In search of economic solutions

It will be at least a year before we know if last Tuesday's 0.5 percentage point cut in interest rates and this Tuesday's promised budget surplus are the right policy prescriptions for the Australian economy.

How the two decisions will interact and how the fine details of the budget will play out are unknown. Firstly, there is this question: should we aim for a budget surplus at all? Then the timing of all the component decisions has to be considered. What, for example, will be the result of the clean energy payment to pensioners starting this month? What results arise from the July 1 starting date for the carbon tax and the compensating household tax cuts?

In truth, no one knows the answers to these questions. There are too many variables. We don't know how employees will react to a little more after-tax income, how companies will respond to the imposition of the carbon tax, or how consumers will handle increased power bills. On top of that, no one can say with certainty how the world economy will perform in the coming year.

Treasurer Wayne Swan and his advisers - like all those who have gone before them - operate in a murky world, relying on outdated statistics and unreliable economic models.

What we do know is that monetary policy - cutting interest rates - takes time to have an impact. Fiscal or budget policy - changing government payments and receipts - acts faster.

Tuesday's budget will be contractionary over the year. The government is promising a dramatic turnaround in spending and receipts, from the current financial year's deficit of about $40 billion to a small surplus for 2012-13.

But in the immediate future, fiscal policy may actually be stimulatory. To compensate for the carbon tax, pensioners will get a tax-free lump sum of $190 to $250 for a couple, either this month or in June. From July 1 all taxpayers with incomes of up to $80,000 will get a tax cut, with most receiving at least $300 a year.

Of course the carbon tax will also be imposed. But unless companies anticipate the tax and pass it on ahead of time, consumers will not feel its impact immediately.

Some consumers will also have the benefit of the interest-rate cuts. Home builders can now factor last Wednesday's cut into their equations as they apply for loans.

The latest interest-rate cut was not a minute too soon. For at least the last six months, the Reserve Bank misread the economy, over-estimating growth, and maintaining interest rates at too high a level. It failed to take sufficient account of the difficulties faced by manufacturing, tourism and import-competing service industries across the nation.

The high-value Australian dollar, which has set back these industries, is largely due to booming mining exports from Queensland and Western Australia.

But the RBA also contributed, through its stubborn insistence on retaining Australian interest rates that were relatively high internationally and attracted capital.

Inflation has not been a threat for some time, while the employment situation in many regions of the country is of concern. Tasmania is in recession, while Victoria is scraping along with last week's state budget optimistically estimating a growth rate for next financial year of 1.75 per cent.

The fine line that finance ministers must negotiate is well illustrated by what has happened in Britain. Figures released last month show that Britain is now back in recession. Responding to the aftermath of the global financial crisis, the government introduced austerity measures. There can be no question that some such measures were required. But now it seems they went too far. Unemployment stands at 8.3 per cent, compared with Australia's 5.2 per cent; and inflation is 3.5 per cent compared with 1.6 per cent here.

Britain applied the theory that cutting spending and raising taxes would boost the economy by reducing government borrowing. This theory was brought to us by the very same economists who gave us the global financial crisis. Before the crash they told us that as long as governments reduced their presence in the economy and deregulated, free markets would take care of everything. US president George W. Bush committed to the strategy and the United States incurred its worst crash since the Great Depression, bringing a large chunk of the rest of the world down with it.

Bush and his advisers forgot the lesson learnt by British economist John Maynard Keynes in the 1930s. Keynes observed that, left to their own devices, market economies do not find equilibrium at full employment and low inflation. Consequently he proposed policies of government intervention to keep the economy roughly on track. In good times governments should cream off a surplus, and in bad times they should have no fear of spending and running up a deficit.

While Keynesianism is now back in fashion, there are still economists in Australia unashamedly running the neo-classical Bush line.

But knowing the theory does not guarantee the right policy. As everyone points out, there's patchwork performance across the nation. Mining may have boomed, but in Queensland tourist regions such as Cairns are struggling.

There is no question that a mining super profits tax is an essential ingredient of the policy mix. It's a pity that the earlier attempt failed and the tax was watered down. The fear is that the Minerals Resources Rent Tax will not generate significant revenue because the companies subject to it will employ every possible strategy to minimise their tax. Consequently the policy will not contribute sufficiently to the rebalance of the economy.

The expected tiny surplus will be threatened by any such cut in revenue.

It is to be hoped that as the year goes on, if the figures suggest that unemployment in key areas is rising, the government will not be too proud to abandon its commitment to the surplus.

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