The supply argument for fiscal consolidation


As restrictions were lifted and the economy recovered, the fiscal response seemed more conventionally Keynesian – boosting aggregate demand to boost confidence and activity. At the same time, emphasis has been placed on removing rigidities associated with policies such as JobKeeper, in order to allow some reallocation of resources in the economy.

The duration of this recovery is a matter of macroeconomic judgment.

There are some limits to the extent to which actual resources can actually be borrowed in the future.

Ultimately, the government’s policy is to return to a stable debt-to-GDP ratio once the recession is over and we are getting closer to full employment.

The prudence of this approach is supported by the probability that bond yields will remain below nominal growth rates.

This means that the debt-to-GDP ratio will gradually decline. Alternatively, we can afford to run small deficits in the future, while maintaining a stable debt-to-GDP ratio.

The risk in the public debate is that this idea – that GDP growth tends to exceed interest rates – is interpreted to imply something quite different and much more important: that debt and deficit do. no longer matter.

That we can afford the next and the next ‘one time’ increase in debt on the grounds that growth rates will continue to exceed bond yields – noting that in other developed economies the same observation is used to justify the debt ratio / GDP ratios more than twice as high as ours.

In the parlance of economists, the idea that growth rates will exceed interest rates is reassuring about the sustainability of existing permanent debt levels, but gives no indication of what level of permanent debt we should choose.

In choosing a level of debt, there is both a macroeconomic and a microeconomic argument for prudence.

The macro case is, first of all, that we need to replenish fiscal buffers for the next emergency.

Second, if inflation reappeared, or if bond yields exceeded nominal growth for a period (which is not impossible for a resource exporter like Australia), then implicitly we would need consolidation. budgetary.

Successful fiscal consolidations in history are rare. They are not often popular. And they would probably be even less popular in times of rising inflation, or falling terms of trade, or slow real growth or rising interest rates: but these are the very circumstances in which our dynamics d The currently favorable debt would be reversed.

The reason fiscal consolidation is difficult in practice is because of the incentives:

  • Spending proposals tend to look appealing individually, but add up to an unappealing and unaffordable total.
  • And future taxpayers are under-represented by voters today.

Then there is a microeconomic case for prudence.

This starts from the observation that tax choices refer to the use of the real resources of the economy. And there are limits to the extent to which real resources can actually be borrowed in the future. This happens in practice through a decrease in the accumulation of capital.

The real cost of public spending is measured in labor, capital and materials used that would otherwise be used elsewhere, for example in the pursuit of a private entrepreneurial goal – innovation or investment.

This feeling of scarcity may seem less evident during a classic demand-side recession or when inflation is low.

Opportunity cost

But as we move forward on the road to recovery – even in an economy operating below its potential – it is a mistake to think that government spending has no opportunity cost.

Resources have an alternative use, with an alternative value to society – a value that may even be greater than that produced by a government program. Obviously, this is especially true if public spending is not universally of high quality.

An infrastructure project that does not successfully pass a cost-benefit analysis, or a financing model that rigidly locks into an existing business model, or an industrial program that diverts resources to a privileged sector, can all act. to reduce growth and well-being.

In other words, in addition to observing global fiscal rules, governments must ensure that their interventions (backed by coercive powers such as taxation) are consistent with allocating scarce resources at their highest value. high.

It is important to apply the same rigor to consumption choices over time (that is, today compared to the future).

The simple story of debt dynamics (growth rates higher than bond yields) is incomplete if it is not based on a certain sense of well-being over time (or utility, as the economists) – that is, the trade-offs between current consumption and consumption in future years or by future generations.

The right time to borrow?

Some might see a long-term reduction in interest rates as indicating a good time to borrow – and that logic works well for a household or business.

But a government trying to manage the scarce resources of the economy as a whole might want to understand why real interest rates are in fact lower and what that means for its resource allocation decisions.

Could it, for example, be that falling real interest rates reflect a shift in societal preferences for the future?

If so, in terms of project appraisal, it might strengthen the case for capital investment: at a lower ‘discount rate’ we might find it more attractive to sacrifice consumption. today, to invest for a future gain.

It does not necessarily follow that at the same time we should (or can) anticipate significant consumption by borrowing heavily in the future, even though the bond markets make this feasible and attractive.

These are complex considerations, which is why the approach of intertemporal choice and intergenerational equity must be carefully considered. In the face of uncertainty about future growth, the arguments in favor of a precautionary principle are even stronger.

The imposition of budgetary limits, in accordance with the current declared policy and medium-term budgetary projections, is part of such an approach. The idea that the debt and deficit no longer matter is no longer important.

This is an edited excerpt from Michael Brennan’s talk Tuesday on the CEDA interactive livestream.

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