Flooded with nonsense

As the days go by we begin to realise the huge scale of the problem that the floods in Northern Australia are presenting our country. Whole communities are being forced to leave their homes and major disruptions to economic activity (in very important regions) are being experienced. The floods are being labelled the worst in Australian history (well the white European occupation of indigenous land history) although that depends on the area – certainly the worst since the early 1950s. The areas that are affected are major sugar, coal, iron-ore and food production regions. So real GDP growth will be reduced and this will exacerbate the already slowing economy. What should be the correct federal government response? Answer: to expand the budget deficit (via discretionary spending increases) to ensure that essential public infrastructure is replaced and private economies are able to function again. What is the current federal government contemplating? Answer: spending cuts. My assessment of this: they have no credibility as fiscal managers.

Here is one of many pictures taken from the floods in Northern Australia at present. This one is actually from the Gascoyne region in Western Australia. The other bad flood areas are in Northern Queensland – at present around Rockhampton and further south near St George – but as the waters flows south through the river system into NSW the flood areas will broaden considerably.

When I see photos like this one I draw several conclusions among them being that there has been a massive destruction of public and private infrastructure which will require billions of dollars of outlays over several years to repair and/or replace. Further, given these are major food production and mining (coal and more) areas and many crops are destroyed and mines closed due to flooding, real GDP will be lower in the coming several quarters.

The federal and state governments are obviously responsible for the replacement of the public infrastructure and ensuring that the private insurance companies do not rip their policy-holders off in the reconstruction.

Bloomberg reports that the state of Queensland “produces 95 percent of Australia’s sugar, is its largest coal exporter and accounts for about 20 percent of the A$1.3 trillion ($1.3 trillion) economy”.

Major mining companies have “declared force majeure” which means they are unable to meet their supply contracts. Bloomberg reports that since the floods began in early December they have “cut production of coal by about 4.5 million metric tons”

Even conservative estimates predict the loss of export revenue will be “quite substantial”.

Estimates of the impact on real GDP growth suggest that in the fourth-quarter 2010 and the first-quarter 2011 (at least), the floods will “cut growth as much as 0.5 percentage points”.

To put that in perspective, the third-quarter national accounts showed that the Australian economy was already slowing as the fiscal stimulus was being withdrawn and monetary policy was being tightened. Australia’s growth rate slowed to 0.2 per cent in the September quarter which was the weakest pace since a contraction at the end of 2008. Please read my blog – The Australian economy loses to the snail – for more discussion on this point.

Add to this the fact current broad ABS labour underutilisation rate is around 12.4 per cent – which is a horrific rate of wastage of our most vital resource – labour power. Please read my blog – Labour force data – most signs good – for more discussion on this point.

While exports have been relatively strong courtesy of the commodities boom being driven by the growth in China, the contribution of net exports to real GDP growth was negative last quarter (imports stronger than exports). I have no problems with imports growing faster than exports. It means that we enjoy the labour of other nations more and have to ship less to them in value terms for these benefits. As long as the “real terms of trade” are in our favour and the foreigners are willing to exchange real goods and services in our favour in return for bits of paper denominated in Australian dollars then why should we complain about that.

But from a growth accounting perspective it put a greater responsibility on private domestic spending and public spending to support stronger domestic growth rates. There has been a modest recovery in private spending over the last year but not enough to keep the economy growing anywhere near strong enough to put a significant dent into the labour underutilisation rate.

Come in … public spending. The problem is that the federal government is so neo-liberal despite their progressive worker-oriented pretensions that they are already pursuing a fiscal rule that aims to put the budget into surplus by 2012, limit real spending to 2 per cent growth per annum, and restrict tax revenue as a share of total GDP to 2007 levels.

Why? No reason, other than they have somehow bought – hook line and sinker – the mainstream economic gibberish about crowding out (higher interest rates); future tax burdens (to “pay back the debt”) and the primacy of private spending (which is no where near strong enough to support adequate growth rates at present).

There has also been some speculation that the central bank (the Reserve Bank of Australia) would have to tighten interest rates given that the floods will increase the Consumer Price Index via the food shortages. Food prices (fruit and vegetables) are already rising and once winter comes and the southern states stop supplying a lot of similar products, then prices will really shoot up.

