Budgets, debt and deficit finance

The question I bring to Budget discussions is not, in the first instance, whether the particulars that make it up are sound, but whether the theory that underpinned the decisions to do what was done make any sense at all. 

Since I think of modern macroeconomic theory as a wrecking ball, incapable of providing sound guidance, I am interested in the outcomes in the global economy as a kind of radical experiment the likes of which the world has seldom seen before. 

The triumvirate of Barack Obama in the United States, Gordon Brown in the UK and Kevin Rudd in Australia are using the precise instruments that modern economic theory tells them they should use. 

They have followed almost to the letter the instructions found in the standard macroeconomics text, and if it turns out that what they have done is disastrous for the economies they will have been shown to have mismanaged, it must then be imperative that the responsibility is brought home to where it belongs. 

And where it will belong will be with the theories that they used to direct the economies into the dead ends into which they will have gone. 

For Obama, Brown and Rudd, I can see there has been no pain in choosing the big spending, high deficit options they have chosen. It’s no doubt lovely when the actions they are compelled to take by the prevailing theory happen to coincide with the very things they would like to do as political leaders. 

Who, if in charge of managing an economy, would not like being told that what they must now do is spend money wildly, quickly and on anything at all? That was, in effect, what they were told, and that is what each has now done. 

That the practice has matched the theory is what accounts for the generally subdued level of criticism. This is the story of the 2009 Budget. The debt appears immense, but in the telling it is merely transitory and will disappear when growth returns. 

The direction of much of the expenditure seems colossally wasteful, but the urgency is in saving as many jobs as possible so properly targeting these outlays could not wait. 

The growth forecasts two years out are very optimistic, but when recessions end the first year of recovery really is recovery of lost ground, and is therefore a reasonable expectation. 

So I, like Lemuel Gulliver before me on his excursion to Laputa, am now merely an observer, an interested observer to be sure with quite a large financial stake, but now merely here for the ride to see how it all unfolds. It is too late for anyone to do anything, so we will just have to see how it all works itself out. 

Moreover, macroeconomic theory really does say recessions are caused by a fall in aggregate demand, and that they are cured by deficits and public sector spending. 

I cannot quite see myself how this recession was in any way caused by a fall in demand, but there is no doubt that once the slide began, the downturn in one business after another was experienced as a fall in their level of sales. 

Who, therefore, can doubt that aggregate demand has fallen? Surely, therefore, at least according to the theory, an increase in aggregate demand is the proper response. 

The Essence of Modern Macro  

This is the very essence of modern macro. It treats aggregate demand as if it is a completely separate entity from aggregate supply when once it was understood that at the aggregate level they are both one and the same thing. 

And what is even worse – worse because it is so superficially inane and ought to be seen as indefensible at least amongst economists – modern macro treats public spending on anything at all as equivalent to the demand that occurs naturally as part of the exchange processes of the market. 

To unravel the problems embedded within existing macroeconomic theory, you really need to go back to the theory that modern macro replaced. The question really is, though, whether the majority of macroeconomists are even capable of thinking about the nature of the business cycle without immediately reverting to thoughts about aggregate demand. 

The unfortunate fact is that since 1936, demand failure has been at the heart of economic theory, and stimulating demand has been the stock response from both economists and policy makers alike. 

The peacetime scorecard on the use of demand stimulation has been pretty dismal, with the two major episodes – the New Deal in the United States and the attempted reflation in Japan during the 1990s – undeniable failures. 

The Japanese have called the 1990s their “Lost Decade” although I am not all that sure they have had a “found decade” even now. 

The New Deal was pronounced on by Henry Morgenthau, Roosevelt’s close friend and Treasury Secretary, when in testimony before Congress in 1938, he said: 

We have tried spending money. We are spending more money than we have ever spent before, and it does not work. . . . We have never made good on our promises. I say, after eight years of this administration, we have just as much unemployment as when we started . . . and an enormous debt to boot. 

