A fetish of recent decades, budget surpluses lead to private sector debt and are unsustainable in the long term. The current obsession could lead us to recession.
On Facebook, Malcolm Turnbull’s announcement of Treasury’s mid-year economic and fiscal outlook began with this flawed statement:
The Turnbull Government understands that like a household budget, when you are trying to pay off debt, you can’t spend more than you save.
Let’s be generous and assume that Turnbull meant “you can’t spend more than you earn” as the literal meaning of his sentence is obviously ridiculous. A quick look at the period directly after the second world war, when Australia’s public debt was at its highest, makes a mockery of Turnbull’s excuse for budget austerity.
As shown in the chart above, governments during the second world war ran massive deficits to fund the war effort and built up government debts totalling over 120% of GDP. The post war period saw that level of public debt steadily decline to about 10% by the end of the 1960s.
How was that mountain of debt paid off? It wasn’t. If it had been paid off Australia would have been an economic basket case during the 1950s and 60s. Menzies was prime minister for most of those years and his governments ran modest fiscal deficits every year.
To make sense of a shrinking debt burden during a time when government is spending more than it is taxing we need to understand that, despite what Scott Morrison and Malcolm Turnbull say, government finances bear absolutely no resemblance to household or business finances.
Government spending is such a significant part of the economy that it can determine national economic outcomes. By deficit spending in the 50s and 60s, the Menzies government stimulated economic growth and built up non-government financial assets. This growth increased government tax receipts and reduced the size of the debt burden without paying off the debt.
Add inflation to the equation, which reduces the real value of the debt, and you can understand how the debt-to-GDP ratio can fall so dramatically while the government continues to run deficits.
This clearly makes a mockery of Morrison and Turnbull’s stated reasons for cutting government expenditure. Recurring modest government deficits are sustainable in the long term. Government surpluses, by contrast, are not sustainable in the long term.
To demonstrate this, there is one basic accounting concept that needs to be explained. Somebody’s surplus is always somebody else’s deficit. This includes the federal government.
For a moment, imagine that Australia is the only country in the world. Imagine that the non-government sector in Australia has $100 in net financial wealth. That year, the federal government spends $45 on goods and services and taxes $50. That’s a federal budget surplus of $5. At the end of this period the non-government sector in Australia has $95 (the government spent $45 into the private economy and took $50 out in taxes). This is a non-government deficit precisely equal to the government surplus of $5. This is a simple accounting identity; it must be true. There is nowhere else for that government surplus to come from.
Adding the foreign sector and trade back in doesn’t change this picture, it just complicates it a bit. Imagine the government continues with the same budget the following year. The non-government sector now has $90 – and the year after $85. I presume you’re starting to see the problem if this continues.
So, the first key thing to understand is that a federal government surplus must be accompanied by a non-government deficit.
Let’s look at Scott Morrison’s fiscal strategy spelled out in Myefo:
The government’s medium-term fiscal strategy is to achieve budget surpluses, on average, over the course of the economic cycle.
What Scott Morrison is really telling you is:
“The government’s medium-term fiscal strategy is to achieve non-government deficits, on average, over the course of the economic cycle.
In the absence of persistent trade surpluses (we mostly run deficits), the only possible outcome of this is increased private sector debt (that’s Australian businesses and households) and, if sustained, eventual private sector bankruptcy.
Private sector debt in Australia is currently about 210% of GDP, compared to government debt of about 30%. What Scott Morrison needs to explain to the Australian people is why he’s so keen to increase the private debt they hold over their homes and businesses when it’s already so high.
With a background of massive government debt incurred during the second world war, the 1950s and 60s are often referred to as the “golden years”, when unemployment was around 2%, economic growth was high, wages grew strongly and inequality was falling. This was not despite persistent government deficits but partly because of them.
Recent decades have seen the quest for budget surpluses become a kind of fetish. It’s important to understand that this is relatively new and that it has no sound basis in monetary economics.
If Scott Morrison and Malcolm Turnbull get their way and run budget surpluses over the business cycle they will cause a recession – simple accounting tells us that, short of some sort of export miracle, there is no other possible outcome.
Warwick Smith is a research economist at progressive think tank Per Capita.