How much? Not that much in terms of their overall impact on the CPI – about 0.2 per cent.

While the bank economists – totally entranced with inflation targetting – always cry out for rate rises when there is a sign of any economic growth, even they are starting to realise that the Australian economy is slowing and inflation has been falling in recent months notwithstanding the hiccup that the floods will cause for a little while.

Bloomberg did a survey of economists today about the desired policy response and representative of the responses was this one:

The RBA is likely to tread more carefully than it otherwise might have … It’s tough to hike when one of your states is suffering a natural disaster.

The economist who made those comments said he had now changed his forecast for a rate hike in February to at least May as a result of the crisis.

So, even in mainstream logic, which considers all aggregate demand management to be the domain of monetary policy, there is no inflation threat and the real problem is likely to be slow (or declining) growth.

Quite apart from their narrow conception of the capacity of the aggregate policy instruments what this tells us is that the “hawks” are even advising against any aggregate demand contraction being induced by policy changes.

Later in 2011 as the reconstruction phase begins there will be some growth support. We must remember that in the recent downturn one extraordinary aspect was the fact that the construction industry, which typically is badly impacted by a recession maintained growth. Why? The large public infrastructure spending that formed part of the second federal fiscal stimulus package. If the federal government had not intervened – that is, followed the advice of the conservatives and let the market sort it all out – then the economy would have followed the path of the US and UK economies.

But as the fiscal stimulus is being withdrawn, construction is a casualty as recent data releases show. The ABS also released the latest data for Building Approvals yesterday (January 5, 2010) which reinforces the sluggish nature of the Australian economy at present.

The summary of those results is:

• The seasonally adjusted estimate for total dwellings approved fell 4.2 per cent in November 2010.
• The seasonally adjusted estimate for private sector houses approved fell 1.7 per cent in November 2010.
• The seasonally adjusted estimate for private sector other dwellings approved fell 5.5 per cent in November 2010.
• The seasonally adjusted estimate for the value of new residential building fell 4.9 per cent and the value of residential alterations and additions fell 11.7 per cent in November 2010.

So not a picture of a booming building industry.

As a result the construction stimulus that any government-led recovery plan will provide should find some excess capacity willing to work.

The problem of-course is that in light of the data presented the recovery plan should definitely be a net addition to public spending. The reality is that it probably will not be.

Clearly, the floods will affect the budget and fiscal position of the relevant state governments and the federal government for reasons noted above.

In that regard, consider this response from our erstwhile leader – the Prime Minister of Australia, Julia Gillard who is a former alleged left-wing faction member and most recently Minister for Education (which implies something about knowledge generation or should).

She apparently interprets a national disaster as a reason to cut federal government spending. It beggars belief how the political and ideological stranglehold on what should otherwise be responsible economic management has become.

The Prime Minister gave a a press conference in Perth yesterday (January 6, 2011) and discussed the floods among other things – Transcript.

Here is some of that press conference:

JOURNALIST: Prime Minister, do you have any update on the impact of the Queensland floods on the federal budget and how much money?

PM: The Queensland floods, as we know, are very very widespread and there are many towns that are still battling rising flood waters as others have gone into recovery. This is going to require a lot of investment, it’s many many dollars that will need to flow from the Federal Government and the State Government. Money is already flowing, it’s flowing through emergency payments and it’s flowing in support of families as they come back to their homes and see the repair task, small businesses and primary producers …

JOURNALIST: Do you think there’ll be a need to put more money into flood affected areas?

PM: Inevitably money will need to flow, absolutely.

While I admired the PM’s knowledge that government spending is a flow not a stock, something that many economics students never understand properly, I thought the choice of expression was somewhat inopportune given the nature of the disaster (-:

The reality is that the provision of public infrastructure increases the potential growth path of the nation and is a intrinsic responsibility of the federal and state governments aiming to advance public purpose. There will also be a need to counter the negative growth impacts of the disaster and the reconstruction helps achieve that.