Well, we too are spending more money that we have ever spent before. We, too, have an enormous debt that will continue to rise year by year before there is even the first effort made to bring it down. 

The question now is whether our government, the American government or the British government, whether any of them will end up making good on their promises of a rapid return to high growth and low unemployment. 

This is why a marker in the sand must be established now. There has been an absolutely undeniable use of Keynesian economic theory to bring this downturn to an end. If it does not work, it will not be because we have not seen Keynesian theory in action. 

We have seen the real thing and then some. If it fails to deliver the strong robust upturn as promised, if recovery is slow and minimal, if real wages stagnate and debt remains an enduring problem, then Keynesian economics should go the way of all crank theories. 

No one should be allowed to walk away from ownership of what may well be an unparalleled economic disaster if the policies that have been used to hasten recovery are eventually recognised as having prolonged the downturn and delayed the return to better times. 

And here I am not referring to the political consequences. They will take care of themselves. What I am referring to are the consequences for the teaching of macroeconomic theory and the future use of the Keynesian macroeconomic model. 

If our economies all end up in something like a lost decade, the entire theoretical apparatus that has led us down this path should be junked for being the misleading and useless nonsense that it will have proven itself to be. 

Some Reflections on the Budget

As for the budget itself, it strikes me that the entire Cabinet, Rudd aside, must be filled with remorse about how matters have developed. Many of them deserve better than finding themselves about to have their names linked to a modern Whitlam in the way that Cairns, Crean (père) and Connor have been to the original. 

Even the Prime Minister may be having second thoughts, but who can tell? He very clearly tries to distance the budget and its parameters from any kind of political process. 

He seems to be trying to ward off criticisms of the budget and the underlying forecasts it was based on by suggesting that its origins are from Treasury, the same group of people who brought us the Costello surplus budgets of the previous decade. He seems to be saying, if it all doesn’t work out, don’t blame me. 

On this, I might mention that the bravest budget I have seen was Peter Costello’s second. In his first, he did what he had always said he would do and cut spending. And you must remember that 1996 was economically a very poor year, employment growth having flat lined through yet another RBA attempt to control a non-existent inflation. It was part of the reason that the government changed hands. 

Conditions after the 1996 cuts to spending had still not taken off at the start of 1997. So, given Treasury’s over-reaction to the mild rise in unemployment we have so far experienced in this recession, I can well believe that the Treasurer would have been given no end of advice on the need for some kind of stimulus in 1997. 

For all that, Peter Costello in that 1997 budget, continued along the same lines as in 1996. More cuts to spending and further steps on the road to a balanced budget. 

Now memories are faulty, I grant. But in my own memory I, or at least ACCI whose budget commentaries I was then writing, was the only one that I can think of to support wholeheartedly what the Treasurer had done. 

It was the reverse of now. It was a policy of cutting public spending to take the economy out of recession. It was the absolute and total reverse of what any and all modern macro texts will tell you to do. 

And the record is there for anyone to see. Australia came out of its recession with five-plus percent growth and maintained strong rates of growth right through the Asian Financial Crisis which was in full swing the following year. Indeed, Australia continued along this sustained growth path right through until 2008. 

For me, this was the closest I could imagine to having a controlled experiment on Keynesian macro policies. Because at the same time that we were growing at four and five percent a year, the Japanese were using the reverse policy by raising public spending to end the recession they had been in since around 1990. 

That was the second half of my controlled experiment. One country cut public spending in a recession and the economy took off. Another country increased public spending during that same recession, and the bottom fell out of its economy. 

So here we are again, another experiment that can once more affect millions of lives and the future prosperity of our economies for years on end. We will soon know whether wasteful, useless deficit financed public spending on government chosen projects, where the returns will not repay their costs, can drive an economy into sustained rates of non-inflationary growth. 

And if it can’t, we will soon enough know that too.

Leave a Reply