Surplus to Requirements - or Lost in Deflation

Australia's Treasurer Josh Frydenberg is a glass quarter full kinda guy. He has just proudly announced last year's Commonwealth Budget within a rounding error of being in surplus, the first such result since before the GFC. The fact that a week or so earlier he had to announce that economic growth was the lowest since the very same GFC and that unemployment was rising, productivity, wages and personal consumption were stagnating and private investment was somewhere in the basement, did not wipe the grin off his face. He was able to point to the even lower growth of other advanced western economies like Germany and Britain that, even before Brexit is consummated, have shrunk. The R-word is echoing through the OECD and IMF. Trump's bombastic boosterism is wearing thin as America slides back towards the cliff. But our Josh still finds liquid at the bottom of his glass. Not so, the Governor of the Reserves Bank of Australia, Phil Lowe, who politely and repeatedly urges the government to bring forward planned infrastructure spending to reboot a domestic economy underperforming at an Olympian standard. Why aren’t they listening?

Simple answer -- the surplus. Morison promised that the federal budget would be back in the black by this fiscal year. In fact, thanks to several fortuitous international factors and some surreptitious cooking of the books regarding underspending on the National Disability insurance Scheme (I'll have more to say about the problems associated with the NDIS in a future post), the surplus could have arrived ahead of time last year. But the figure would have been embarrassingly small, one or two billion dollars in a one and a half trillion-dollar economy. Far better optics, as the strategists and commentators say, to engineer a bigger headline-splashing figure to announce this time next year. Their hope (prayer) is for a double-digit surplus. They might well see this, though if so, it will again be due to factors beyond their control, since the government's policy is to do nothing itself and leave the heavy lifting to domestic and international forces, and our increasingly threadbare central bank. This is very much in line with orthodox, academic economic advice and the ideological predilections of the conservative elements dominating this government.

Why is reaching and maintaining a budget surplus important? Well, in the long term, future generations must pay off the public national debt through their taxes. Failure to do so creates a situation where more and more government revenue is garnisheed to make debt repayment, curtailing the ability of government to meet all its other important economic and social responsibilities to its citizens. But this matters far less in the short to medium term. As Keynes famously quipped -- in the long run, we're all dead. Australia's current national public debt exceeds half a trillion dollars. Ten years of modest surpluses on the back of anaemic economic growth will make little impact, and even less if the small forecast surpluses don't eventuate. What will, is a fully employed economy over the long period. And that is going to require government investment up front to compensate for under spending by consumers and investors fearful of what lies in store in the next few years.

Frydenberg and his advisers are wedded to an orthodoxy that believes that monetary policy -- notably lowering interest rates -- will eventually bring about increasing private investment. For those who are interested in such things, this view is based on the venerable 'loanable funds' theory that posits interest rates as the key variable that equates savings and investment at full employment, the latter determined by 'real factors like technology and the preferences of consumers and investors. This is the theoretical fiction of the fabled long run, based on the assumption that nothing else changes during the transition to equilibrium, but is a hopelessly unreal picture of what happens in the here and now, which promises to ever push the long run further over the horizon. As Keynes also demonstrated, when central banks act to push interest rates down, they send a signal that the economy is doing poorly. Investors take heed and head for calm waters. Fear overtakes greed. Far better to hold onto your liquid resources in money (bank deposits) or easily resold bonds. In addition, as interest rates fall, the cost of staying liquid falls; you have to give up less in interest or dividends to have your money at the ready, to cover contingencies caused by, for example, losing your job or overtime. As rates continue to fall toward zero, expectations begin to percolate that they can't go lower and will eventually rise. This reinforces the policy of hanging onto your money to speculate on better investment opportunities in the near future. The result is that investors don't invest; they save instead of borrowing at the low current rates to invest in productivity enhancing ventures. Money circulates through bond and securities (and housing) markets looking for a mixture of safety with respect to preserving the capital value of wealth and liquidity to tide over bad times and be ready for new opportunities if and when they appear.

This means that the power of central banks to stimulate a flagging economy diminishes, as its primary weapon, manipulating the structure of interest rates through the economy, loses its potency. This has led to the appearance of novel new policies that would have once seemed inconceivable. 'Quantitative easing' (also called colloquially, printing money) refers to the actions of central banks in buying up existing government bonds and other securities to increase liquidity in the banking system with the hope that banks will on-lend to borrowers to invest. But the problem remains, who will borrow if the investment outlook is so bleak? The answer can only be, government. But that means running the budget into deficit until the economy picks up. This is precisely what the Morrison-Frydenberg government is pledged not to do.