The stimulus associated with a disaster recovery strategy is also ephemeral so does not lock the government into spending programs that are politically difficult to withdraw from once the need for the fiscal support declines (when private growth returns).

So on all counts there is no question that a new stimulus package from the federal government in the face of the disaster is a very responsible and economically-productive response.

Back to the press conference (here is the section that relates to fiscal policy responses):

JOURNALIST: With economists saying the economic impact will be between $6 and $9 billion, is it going to affect the time when the budget returns to surplus?

PM: I’m determined the budget will be back in surplus in 2012/13 as promised. That does mean that we’re going to have to make some tough choices and we will to bring the budget back to surplus as well as meeting the needs of Queensland as they recover from this flood crisis, which is so widespread. We are going to be there in partnership with the State Government and local communities as they recover and what’s also been a tremendous thing to see is the generosity of Australians towards their fellow Australians who are doing it tough. Right around the country, you know, mums and dads have gone and put in 5, 10, 20, 50 dollars to help out Queenslanders and we’re now seeing, you know, our sporting codes like cricket responding, they’re going to have a special one day match at the Gabba to fundraise for the Queensland floods. So there’s a lot of community generosity as well as work from government.

When I read responses like this I just shudder with angst and despair.

As an aside, to readers from cricketing nations, I would conclude from the comprehensive drubbing that our cricket team has been given by the English touring team in the now concluded Ashes series that there isn’t much capacity in that sporting code to respond at all. I cannot imagine anyone being interested enough to go to see them play again so the “special one day match at the Gabba” is likely to be a total fizzer (-:

But lets think about her statement. It is clear that the “budget will be back in surplus in 2012/13 as promised” is seen as a context free statement by the PM. The Treasurer also talks like this.

That means they only see the budget as a stand-alone financial balance that can be targetted and delivered to suit the political will of the government.

When this “target” was set, the Australian economy had just escaped a technical recession courtesy (and unambiguously) of the relatively significant and very timely fiscal stimulus packages that were introduced in December 2008 and then again in February 2009. Economic growth was improving and the Government was under extreme political pressure from the conservative nutters (aka deficit terrorists) to announce when they would deliver a surplus.

The surplus was like a golden egg. In all of the public discussions, I have never heard one person who has their hand on the policy levers or would have if they were in office – recognise the contextual nature of the budget balance.

Even among the bank economists I never hear them reveal an understanding and recognition of the way the major sectoral balances – budget, external and private domestic – interact in an accounting sense – which, of-course, is just recording interdependent behaviour. Not once have I heard any one argue that the fiscal rules the government is blindly following without recourse to broader events in the economy is nonsensical.

Let me emphasise – any fiscal rule is nonsensical because the government really doesn’t have the capacity to guarantee performance in relation to it. In fact, in trying to deliver the undeliverable the government is liable to cause more damage (slow growth unduly) than if it just forgot about the budget balance altogether and realised that it is just an ex post record of non-government saving.

While the government can clearly set discretionary spending and revenue aggregates it cannot control the final budget outcome. That depends on non-government spending decisions. If the non-government sector reduces its rate of spending or if the supply-side of the economy contracts (for example, due to floods) and reduces income production (and hence private spending) then the budget balance will move towards or into deficits.

The floods will definitely push the federal budget into a wider deficit if only because the automatic stabilisers (lost tax revenue as activity slows or increased social transfers to ameliorate the income losses in the private communities) will ensure that is the case.

Even without the floods there is no legitimate case that can be made on economic grounds to cut the federal deficit. Growth is languishing and labour underutilisation remains unacceptably high. In fact, the federal government should be seeking to increase the deficit by expanding net spending at present to push the growth rate up to a level that will eat into the massive pool of idle labour.

With an economy that is facing slowdown in private activity there is never a case that can be made to pursue a fiscal rule that will, if successfully achieved, introduce anti-growth fiscal drag.

But that was then. Now we have a growth-sapping flood disaster. It is unacceptable for the Prime Minister to think it is responsible fiscal management to cut public spending elsewhere to make room for the flood relief funding when there is no danger of the Australian economy overheating.

