Following is a guest post from Saul Eslake on last week’s Budget. Also find below a considered set of charts that offer a very clear view of last week’s Budget revenue assumptions. If you want to understand the punt we’re taking on China, not to mention growth in capital gains, this document is a must read. Saul will also be available throughout the day to answer questions if would like to post them in comments…Enjoy.
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Interest rates will start rising again quite soon, the Reserve Bank indicated – about as clearly as central banks ever do signal their intentions – in its most recent quarterly Statement on Monetary Policy (issued on 6th May), despite the fact that, as Treasurer Wayne Swan said in his Budget Speech just four days later, ‘for some, talk of an investment boom seems divorced from reality’.
According to the Reserve Bank’s latest forecasts, ‘underlying’ inflation will rise from its present level of about 2¼% to 3% by the end of this year, and remain at that level for another 18 months, before accelerating further to 3¼% by the end of 2013, reflecting a gradual upward drift in labour cost inflation ‘as capacity utilization and the labour market tighten’, continued significant increases in utility prices and rents, and higher global prices for both commodities and manufactured goods (now that inflation is rising in China and other countries which have become major exporters of manufactured goods), the moderating influence on which of the recent appreciation of the Australian dollar is expected to fade.
These forecasts are also explicitly premised on what the Reserve Bank calls the ‘technical assumption’ that interest rates rise by one-quarter of a percentage point in early 2012 and again by a similar amount by mid 2013 (in line with what financial markets were pricing when those forecasts were assembled for the Bank’s May Board meeting).
But such an inflation outcome is not acceptable to the Reserve Bank, which is required by its agreement with the Government to keep inflation at ‘between 2 and 3% per annum, on average, over the course of the business cycle’.
Hence, when the Reserve Bank says, as it did in its Monetary Policy Statement, that it will ‘set policy to ensure a continuation of … low and stable inflation’, you can be pretty sure that it’s planning to increase interest rates by more, and almost certainly sooner, than that ‘technical assumption’. That’s about as close as the Reserve Bank ever gets to signalling that it is contemplating putting rates up again sooner than the financial markets have been
pricing.
The background to all of this is, of course, that Australia is experiencing the largest (by a wide margin) commodities boom in our post-European settlement history, driven by the rapid industrialization and urbanization of the two most populous nations on the planet, China and India, a process which both the Reserve Bank and the Treasury believe has at least 15 years (and in all likelihood longer) to run. And Australia’s previous experience of commodities booms – the gold rushes of the 1850s and 1860s, the Korean War wool boom of the early 1950s, the mining and subsequently rural commodities boom of the late 1960s and early 1970s, and the rather more fleeting energy price boom of the early 1980s – tells us unequivocally that one of the biggest risks
associated with such events is that they can generate substantial inflationary pressures. The last three of these episodes were each associated with bursts of double-digit inflation, followed (as such bursts inevitably are) by recessions.
To be sure, there have been some important changes in the Australian economy, and the way it is managed, since the last, brief, resources boom of the early 1980s. We have a floating exchange rate, which, by appreciating as it has done since the current resources boom began nearly a decade ago, has helped to dampen inflationary pressures and (by ‘squeezing’ the profit margins of many non-resources, trade-exposed sectors of the economy) helped to ‘make room’ for the resources sector to expand. Politicians aren’t able, as they were (and did) in the 1950s, 1960s and 1970s), to succumb to pressure from manufacturing and farming interests to keep the exchange rate artificially low (in ways that ultimately lead to even greater inflation, as they did in Australia in the early 1970s and as they are now doing in China).
We have a much more flexible labour market and decentralized wage-setting system, so that the large wage rises obtained by workers in the mining and engineering construction sectors (which can afford to pay them) aren’t semi-automatically passed on by arbitration tribunals to workers in other sectors of the economy (which can’t), as happened in the 1970s and again in the early 1980s.
Australian producers aren’t sheltered behind high tariff walls, and thus aren’t able freely to raise prices (or run off to Canberra to plead for even higher tariffs) in the face of rising costs, but instead face the discipline of competition from imports, and have more of an incentive to resist pressures for higher wages. And we have an independent central bank, which can’t be leaned on by the Government of the day to abstain from doing what needs to be done to keep inflationary pressures under control (as it was during previous commodities booms).