Quantitative easing is suspect because no one is sure if it works, in part because it signals to everyone that it's panic stations. This is even more obvious when another unthinkable development in monetary policy occurs -- negative interest rates. It was once thought obvious that nominal interest rates had a fixed lower bound, zero! Real rates could and have often been negative when inflation rises above nominal rates. But surely, nominal rates couldn't fall into the red. That would mean lenders paying borrowers to take their money! Well, its happened in countries like Germany, Denmark, Switzerland and Norway. Some credit-worthy borrowers are even securing mortgage loans with a negative interest rate. Can you imagine? The bank progressively writes down the principal on the loan used to buy your house! In Australia this would unleash the mother of all property booms, useful for state government coffers but of limited contribution to the federal budget situation once the initial impact of a local building boom played itself out .The European Central bank is now charging banks half a percentage point for the privilege of leaving their money overnight in the hope of forcing them to lend and not simply sit on their deposits or endlessly buy government bonds. It's not working. Banks like other businesses and households are getting their houses in order, so as to withstand the financial storms to come. For business and households, this means paying down debt not taking more on.

Hence, the pleas of Governor Lowe for government to take off the fiscal restraints. The most effective initial thrust would be to substantially increase the Newstart allowance, since the unemployed 'living' below the poverty line would immediately spend the increase, like a drowning sailor clutching a lifeline. The government response, however, is to berate business leaders for paying profits back to shareholders instead of expanding their operations. Australia's business leaders are pussies, they lack entrepreneurial zeal. They, like the Opposition, are talking down the economy. It's all your fault. Here we are providing the ideal investment climate -- lower taxes, deregulation, tough on unions -- and you are not pulling your weight. Yes, we haven't managed to get an energy policy that sticks. And there are 'stiff headwinds' in the international economy -- a euphemism in the age of Trump, Brexit, trade wars and real wars -- but the underlying foundations are strong. (As an aside, whenever you hear a politician use a metaphor from the building industry, reach for your gun; either that, or remember the current problems in the local building industry over cladding and collapsing foundations.)

It is this context within which sensible economic actors and commentators are advising governments to step in and boost aggregate demand in the Australian economy. Even Laurence Summers, Bill Clinton's economic guru, has experienced his Damascene conversion. Once a loud and proud proponent of the use of monetary policy to get us out of the 'great stagnation' he named, he now concedes that Keynes was right. It is not price and wage rigidities hampering recovery but chronically inadequate aggregate demand. Relying on monetary policy in the current deflationary loop generated by a global liquidity trap is like pushing on a piece of string. Manipulating interest rates works reasonably well to control inflation --albeit at the excessive cost of ramping up unemployment, bankruptcies and general pain --  but not deflation. In the latter case it just makes matters worse, unless married to active fiscal stimulation. Why, then, is the Reserve Bank joining the crowd and lowering rates? Because if it didn't when other countries did, the Aussie dollar would rise, squeezing off the one current source of buoyant aggregate demand, our exports. Of course, if China goes into recession that will happen anyway. And still the Australian government refuses to borrow at the very low, even negative rates to steady the economy's listing keel.

Whether Australia will ever see a continued run of surpluses, significant enough to make a dent in the national debt is impossible to say; the answer lies beyond the veil of a very uncertain future. We did have one such golden run in the lead up to the GFC. In retrospect, this was driven by a once-in-a-century mining boom and a paper boom built on financial innovations that proved toxic. The government revenue bonanza was wasted, given away in the form of legislated tax cuts that have proved politically impossible to reverse, as the Labor Party found out at the last federal election. Unlike the situation in a number of other countries, this national windfall was not sequestered in a sovereign wealth fund (in addition to the future fund with its narrow mission) that could be drawn upon to develop the nation's infrastructure and skills and provide a bulwark against future recessions. That boat has sailed. Now, if and when economic disaster strikes, when recession hits, and it will, the government will be forced to go deeply to the deficit well to prevent a massive depression. They will do this from a very much weakened position than last time. Frydenberg's glass is leaking.