Statement 4: Fiscal policy in the current economic environment (Continued)
Medium‑term fiscal strategy: underlying principles and rationale
A key element of the Government's medium‑term fiscal strategy is to achieve budget surpluses, on average, over the medium term. This objective allows flexibility to respond to economic conditions in the short term, while maintaining fiscal sustainability over the medium term. Adhering to the surplus objective helps to ensure that net financial worth improves over the medium term, which is another element of the strategy. The strategy also commits to keeping taxation as a share of GDP below its 2007‑08 level, on average, so that the surplus objective is achieved through expenditure restraint rather than an increasing tax burden over time.
Flexibility to respond to economic conditions in the short term
The medium‑term objective of achieving budget surpluses on average allows flexibility to respond to cyclical fluctuations in economic conditions. Although monetary policy normally plays the primary role in macroeconomic stabilisation, fiscal policy has an important complementary role. There are three aspects to this role.
First, in normal circumstances, fiscal policy plays a counter‑cyclical role primarily through the automatic fiscal stabilisers — fluctuations in tax revenue and spending that result from temporary variations in output and employment. It is generally desirable to accommodate the automatic stabilisers, rather than seeking to offset their fiscal impacts, because:
- they respond automatically to dampen economic fluctuations, avoiding the lags associated with discretionary policy (both fiscal and monetary); and
- they should have minimal effect on the medium‑term fiscal position as they unwind automatically once the economy returns to full employment.
Second, in circumstances where the economy is hit by a large shock and monetary policy cannot respond with sufficient speed and force, a discretionary fiscal response may also be warranted. This was the case during the GFC, when a large fiscal stimulus was implemented to support the economy. Maintaining this capacity to respond requires a foundation of fiscal sustainability, including moderate government debt levels. Fiscal stimulus measures can deliver lasting benefits beyond the short‑term boost to the economy if significant long‑term unemployment — and the associated skill atrophy — can be avoided, and if the measures expand the economy's supply potential, as was the case with the infrastructure spending elements of the Government's stimulus measures during the GFC.
Third, in circumstances where substantial fiscal adjustment is needed to maintain sustainability — for instance, due to unanticipated long‑lived changes in the economy that adversely affect the budget — it is desirable that the speed of this adjustment and its composition is set to limit adverse impacts on macroeconomic stability. That is, the implications for economic and employment growth need to be considered when contemplating the pace of adjustment — adjustment that occurs too slowly can be as much a threat to medium‑term employment and growth as adjustment that occurs too rapidly.
In Australia's case, low levels of government debt provide the flexibility to return the budget to surplus on a timeframe that does not undermine economic growth or threaten jobs. Australia's flexible exchange rate also means that the Reserve Bank can set interest rates that are appropriate to conditions in the Australian economy. Combined with the relative strength of the Australian economy, this means that not only does Australia have a much smaller fiscal adjustment task than most other advanced economies following the GFC, but also that the impact of fiscal consolidation on economic growth (the so‑called 'fiscal multipliers') are likely to be smaller, reinforcing our enviable position internationally (see Box 1).
Box 1 : Fiscal consolidation and fiscal multipliers
The appropriate pace of fiscal consolidation in the period since the GFC has been a contentious issue internationally. This is particularly the case for countries with high government debt but also weak economic growth and high unemployment.
One point of contention has been around the size of fiscal multipliers. There is now considerable evidence that fiscal multipliers — which measure the impact on economic output of discretionary changes in fiscal policy — are likely to be considerably larger in Europe, Japan and the US than in Australia at present (Blanchard and Leigh 2013).
There are three reasons to expect multipliers to remain high in Europe, Japan and the US. First, after deep, prolonged recessions, their economies have considerable unused productive capacity. In these circumstances, fiscal tightening can normally be expected to have a large impact on economic activity by reducing demand further below the economy's productive potential, raising the prospect of so‑called hysteresis effects. Second, with nominal short‑term interest rates already close to zero and credit channels impaired, there is limited scope for monetary policy to offset the contractionary impacts of fiscal tightening. Third, with many economies simultaneously undertaking fiscal contraction, there is less scope for contractionary effects of fiscal policy to be offset by exchange rate depreciation leading to increased net exports.
So what is the appropriate course of action? The IMF advises in its April 2013 Fiscal Monitor that, while countries with limited access to financing have no choice but to front‑load fiscal adjustment, the most appropriate course of action for countries that retain the capacity to borrow is to undertake a path of gradual but sustained adjustment that aims at steady progress over the medium term toward a clearly‑defined fiscal objective. The Government's plan to return to surplus at a measured pace is consistent with this advice. Box 2 highlights the importance in this regard of articulating a clear and credible medium‑term objective for fiscal policy.
The IMF also acknowledges that even with modest up‑front adjustment it will be essential to ensure that other policies remain as supportive as possible in order to limit output and employment costs. In particular, monetary policy should remain accommodative for the foreseeable future, and structural policies to expand the supply side of the economy and promote growth should also be pursued. It is also desirable that the composition of fiscal adjustment be designed to mitigate adverse impacts on the most vulnerable, consistent with the Australian Government's approach.
