Why the Federal Budget is a textbook policy dilemma

A standard principle in economic policy-making is that if you have only one tool, then you cannot achieve two distinct objectives.

The problem for prime minister Tony Abbott is, in fact, even worse: he has one tool to pursue two objectives that are not just distinct, but even conflicting.

The tool is fiscal policy or, more precisely, the combination of expenditure and taxes which generates a certain fiscal balance. Fiscal policy can be either expansionary (that is, more expenditure and/or less taxes) or restrictionary (less expenditure and/or more taxes).

The objectives are (a) ensuring that fiscal position and debt are sustainable (debt stabilisation) and (ii) stabilising the cyclical fluctuations of production and unemployment (output stabilization).

These two things require opposite policies. Debt stabilisation requires a restrictionary fiscal policy. Output stabilisation - given Australia’s current economic outlook - requires an expansionary fiscal policy.

Bad news from Washington

The Australian economy is going through a contraction. This has been known for a while.

However, the news here is that this contraction seems to be deeper and longer than expected. This is suggested by the output gap data reported in the World Economic Outlook (WEO) of the International Monetary Fund.

The output gap is the difference between actual GDP and its trend level, expressed in a percentage of the trend. A negative output gap indicates that the economy is below potential; that is, in a contraction.

In the October 2014 issue of the WEO, the output gap in Australia in 2014 was estimated to be -0.095%. This figure has been revised to -1.4% in the April 2015 issue and projections indicate that the output gap will remain negative in 2015-16.

Australia Bureau of Statistics (ABS) data also show that throughout 2014, Gross Domestic Income (GDI) has grown much less than GDP.

While both GDI and GDP measure output, GDI is statistically more reliable in the short term. Its slow growth is therefore a further indication that the Australian economy is probably weaker than we thought.

At the same time, the WEO data suggests that the government’s fiscal position might also be worse than expected six months ago (see table below for a comparison).

More specifically, the primary balance is now projected to remain negative until 2018, with gross debt increasing above 40% in 2016 and declining no earlier than 2019.

The multiplier effect

Output contraction calls for expansionary fiscal policy measures.

Some might argue that more expenditure (and/or lower taxes) does not increase output and hence does not help the economy recover from a contraction.

But consider the figure below. It shows the percentage change in Australian GDP over 20 quarters for a 1% increase in government consumption in quarter 0.

On impact, GDP increases by 0.16%. The response remains positive in the first year. Afterwards, it becomes statistically not different from zero, but it never turns negative.

The cumulative effect is that output increases by $1.20 for every extra dollar spent on government consumption.

Hence, in Australia, government consumption has a positive multiplier effect. This multiplier effect is the reason why the Australian government should pursue expansionary fiscal policies when facing an economic contraction.

Of course, an increase in expenditure is not exactly what would help the government redress its fiscal deficit. Hence, Abbott and treasurer Joe Hockey have a fiscal policy problem: to expand or to restrict?

If Hockey opts for a fiscal expansion, he will facilitate the recovery, thus putting an end to a period of growing unemployment and uncertainty; but he will have to accept more deficit and debt.

If he chooses a fiscal restriction, he will stop debt from increasing, but will also make the contraction worse. Yes, because the multiplier effect also works in reverse: for every dollar of expenditure cut, Australian GDP decreases by $1.20.

Admittedly, the choice is not easy. Or is it?

A matter of priorities

A 40% debt to GDP ratio is not really a problem. It is low by any international standards and well below the threshold above which it might reduce economic growth.

A contraction instead is a problem because it directly affects the welfare of individuals, especially those at the bottom end of income distribution.

A contraction also causes uncertainty, which in turn reduces business confidence and investment, with negative effects on the economy’s long-term growth potential.

Shouldn’t then output stabilisation (that is, facilitating the recovery) have priority over debt stabilisation?

This does not mean that debt should be allowed to grow unchecked. If the government pursues an expansionary fiscal policy in time of contraction, then in time of economic recovery it will have to tighten fiscal policy.

In this way, the deficit generated during the contraction is offset by the surplus realised during the recovery. The result is that the fiscal policy position will be stabilised over the medium term and debt will not accumulate.

The 2015/16 budget provides the government with the opportunity to start implementing this pattern of “counter-cyclical” fiscal policy. But so far there has been little sign the government sees it this way.

Fabrizio Carmignani receives funding from the Australian Research Council for a project on the estimation of the continuous piecewise linear model and its macroeconomic applications.