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Australian economy: budget surplus myths meet the “China Syndrome”
Gerard Jackson
Costello’s budget has received much praise, some of it generous, much of it grudging. But what really matters is not so much the budget but the thinking behind its principle parts and how it will affect the Australian economy.
In a glowing report Terry McCrann, business correspondent for the Herald-Sun praised Costello’s “sustainable stabilising surpluses” ( Crowning glory for Costello, 11 May). He was not the only one to fail understand the nature of surpluses. David Uren, economics correspondent for The Australian made the same error, when he claimed that “new spending and tax cuts . . . will not force interest rates higher” because of accumulating surpluses.
George Megalogenis, economics writer for The Australian wrote in a similar vein, saying that “Mr Costello wanted a big surplus, to assure the Reserve Bank that domestic demand was not about to run ahead of the economy’s capacity to supply it”.
The old Keynesian view was that governments accumulated surpluses in the good times so that they could spend them when the bad times arrived. This was called counter-cyclical. What is overlooked is that these surpluses are the product of loose monetary policies which in themselves are the cause of the so-called business cycle.
In plain English, loose money raises nominal incomes which in turn raise tax revenues. So when someone argues that a surplus is needed to make sure demand does not “run ahead of the economy’s capacity to supply it” he is, whether he realises it or not, arguing that the central bank has printed too many dollars. Clearly it would have been better if the money supply had not been expanded.
This leads to the conclusion that spending a surplus in an attempt to alleviate or prevent a recession is no different in principle from the Reserve simply printing the dollars and then giving them to the government of the day to spend. This is something that Megalogenis should know.
Uren’s argument that the surpluses will prevent tax cuts from driving up interest rates is just plain silly. True tax cuts cannot drive up interest rates. In fact, it’s even possible for them to drive rates down. (See President Bush: deficits and interest rates)
A true tax cut occurs when there is a genuine transfer of purchasing back from the government to the taxpayer. In short, the tax cuts are not funded by borrowing or inflating the money supply. In such circumstances it ought to be clear that it is impossible for tax cuts to raise rates. Moreover, if the cuts are saved then they can actually drive rates down, depending on the social rate of time preference.
Unfortunately it gets worse. The Government is banking on the expectation that the tax cuts will not flow into consumer spending because Treasury and Reserve Bank officials assured Costello that some households saved the additional income from the 2004-05 budget.
According to the budget papers “This trend is likely to continue with further income tax cuts and measures to support saving in the 2005-06 budget”. This has led some economic commentators to assert that increased savings will lower consumption and drag the economy down.
We had, for instance, Megalogenis, claiming that “the economy is sluggish because consumers are frankly exhausted by spending. . . . Last year’s tax cuts do not appear to have been spent. They were saved”.
As I said earlier on, a true tax cut involves a transfer of purchasing power back to the taxpayer. This also means that aggregate spending must therefore remain the same. (Forget the Keynesian multiplier effect: it’s just another economic fallacy). Moreover, as Ricardo said to Malthus: “To save is to spend”. Our commentators have once again fallen into the old economic fallacy of confusing savings with cash balances.
(See Is the Australian economy heading into recession?, Consumer confidence and consumer spending equal twaddle and An economic fairy tale).
All the commentators seem to agree that the budget assume the Chinese and US economies will continue to rapidly expand. Chinese expansion has given us the biggest minerals boom in 30 years, driving the terms of trade — the ratio of export prices to import prices — to a 30-year high.
Basing the budget on continued Chinese expansion was not a smart move. Costello evidently does not know that the Chinese economy is in a highly unstable condition
Chinese banks are considered to be in a perilous position with non-performing loans estimated at about 50 per cent of GDP. Additionally, the central bank has been raising the reserve ration in an attempt to rein in credit expansion. M1 (basically currency and bank deposits) has been running red hot for some years now, frequently exceeding 17 per cent and 20 per cent annually calculated on a monthly basis, i.e., year-on-year for each month.
It’s this monetary expansion that has been driving the Chinese economy, not cheap inputs, particularly labour. It also raised fixed capital investment to nearly 50 per cent of GDP, an unsustainable rate that even her high domestic savings rate could not hope to support.
However, things are coming to a head. M1 year-on-year growth for March 2004 was 20 per cent – and that was normal! But since then M1 has been slowing. Last January it was 15.3 per cent, for February it was 10.6 per cent, falling to 9.9 per cent in March
I think Pete has bet on a losing horse. Once the credit crunch finally bites in China what does Costello think will happen to the demand for Australia’s minerals, not to mention all that lovely tax revenue?
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday16 May 2005