It's the economy, stupid!

What is “good fiscal policy” in Australia?

The statement of Tony Abbott strengthens my impression that candidates (and Mr. Abbott above all) confuse the tools of fiscal policy with its objectives.

Tools vs. Objectives of fiscal policy

The objectives of fiscal policy are (i) to supply public goods that contribute to population’s welfare and economy’s long term growth and (ii) to help stabilise the cyclical fluctuations of the economy. The budget is a tool to achieve these objectives.

Therefore, fiscal policy should not be aimed at “balancing the budget”. Similarly, “a budget in the black” is not a good criterion to assess the success or failure of fiscal policy.

Of course, a budget persistently in deficit, leading to the accumulation of a large stock of debt, is harmful to the achievement of the objectives of fiscal policy. But this does not mean that the budget should always be in the black. Quite the contrary: the budget should be allowed to be in deficit when the economy is in a cyclical downturn. Furthermore, the budget should stay in deficit for all the time that is necessary to promote the recovery.

I have explained in a previous article why it is important to run fiscal policy counter-cyclically. In Australia, estimates indicate that the multiplier of government expenditure is positive and larger than one while the multiplier of taxes is negative. So, when the economy is in a downturn, an increase in expenditure and decrease in taxation will boost recovery. Conversely, in a boom, lower expenditure and higher taxes will prevent the economy from overheating.

Overall, the deficit realised in a downturn will be compensated by the surplus realised in an expansion, thus ensuring that the budget is balanced in the long-term and that debt does not accumulate to any significant extent.

So, when assessing fiscal policy, we should not be looking at whether the budget is in the black/red at some given point in time. Instead, we should be looking at the extent to which the fiscal policy instrument (i.e. the budget) moves counter-cyclically.

The cyclicality of fiscal policy in Australia

In order to provide some quantitative evidence for the assessment of fiscal policy in Australia, I have computed a measure of “counter-cyclicality” of fiscal policy for a group of seven countries. To compute this measure, I regressed the annual change in gross general government debt on the output gap. The output gap is defined here as the difference between potential output and actual output in percent of potential output. So, the output gap is positive when the economy is in a downturn.

The estimated coefficient of the output gap in this regression can be interpreted as a measure of counter-cyclicality: a positive coefficient indicates that fiscal policy is counter-cyclical and a negative coefficient indicates that fiscal policy is pro-cyclical.

The data for estimation are sourced from the IMF World Economic Outlook. Results are summarised in the Table below. For each of the seven countries, the Table reports the estimated measure of counter-cyclicality. For Australia, I have also reported two separate measures: one for the years of Labor governments (Hawke, Keating, Rudd I, Gillard, Rudd II) and the other for the Howard Government (the only Liberal government in the period covered by the data).

The relatively small number of observations available for estimation calls for some caution in the interpretation of results. However, even with this caveat in mind, it is clear that fiscal policy in Australia is markedly counter-cyclical. However, there is a clear difference between the Labor governments and the Liberal government of Howard. Under Howard, fiscal policy actually became pro-cyclical, which means that it contributed to destabilising the economy.

It should be noted that over the period of observation, Australia has achieved the highest rate of economic growth: 3.24% a year on average against 2.58% in the US, 2.25% in the UK, 2.11% in Japan, and less than 2% in the continental European countries.

Perhaps more importantly, from a fiscal policy-making point of view, Australia has experienced less cyclical volatility than all the other countries. I measure volatility by the standard deviation of the output gap. This is equal to 1.18 for Australia, 1.79 for France, and it is greater than 2 for all the other economies. In terms of volatility of the growth rate, Australia is second only to France (1.45 against 1.59).

Assessing Australian fiscal policy

The data indicate that the counter-cyclical stance of Australian fiscal policy has been conducive to the achievements of two key objectives: promoting long-term growth and stabilising the economy. While it might be difficult to establish the exact contribution of fiscal policy to long-term growth, the link between fiscal policy and cyclical stability is much more direct. If Australian people have benefited from a relatively stable economy in the past 25 years, it is thanks to the fact that fiscal policy has been run counter-cyclically, at least under the Labor governments.

The benefits of cyclical stabilisation should not be underestimated. A more stable economy encourages investments, which in turn strengthen the long-term growth potential of a country. Stability also allows for consumption smoothing, which raises individual’s welfare. Moreover, with a counter-cyclical fiscal policy, the government makes lower-income groups less vulnerable to the adverse consequences of recessions.

In light of all this, I think that Labor governments should be praised for their approach to fiscal policy-making in these last two decades. In particular, the increase in debt under the first Rudd government is a sign of competent policy-making: fiscal policy became strongly expansionary when the economy was hit by a strong negative shock and the country was at high risk of recession. Any different course of action, would have been a mistake.

It is also important to stress that the increase in debt did not make the debt to GDP ratio unsustainable. In fact, Australia is today one of the countries with the lowest debt-to-GDP ratio

In conclusion, I am not worried if a government increases debt in a time of recession. Actually, I would be worried if a government did not do that. In the same way, I am worried if a government plans its budgetary policy ten or so years ahead without any reference to or consideration for the cyclical fluctuations of the economy. It’s just not good fiscal policy-making.