All of these structural changes will help to lessen the chance that the sorry history of previous commodities booms will be repeated in the current one. Nonetheless, the experience of what this year’s Budget Papers call ‘Mining Boom Mark I’ – the phase of the current boom which began around 2003-04 and was terminated by the global financial crisis – suggests that these changes aren’t enough, on their own, to guarantee that history won’t repeat itself. Inflation was showing signs of getting ‘out of control’ during the latter stages of ‘Mining Boom Mark I’. ‘Underlying inflation’, which had only been above the top end of the Reserve Bank’s 2-3% target range in three quarters since the early 1990s when the Bank first adopted an inflation target, broke out of the target range in the second half of 2007, peaked at 4.7% in the year ended the September quarter 2008, and (in annual terms) didn’t come back within the target range until the June quarter of 2010.
The main reason for this surge in inflation during the latter stages of ‘Mining Boom Mark I’ was that the Australian economy ‘over-heated’. Unemployment fell well below the 5% level conventionally regarded as representing ‘full employment’; and economic activity began bumping up against a wide range of other ‘capacity constraints’. And one of the reasons why this happened was that the Howard Government (in its last term), and the Rudd Government (in its first year in office) found themselves experiencing substantially larger flows of tax revenue than they had anticipated: but rather than using that to run bigger budget surpluses, they ‘gave it away’ in the form of repeated rounds of personal income tax cuts and increases in welfare payments, which those who received them in turn spent, putting further upward pressure on aggregate demand in an already over-fully employed economy. Those pressures were in some ways compounded by the surge in immigration that occurred at the same time.
The key economic policy challenge which this year’s Budget needed to address is that of ensuring that the same thing doesn’t happen again, as ‘Mining Boom Mark II’ moves into full swing. That’s why Wayne Swan is right to insist that the Budget should move decisively into surplus (although precisely which year a surplus is attained is of greater political than economic importance).
Unfortunately, this year’s Budget did very little to advance that objective. That’s not to say that it didn’t contain some very good initiatives. Among its 541 different ‘policy decisions’, there were many which (by themselves) make lasting improvements to the Government’s ‘bottom line’, or which sensibly target specific problems (such as those which boost investment in vocational education and training, which seek to induce greater participation in work among those who have been on unemployment benefits or disability support pensions for extended periods of time, and which provide more resources for mental health).
But from a macro-economic perspective, all of the myriad reductions in spending were outweighed by new spending in other areas, leaving $6.2 billion in net tax increases including (the temporary ‘flood levy’, changes to the motor vehicle fringe benefit tax rules, the abolition of the dependent spouse tax offset for younger spouses and other measures) to increase the surpluses otherwise in prospect by amounts equivalent to just 0.1 percentage point of GDP in 2012-13 and 2013-14. That’s less than the amount by which projections of the budget balance are typically in error, that far in advance. Indeed, if lower-than-assumed ‘terms of trade’ (the ratio of export to import prices) were to take 1 percentage point off nominal GDP growth in 2011-12, the $3.7 billion surplus forecast for 2012-13 would turn into a $2.6 billion deficit.
So the 2011-12 Budget did nothing that will persuade the Reserve Bank to delay whatever plans it now has to lift interest rates in coming months.
Nor did it do anything to reduce the risk that, assuming ‘Mining Boom Mark II’ lasts into the second half of the current decade, we won’t repeat the policy mistakes made during the last state of ‘Mining Boom Mark I’. The Government’s fiscal strategy says that the ‘disciplines’ by which it has bound itself since the global financial crisis – that any unexpected increases in revenues will be directed towards improving the ‘bottom line’, and that real growth in government spending will be restrained to less than 2% per annum – only apply until the budget surplus reaches 1 per cent of GDP.
On the medium-term projections contained in this year’s Budget, that will be in 2016-17. After then, presumably, the present Government (if it’s still in office after the two elections between now and then), or whoever else might be in government, will feel free to ‘splash the cash’ around in the same way that successive governments did between 2005 and 2008. The best way to prevent that happening is to establish some kind of ‘sovereign wealth fund’, governed by tight rules to prevent future governments from dipping into it for as long as Australia’s ‘terms of trade’ remain above their historical average. But for now, at least, that seems to be a ‘bridge too far’ for all but a tiny handful of Australia’s current crop of politicians.