There is now considerable apprehension in the community about the government debt that will arise from recent and forthcoming government spending. Australia is entering a potentially acute recession with export earnings, economic growth, tax revenues and private spending falling and unemployment rising. If the private sector reduces spending, increased government spending can help fill the gap, but government budgets deficit and debt will result. On the other hand, balancing the budget in an attempt to avoid this debt would require a drastic reduction in government spending, adding to the contractionary pressure and worsening the recession.
Therefore, it is unfortunate that the Opposition has seen fit to express disquiet about increases in government debt. It is true that, to their credit, the previous government did run surpluses and retire debt, but that was in the prosperous times when growth, export earnings and tax receipts were high.
The present global slump was generated largely by the failure of the US subprime mortgage loans market to perform profitably, by the successful unloading of this debt by the original lenders and by the inability of the private or official sectors to see all this coming. If treasuries and central banks around the world (or anywhere) had foreseen the crisis, their policy in the last year or so of raising interest rates to curb spending and inflation would not have been pursued so vigorously. As well, if the financial agencies that appraise debt (rating agencies) had foreseen this crash they would not have given subprime mortgages a triple A rating.
Thus lack of foresight led to the worldwide spread of private toxic debt and tighter monetary policy than with hindsight was prudent. The result has been a failure of trust, bringing an unwillingness to lend and spend, a loss of confidence in future economic conditions and so the prospect of a sustained fall in economic growth. Treasuries and central banks recognise that a cut in interest rates by itself is not enough. The private economy thrives on debt (credit cards, mortgages, bank loans, shares, bonds). Why shouldn't government also use debt financing, especially when the returns could be large?
There are three major issues to consider. The first is that debt should be judged against assets, income and the rate of return to the expenditure that produces it. Secondly, if in an attempt to balance the budget little or no extra spending is undertaken, the economy could languish in a very low state of activity involving plenty of government debt and for a longer time than otherwise. Finally, what constraints should governments place on their spending and debt? Government debt can create a wide variety of assets, both government and private.
Considerable financial assets were accumulated by the federal government from the budget surpluses in the long boom since the 1990-93 recession and from sales of such assets as Telstra shares. Some of this has been used to retire debt and some placed in funds for future use. When the good times return, the process of retiring debt can again be resumed. Further, it is critical to recognise that one of the important returns to extra government debt now will be the higher output, lower unemployment, less bankruptcies and less harm to the social fabric that will arise from the reduced recession that the debt creating new spending will produce. It is also relevant that the major asset of a government is its taxing capacity.
If in the next boom additional taxes are needed to retire debt, raising taxes would be a feasible, if unpopular, action.
Consider the choice between extra debt and attempts to balance the budget. Government deficits and debt are now inevitable, even without additional expenditure and especially if we want to minimise this recession. So if expenditure of consumers and firms is languishing, additional spending by governments and/or reduced taxation rates are now the major options to support the economy. Instead, if the Government decided to balance its budget at a time when taxes were falling because of the recession, it would have to drastically reduce its spending. This would further reduce demand, output and tax receipts leading to further falls in output and incomes and then further falls in tax receipts. These falls would be multiplied because of spending responses of those whose incomes are reduced in each round of private spending.
Much of government expenditure is in areas such as health, schools, defence, police, road maintenance and so forth where spending is hard to cut without significant effects on the public's wellbeing. Hence, an attempt to prevent a deficit could be most unwelcome and unlikely to succeed. Bringing an economy out of a recession more quickly may even otherwise occur. Further, the social fabric would emerge in a less damaged state, needing less remedial expenditure.
For instance, people unemployed for long periods lose credibility and skills in the workforce and are a continuing cost to the budget. An important example is the large rise in the long-term unemployment rate following the acute mid-1970s recession. Mitigation of this required many years of economic growth. Thus the real return to the debt will be the reduced unemployment, the higher levels of output, the fewer bankruptcies and the less social harm that the stimulus spending will produce. There must, of course, be limits to government spending.
A useful broad rule of thumb is the principle of balancing the budget over the cycle. Thus the surpluses of previous governments garnered in past and future good times must be matched against the deficits that are about to come.
Among many further constraints, the authorities must choose to stimulate a rate of recovery that will not lead to excessive rates of inflation when the economy improves. It is a delicate task of trial and adjustment to find the appropriate amounts to spend as the situation evolves. The present financial crisis looks rather like a comedy of errors, albeit a very serious one. If it is not to be repeated, both public and private surveillance of the activities of financial markets and banks needs to be greatly expanded and improved.
This should include a review of the incentive structure and motives of private credit rating agencies. They not only failed to spot the failure of the subprime debt, but instead gave it a triple A rating! How ludicrous if they were to withdraw that rating from the NSW Government.
Emeritus Professor John Pitchford is a visiting Fellow at the Australian National University's Centre for Applied Macroeconomic Analysis.
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