Sustainability over the medium term
The medium‑term objective of budget surpluses on average also ensures that fiscal policy remains sustainable, preserving the fiscal space needed for flexibility. Indeed, the objective is tougher than the commonly‑used international benchmark for sustainability — that government debt is stabilised as a share of GDP at some level that can be serviced over time. Achieving surpluses on average means that the net debt position improves over time.
The Australian Government's low net debt means capacity to service debt is not an issue. At the expected peak of 11.4 per cent of GDP in 2014‑15, the annual net interest burden is only 0.5 of a percentage point of GDP. This is around one‑quarter of the G‑7 average, even though interest rates are higher in Australia than in the major advanced economies due to the relative strength of our economy.
Nonetheless, consistent with the medium‑term fiscal strategy, there are good reasons for Australia to aim higher than just stabilising the debt‑to‑GDP ratio. This is consistent with a broader concept of sustainability that encompasses not only the government's capacity to service its liabilities into the future, but also its ability to do so without adverse effects on economic performance and intergenerational equity in the face of an ageing population.
First, Australia's reliance on foreign capital is often seen as exposing us to a somewhat higher degree of external vulnerability, notwithstanding that we benefit from importing capital to finance productive investment in excess of domestic saving. This perceived vulnerability is mitigated by a number of factors; including a strong and well‑regulated financial system, low public debt, and the fact that our external borrowing is largely in our own currency. Indeed, recent years have seen a material improvement in the robustness of our external funding mix, characterised by an increasing proportion of direct equity investment and a substantial lengthening of the maturity profile of our external debt (see Box 5 in Budget Statement 2). Nevertheless, it is prudent for government to seek to offset at least part of the private sector saving‑investment gap by running surpluses over time, given that businesses and households are unlikely to factor their contributions to aggregate risk into their decisions.
Second, future generations will be better placed to deal with longer‑term budgetary pressures from population ageing and health costs if we leave them a stronger government balance sheet and sustainable fiscal settings. This is appropriate in terms of intergenerational equity because these pressures partly reflect the costs of future benefits that the current generation will receive. This argument should not be overstated, however, as future generations will also have the benefit of higher standards of living, in part a consequence of investments in technology and ideas made by current and past generations.
Third, Australia's terms of trade are expected to decline from current high levels over time. The budget may also be more exposed to volatility in commodity markets because an expanded resources sector now accounts for a larger proportion of the tax base. This also means that the budget is more exposed to developments in emerging market economies, whose rising demand for minerals and energy has been the key factor driving the rise in the terms of trade and the resources investment boom. While commodity prices remain high this reinforces the case for improving the government's balance sheet over time, both for precautionary reasons and as a way of spreading some of the benefits to future generations.
More generally, improving the government's balance sheet over time provides insurance against unforeseeable adverse shocks in a global environment that may be more volatile than that experienced in the period before the GFC. In addition to allowing automatic stabilisers to be accommodated in the event of adverse shocks, this will allow scope for discretionary stimulus if required.
Box 2: Fiscal frameworks in other advanced economies
The sharp rise in public debt levels across many advanced economies in the aftermath of the GFC has highlighted the importance of clear and credible medium‑term fiscal frameworks for retaining market confidence that public finances will remain on a sustainable footing. The existence of such a framework was one of Australia's key strengths during the GFC.
The design and application of medium‑term fiscal strategies varies across the advanced economies. The United Kingdom, New Zealand and Germany provide other examples of the use of medium‑term fiscal strategies, but not all countries have such frameworks. Furthermore, the application of some medium‑term strategies can lead to policies that are not well attuned to economic conditions.
The United Kingdom's fiscal strategy involves a forward‑looking target to achieve cyclically‑adjusted current balance by the end of a rolling, five‑year forecast period (the current balance is the budget balance excluding investment spending, but including depreciation). It also specifies that public sector net debt as a share of GDP should be falling by 2015‑16.
New Zealand's 2012 Fiscal Strategy Report sets a short‑term objective of returning the budget to surplus in 2014‑15, and a long‑term objective of bringing net government debt down to no higher than 20 per cent of GDP by 2020.
Germany has a so‑called 'debt brake' legislated in its constitution, which mandates that from 2016 onwards the federal government's cyclically‑adjusted budget deficit in any given year cannot exceed 0.35 per cent of GDP.1 The debt brake will apply from 2020 onwards for Germany's regional governments (Länder), who will be required to have structurally‑balanced budgets.
On the other hand, some other advanced economies have no articulated medium‑term fiscal strategy, in particular the United States and Japan. The IMF has expressed concern in recent years about the absence in both countries of medium‑term fiscal consolidation strategies.
1 It is worth noting that 'cyclically-adjusted' refers to the business cycle in the German economy, rather than in the whole euro area economy. This has implications for the overall stance of fiscal policy in the euro area when there are asymmetric shocks.
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