An inconvenient obsession

There was a glimmer of hope earlier today that, boxed repeatedly around the head by evidence that the economy isn’t really travelling so well and that slashing Government spending was only compounding the problem, Joe Hockey had a conversion of sorts.
The Treasurer talked in almost Keynesian terms of the need for the Budget to act as a “shock absorber” for the economy.
Was the political obsession with returning the Budget to surplus as soon as a possible and bugger the consequences for the rest of the economy to be consigned to the rubbish heap of history?
Unfortunately, it appears not.
Whatever Joe Hockey’s rhetoric, in its latest update on the economy, the Government remains obsessed about public spending, devoting a major slab of the Mid Year Economic and Fiscal Outlook (MYEFO) to its “Smaller Government” reforms, including cutting the size of the public service to levels last seen in 2007-08, holding down public sector wage growth to 1.5 per cent a year and axing 175 Government bodies.
None of these bode well for support for economic activity.
The fact is, in earlier times, governments could fiddle with the Budget and not worry too much about the effects on the economy.
But, as Reserve Bank of Australia officials pointed out in a research paper earlier this year, governments need to be a lot more careful now:
“The changes to the taxation system overall are likely to have increased the sensitivity of revenues to fluctuations in the terms of trade and economic activity in the current episode.[8] The larger size of government means that the operation of automatic stabilisers has a more significant effect on overall economic activity” – Australia after the Terms of Trade Boom, RMA Bulletin, March 2014.
There is no doubt that the Budget is looking pretty ugly.
Tax receipt estimates have been slashed by $31.6 billion since May, contributing to a $43.7 billion deterioration in the Budget position.
As a result, the deficit this year (2014-15) is expected to reach $40.4 billion (as opposed to $29.8 billion in May), and the books will stay in the red right through the forward estimates – a deficit of $11.5 billion is projected in 2017-18.
There is no return to surplus projected until very late this decade, at the earliest.
This outlook is hardly surprising given what we have been through, not least a global crisis that has left the international financial system badly shaken.
Overlaid on this has been the unsettling surge and ebb of the resources sector.
Booms, whatever their source, rarely end smoothly, and the economy was always likely to hit some rocky times as mining-related investment faded and other sectors were slow to pick up.
One of the features of this period – a rapid decline in the terms of trade – was hardly unanticipated. All along, it was expected that the massive worldwide investment in mining capacity, encouraged by soaring commodity prices, would drive a huge increase in supply that would drive prices down – and this is what has happened.
In the lead-up to releasing today’s Mid Year Economic and Fiscal Outlook, the Government has been enthusiastically briefing the media on what has been described as a “collapse” in the terms of trade (principally as a result of plunging iron ore prices) and what this has meant to Commonwealth revenues.
It has been keen to highlight a 50 per cent plunge in global iron ore prices since the start of the year, including 30 per cent since the May Budget.
“The extent of the fall in the price was widely unexpected,” the Government said in MYEFO – Treasury had estimated a drop from $US120 a tonne to $US92 a tonne by mid-2016, whereas it is currently at $US63 a tonne.
The result of these and other moves, the Government says in MYEFO, “would be the largest fall in the terms of trade in a financial year since the Australian Bureau of Statistic’s Annual National Accounts started in 1959-60”.
But, as one of this column’s correspondents, Property Insights principal Rob Ellis points out, claims of a record fall in the terms of trade are overblown.
True, the terms of trade have fallen sharply (the index has fallen below 160 points surging above 180 around the start of the decade), but they are still very high in historical terms (see chart).
Nonetheless, the Government has trimmed its real non-farm GDP growth forecasts. The economy is now expected to expand by 2.5 per cent this financial year (a 0.25 percentage point reduction from the May forecast) but still grow by 3 per cent in 2015-16.
And it expects household consumption to grow at a similar rate – a questionable assumption when many workers are seeing their pay go backwards in real terms, and rising unemployment and slowing house price growth are only making households even more careful about their spending.
Dumping even more off the public payroll and squeezing the incomes of those left on it is only going to make the task of achieving these growth forecast more difficult.