It’s the structural deficit, stupid

“It’s cyclical, no wait…” AAP

In order to understand why the government has committed itself to a budget surplus, we must distinguish what is known as the structural budget balance from the cyclical budget balance.

We also need to review the behaviour of the terms of trade since the mid-1990s because it played an important role in guiding policy makers’ expectations of Australia’s growth prospects after the global financial crisis.

The cyclical balance reflects the influence of the business cycle on government revenue and expenditure for an unchanged structural balance in the current period. This is the balance that Treasurer Wayne Swan will mostly refer to on budget night next week.

The structural budget balance is an estimate of the budget balance excluding the cyclical factors.

While media attention is paid to the cyclical budget, it is the structural budget balance that signal changes in fiscal policy.

Few in the financial and political media fully understand this concept, and few academic economists are able to explain it coherently to a general audience.

All federal budgets have a built-in structure that increases the tax revenue intake during booms while simultaneously reducing government expenditure and transfers – and vice versa during a recession.

The federal budget balance therefore moves automatically with the business cycle towards a surplus during a boom and towards a deficit during a recession.

Estimates of the structural budget balance attempt to wash-out these cyclical factors to identify any discretionary changes that the government has made to existing spending and taxation settings.

The Treasury recently provided an excellent technical briefing on how this is done.

The importance of this concept is that it reveals how governments change the budget settings to achieve longer-term macroeconomic policy objectives.

For example, faced with the global financial crisis G20 governments all agreed to engage in a coordinated fiscal stimulus.

In other words, they all agreed to change the setting of the structural budget balances towards deficits and away from surpluses.

In Australia’s case, the Rudd government moved early and aggressively as part of this initiative with a cash splash and followed up with the “pink batts” and school building programmes.

The impact of these on the structural budget balance was to move it from a small structural surplus to a structural deficit in the region of 5% of gross domestic product in 2009-10.

Therefore, Swan should now aim to return the budget back to structural surplus as the negative effects of the global financial crisis on the Australian economy wear off.

But to fully understand the reason for this, we need to look at Australia’s terms of trade and its behaviour over the last decade.

The terms of trade is defined as an index of our export prices over our import prices. Everyone should now be aware that Australia’s export prices have been booming over this period.

What is perhaps not so clear is how the behaviour of the terms of trade interacts with the structural budget balance to complicate the governments’ macroeconomic policy task.

Not only have Australia’s export commodity prices and terms of trade been at historically high levels, they have also been on a spectacular rollercoaster ride as a result of the global financial crisis.

The RBA index of commodity prices rose from 40 in 2000 to a peak of 120 in 2008 before falling to 80 in 2009 only to rebound rapidly to an even higher peak above 130 in 2011.

When Australia’s commodity prices and terms of trade fell so sharply in 2009 this had a potentially significant negative effect on Australia’s income and the Rudd government sought to counter this negative effect with the fiscal stimulus package that produced the structural budget deficit.

At the time, most forecasters of commodity prices were also projecting that the terms of trade index would remain at about the 100 level (the 2008-09 average) out to 2012, so the fiscal settings seemed appropriate.

The commodity price index instead bounced back to 120 by 2010 and rose above 130 in 2011, dragging the terms of trade with it.

From the perspective of the structural budget balance a structural deficit of 5 per cent of GDP was then no longer compatible with the terms of trade index in excess of 100.

The terms of trade at current levels means a significant income gain to Australia, even if the distribution is uneven, that acts a strong stimulus to aggregate demand.

Mr Swan is moving the federal budget to structural surplus because the need for the structural deficit and fiscal stimulus no longer exists.

To leave the fiscal settings at their current levels would run the risk of ‘overheating’ the economy and rising inflation in Australia.

This raises two additional issues. First, it now appears that the Rudd government’s fiscal stimulus in 2008-09 was too large because it was based on a too conservative, if understandable, view of commodity prices.

Second, it raises the fundamental and more awkward question of why there was any need for a structural deficit in 2009.

A doubling in Australia’s terms of trade between the mid 1990s and 2008 should have seen a significant structural surplus in place prior to the global financial crisis.

The Rudd fiscal stimulus may then have reduced the structural surplus but not generated a structural deficit of the size that now exists.