Opinion & Commentary
Short-term fixes are a fiscal fallacy
Policymakers in Australia have instinctively reached for the Keynesian playbook in the context of the current global economic downturn, rolling out discretionary fiscal stimulus measures of unprecedented size.
Governments cannot create new economic activity. They can only redistribute the income and wealth created by the private sector. This redistribution can occur either between different sectors of the economy or across time. Fiscal stimulus measures attempt to bring forward demand through unfunded spending measures that reduce the budget balance.
The ability of activist fiscal policy to stimulate aggregate demand and economic growth rests on the idea that governments can bring unemployed resources and labour back into employment when private sector activity is depressed.
However, fiscal stimulus packages are rarely targeted directly at these unemployed resources. They often simply divert already employed resources from one sector of the economy to another, with no net gain to employment or economic activity.
Even where stimulus packages are targeted at depressed sectors of the economy, fiscal stimulus measures can interfere with the reallocation of resources that is often required before an economic recovery can get underway. Economic downturns are rarely purely cyclical affairs. They often signal the need for structural change and a reallocation of capital and labour to more highly valued uses. Government support for favoured sectors of the economy, through measures such as the proposed Rudd Bank, can stand in the way of these necessary adjustments, making an economic downturn deeper and more protracted than necessary.
When an economy is at its ‘full employment’ level of output, it is readily accepted that increased government spending crowds-out private activity. Treasury Secretary Ken Henry used to argue as much. In the short-run context of an economic downturn, crowding-out may not seem like an important issue, but it is enormously important in the long-run.
“When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.” So says Joshua Gans in his Principles of Macroeconomics text. Yet Gans was also one of the 21 economists who recently signed a letter defending the government’s discretionary deficit spending.
An increase in the stock of government debt reduces the amount of capital available for private investment, although this crowding-out effect may be offset by increased private saving and foreign capital inflows. In a small and open economy like Australia, crowding-out occurs not so much because interest rates rise, but because it induces foreign capital inflows that put upward pressure on the exchange rate, lowering net exports and reducing aggregate demand, which offsets the increase in government spending.
Increased public sector debt displaces the role of the market in allocating capital, to the detriment of private sector capital accumulation, productivity and economic growth. Governments do not become any better at allocating resources in an economic downturn. Indeed, once fiscal discipline is abandoned, it is likely that governments will make even worse decisions, reducing the quality of government spending. The government itself admits that it has prioritised projects where money can be spent quickly rather than well.
The government’s $800 million ‘community infrastructure’ program and the $14.7 billion ‘Building the Education Revolution’ programs are examples of ‘soft’ infrastructure spending that will do little to improve the productive capacity of the Australian economy and will deliver economic returns that are lower than the cost of government borrowing.
Back in 2005, Ken Henry said to the Sydney Institute:
let me say something about the emerging pressure for increased infrastructure spending. This pressure is mostly well-intentioned – more spending on infrastructure will indeed tend to increase the productive potential of the economy. And, with long-term interest rates and therefore the cost of capital at a cyclical low at the moment, both the public and private sectors are in a relatively strong position to undertake additional spending.
But without appropriate price signals, quality investment decisions will not be made. And present price signals are far from appropriate. The risks of making large infrastructure investment decisions in such an information-poor environment are very great.
Although he probably wouldn’t concede the point now, the government’s fiscal stimulus spending has largely validated Ken Henry’s fears.
Government spending and taxing contains a counter-cyclical component, the so-called ‘automatic stabilisers’, that kicks-in during an economic downturn, reducing the budget balance and cushioning the effects of an economic downturn, without governments having to make explicit policy decisions. These automatic stabilisers should be allowed to operate and have the advantage that they are self-correcting, with the budget balance improving as the economy recovers, without the government having to take new policy decisions.
No one is arguing that the government should run a budget surplus in the context of an economic downturn.
Discretionary fiscal stimulus measures, by contrast, are not self-correcting. Unfunded tax and spending measures ultimately need to be paid for. An unfunded increase in government spending today implies a higher tax burden in the future. To the extent that households and businesses anticipate this increased tax burden, they will increase their saving to offset public sector dissaving (so-called ‘Ricardian equivalence’). The effectiveness of discretionary fiscal policy in stimulating economic activity thus relies on fiscal illusion.
However, the ability of governments to exploit this illusion is limited. Most of the gains in household disposable income due to fiscal and monetary stimulus have been saved, as evidenced by recent increases in the household saving ratio.
To the extent that fiscal stimulus results in a short-run increase in demand, much of this demand will leak into imports. This might stimulate production in foreign economies, but not domestic production.
Instead of short-run demand management, discretionary fiscal policy should focus on boosting the long-run growth potential of the economy. Any future discretionary fiscal consolidation should have a long-term, supply-side focus. The criteria for good public policy are independent of the business cycle. Unfortunately, governments all too often lose their appetite for reform in the context of an economic downturn in favour of short-term stimulus efforts that are ineffective in the short-run and undermine the economy’s growth potential in the long-run.
Dr Stephen Kirchner is a Research Fellow at The Centre for Independent Studies. This is an extract from CIS publication Fiscal Fallacies: The Failure of Activist Fiscal Policy.
