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Budget cuts are one big gamble

From the AFR today comes details of a forthcoming speech by Prime Minister Gillard on why we need budget cuts and lots of ‘em:

Prime Minister Julia Gillard will today aggressively link her budget surplus goal directly to lower interest rates, saying that the Reserve Bank of Australia has “plenty of room” to cut its 4.25 per cent cash rate.

…The government has been arguing for months that a surplus is an economic and political imperative.

But it has only recently started publicly linking a budget surplus outcome with lower rates, reflecting growing confidence among senior ministers that a changing economic assessment within the RBA makes a cut more likely in the near term.

Ministers believe a budget surplus would help boost waning consumer confidence by convincing people the economy is being well managed.

Oh dear. Where have heard this before? I think it started with David Ricardo and his highly questionable notion of Ricardian Equivalance, that when a government chooses to save, the people like to spend and vice versa. That is, aggregate demand stays unchanged.

There may be something in it in the good times – maybe. But when you’re entering or some way through a longer cycle of debt reckoning and deleveraging, it is highly questionable, as Japan and Europe have shown convincingly.


And the rub is this:

In her speech to the Chamber of Minerals and Energy of Western Australia and the WA Chamber of Commerce and Industry in Perth this morning, Ms Gillard will say: “A surplus means we will have a buffer in case the global economy gets worse, it means we can protect jobs, and we can give the Reserve Bank room to move on monetary policy if it chooses to, knowing that an interest rate reduction is good for families and business.

“A surplus is a fundamental economic imperative. It lies at the very heart of good economic management. I find myself in respectful disagreement with every commentator and economist who says otherwise, and in furious agreement with those who see the need,” she says.

“In the current economic environment, should the RBA consider it appropriate to change the cash rate, this could deliver widespread benefits for households and business – noting that a number of sectors of the economy most under strain are arguably more sensitive to interest rates.

There is no doubt that slashing 2.5 per cent of GDP worth of spending next year will free up economic resources – that is, deflate parts of the economy – so that other parts can potentially grow more strongly without sparking inflation. And the rates “sensitive” sectors are those that will be potentially in a position to “benefit”.

They do include households, who carry the nation’s huge mortgage burden, and the external sector that’s been getting hammered by the higher dollar, including manufacturing and services like tourism.

The question is, is this in the national interest? Here are some scenarios if rates fall 1 per cent as a result of budget cuts:

  • will households save the extra cash as they are doing now? If so, the government is bringing on a recession which is clearly bad
  • will households spend their extra income, providing some relief to the beleaguered retail sector? If so, growth will accelerate which is potentially good and you can expect a rally in retail stocks on this possibility. However, it would be much better to see the newly created economic space filled by expanding exporters 
  • will households spend the extra income and resume borrowing for housing, causing house prices to rise again? If so, the rate of deposit accumulation at the banks will fall and they will accumulate further wholesale debts in foreign markets. This would also fire up a short term cyclical stocks rally which would include the home builders. But it is very bad in the medium term and would very quickly result in either ratings agencies or the RBA stomping on the brakes
  • what degree of downwards pressure will a 1% fall in interest rates place upon the dollar? This is not an easy question to answer. Interest rate differentials are only one of the five drivers of dollar value.  My guess is that such a level of cuts would push the dollar into a new trading range somewhere below parity assuming global growth remained decent, but not much lower. Thus, we’d see a boost in currency exposed stocks and some boost to the export sector more generally.

In other words, the government’s planned budget cuts are a big gamble. The Australian economy is caught in a trap that has been fifteen years or so in the making. The teeth on one side of the trap is offshore borrowing and the teeth on the other is housing deflation.

That this needs to be left to chance is a reflection of the entrenched politico-housing complex. To insure against the potentially nasty outcomes one of two things needs to happen. There must either be fiscal reform to reduce the tax appeal of housing investment or the RBA and APRA need to use macroprudential and or jawboning to prevent the banks charging into the newly created economic space with easy term mortgages. They should be used to doing all of the hard work by now anyway.

Whatever the outcome, it seems clear that the desperation of the Labor government is about to break the tight compact of fiscal and monetary policy that has, since late 2009, enabled the Australian economy to follow a path of disleveraging.

That is the process that I describe in which we have aimed to lower the growth rate of our private debt burden while enabling major banks to rebuild their liabilities around more secure savings like deposits, without tipping into the outright deleveraging and deflation of other Western nations.

David Llewellyn-Smith is the editor of MacroBusiness and co-author of the Great Crash of 2008 with Ross Garnaut.