation will also add to future productive capacity.
In short, there is no good reason for distinguishing between so-called productive investment and other financial assistance in judging whether the budget deficit is appropriate.
The final concern about the prospective budget deficit is that the resulting debt will represent an unfair burden on young people who will have to pay that debt off. But first, it is young people who have especially benefited from the assistance from the JobKeeper and JobSeeker programs because they are typically far more at risk of becoming unemployed.
Second, as I have said, it can be expected that the debt will fall relative to GDP over time while interest rates remain low. And when interest rates eventually rise again, it will be because the economy is richer, tax revenue will have risen accordingly, and it will be possible to service the debt comfortably.
Third, there is no reason to assume that public debt should ever be reduced to zero. All that is necessary is to ensure that it can be comfortably serviced. Indeed, public debt is no different to business debt, which can be rolled over so long as the business remains viable. Furthermore, when public debt has been dramatically reduced historically, it was due to very rapid inflation. This was most unfair to the bondholders, and we don’t want to repeat that experience.
The present budget deficit is an appropriate response to the present recession, and the biggest risk to the recovery would be premature action to reduce that deficit. As that orthodox journal, The Economist, put it recently: “rich-world governments will make a big mistake if they succumb to premature and excessive worries about deficits”.