The requirement that budget outcomes should be some arbitrary balance (surplus) not only restricts the fiscal powers that governments would ordinarily enjoy in fiat currency regimes, but also violates an understanding of the way fiscal outcomes are effectively endogenous. Any economist with even the simplest understanding of the way in which automatic stabilisers operate will see the lack of wisdom in the Prime Minister’s statement.

In Australia, the external sector is typically in deficit (draining growth). As a result of the credit binge, the private domestic sector (principally households) are holding record levels of debt and a very vulnerable to another economic slowdown. The Australian property market is overvalued at present and a correction will come in time which will cause further pain to the heavily indebted household sector.

In this context, a budget deficit is indicated if growth is to continue and the private sector is to have the scope to reduce their debt levels. There is no other option! So to be targetting surpluses in this environment with the need for a major deleveraging in the private sector is equivalent to vandalism.

But then a major disaster hits and brings that madness out in relief.

A sharp negative demand shock which causes an economic downturn will reduce tax receipts and increase benefits, automatically increasing the deficit. Reducing government expenditures in that situation to meet the rule will worsen (prolong) the downturn – that is, increase the output gap and deliberately (and unnecessarily) undermine income generation in the economy.

This dynamic will then see the fiscal ambitions of the government thwarted and the subsequent political fallout is likely to see renewed attempts on its behalf to cut spending even further.

The vicious circle of spending cuts implied is unsustainable and is the exemplar of irresponsible fiscal management.

In other words, fiscal policy becomes pro-cyclical under this sort of fiscal rule in the current circumstances (taken into account the context and the forces which drive the budget balance).

Another problem relates to the bias in the way fiscal adjustment is conceived. In particular, it is automatically assumed that discretionary actions to reduce the budget deficit will involve spending cuts rather than increasing taxes. I always have the impression that some politicians are not primarily concerned about the size of the budget deficit, but praise the sanctity of these fiscal rules as a welcome excuse to force their ideological predilection for small government.

In other words, the ideological bias against public activity, particularly in the social security sphere, is dressed up as prudential economic management to give the crude religious zeal an air of authority and respectability.

Of-course, many politicians who mouth the same fiscal rule mantras are just plain ignorance.

Please read this blog – Fiscal rules going mad … – for more discussion on this point.

The responsible fiscal response to the crisis is to ensure that fiscal policy fulfills its basic function before anything other – that is, to fill the aggregate spending gap. The only sustainable fiscal policy approach is to ensure that net government spending is sufficient to fund the net saving desires of the non-government sector. End of story.

Thus when there is a positive desire to net save by the non-government sector then the government sector has to be in deficit to ensure there is enough spending left in the system to underwrite production levels consistent with full employment.

For more on this see my blogs on – Fiscal sustainability 101 – Part 1 – Fiscal sustainability 101 – Part 2 – Fiscal sustainability 101 – Part 3

You hear constant references to the term “fiscal room” when you listen to deficit terrorists. The Prime Minister clearly thinks that to meet the needs of the disaster relief, “fiscal room” has to be created by spending cuts elsewhere.

Why? Because the fiscal rule is sacrosanct.

This way of thinking just reflects the straitjacket that the neo-liberal approach has the policy world in. The concept of fiscal room is an irrelevant construct unless we consider there are no spare real resources available. With more than a million workers idle at present (12.4 per cent at least of the total available labour force) and industry with spare capacity being available (for example, construction) there are stacks of real resources available for deployment.

Conclusion

The disaster relief should be seen as a means of expanding net public spending to ensure that economic growth gathers speed and we start using our available resources more fully.

And with our land having its “its third-wettest year on record during 2010” when are we going to have some serious discussion about climate change responses in this country? Answer: do not expect any leadership from the current federal government or its opposition. Both sides of politics are brain-dead on this issue.

Ironically, while the political debate is about the burden the future generations are alleged to bear because of the rise in public debt arising from the fiscal response to the recent financial crisis, the real burden we place on our children will arise from ignoring the signals to put in place viable responses to the climate change challenge, in addition, to the persistently high wastage of labour resources and the budget cutbacks in education and training.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – even harder than last week!

That is enough for today!