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Cutting rates, then tightening fiscal policy? Trying to make sense of the quest for a surplus

Given the RBA’s decision to slash the cash rate by 50 basis points, it’s hard to justify Treasurer Wayne Swan’s pursuit of a budget surplus. AAP

The former Governor of the Reserve Bank, Bernie Fraser, hit the nail on the head the other night when he found it absurd that the Reserve Bank could be reducing interest rates one day, while a week later, fiscal policy is set to be tightened in an attempt to bring in a budget surplus.

And it is absurd! Part of the RBA’s justification for its rate cut on Tuesday was that since inflation showed no signs of getting out of the RBA target range, if there was a need to adjust interest rates in the interests of preventing a further softening of the Australian economy, they had the room to do it.

The RBA’s action therefore could unambiguously be read as a view by the RBA that there was a danger of further softening in the Australian economy.

One would have thought on this reasoning that the appropriate setting for fiscal policy was either mildly stimulatory or else standing still: namely, if the economy is sluggish, and the RBA has cut rates, you want a fiscal policy supportive of any stimulus that the rate cut might give to activity.

It is difficult then to see the justification for a budget strategy which, if it has any effect at all, is likely to soften activity (unless one subscribes to the bizarre view that has sometimes does the rounds in economic discussion, that fiscal expansion is contractionary). This is precisely the incoherent economic thinking Bernie Fraser was referring to in his comments about bringing the budget back to surplus.

If the attempt to bring in a surplus is accompanied down the track by further interest rate cuts, then it won’t be for the reasons the supporters of this strategy think.

Rather the tightening of fiscal policy may do this by weakening the economy and putting further pressure on the RBA to cut rates. But this would be a rate cut coming at the cost of a slowing economy and potential rising unemployment: somewhat of a hollow victory.

The Treasurer, in his various justifications for moving the budget back to surplus, has argued that a surplus would provide an economic safeguard in a fragile world economy. He has also argued that in an economy returning to its trend rate of growth, bringing in a surplus is appropriate.

Neither of these arguments are particularly convincing and are barely more than spin.

Regarding the surplus as a safeguard, the argument is presumably that if in the near term fiscal stimulus is again required, the bigger the surplus now, the less of a deficit which would be created by any required stimulus. That logic is correct so far as it goes. But even the fiscal stimulus used in 2008-9 did not put Australia anywhere near the danger zone of a runaway deficit or public debt.

It is clear that the deficits and debt generated in the GFC years were clearly within bounds that allowed them over time to be reduced as proportions of GDP, without the requirement of fiscal contraction sufficient to slow the economy.

Even that bastion of conventional economic thinking, the IMF, is apparently unconvinced by such an argument, having been reported (ABC News, Oct. 2011) as arguing late last year that the Australian government had the “fiscal space” to delay bringing the budget back to surplus.

As for the need to bring the budget back to surplus because the economic activity is returning to trend, economics provides no hard and fast rule here, unless one thinks that economics provides some justification for balancing the budget on average over the cycle.

But the latter is not much more than an article of faith for this writer, and one still looking for a coherent economic argument to justify it.

More importantly, the economic and particularly the social implications of a significant fiscal withdrawal from the economy, cannot and should not be made to serve the quest for a particular budget balance in circumstances where there is no foreseeable danger of unsustainable and burgeoning deficits or public debt.

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