{"id":22871,"date":"2013-03-04T18:28:01","date_gmt":"2013-03-04T08:28:01","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=22871"},"modified":"2013-03-04T18:28:01","modified_gmt":"2013-03-04T08:28:01","slug":"balancing-budget-over-the-cycle-is-not-a-sound-fiscal-rule","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=22871","title":{"rendered":"Balancing budget over the cycle is not a sound fiscal rule"},"content":{"rendered":"

\t\t\t\tThere were three data releases from the Australian Bureau of Statistics today and all showed that the Australian economy is continuing to weaken. The – Business Indicators, Australia<\/a> – showed that company gross operating profits fell for the fifth consecutive quarter (7 our of the last 10). Second, the data for – Building Approvals, Australia<\/a> – which is one indicator of the strength of the housing market and the construction industry, showed that the seasonally adjusted estimate for total dwelling approved fell by 2.4 per cent in January, the second consecutive monthly fall. Finally, the – Mineral and Petroleum Exploration, Australia<\/a> – showed that “mineral exploration expenditure decreased by 10.2% in the December quarter 2012”. What this data tells us is that private spending is weak and probably weakening. It tells us that fiscal policy should be expansionary rather than following its present course of austerity. It tells us that unless the government reverses its current strategy, the Australian economy will weaken further. It also tells us that commentators and politicians that think fiscal rules such as “balancing the budget over the cycle” are sound strategies to adopt are either operating in a cloud of ignorance or deliberately misleading the public as to the likely outcomes that would follow from pursuing such a rule.
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\nLast week, the ABS released their latest – Private New Capital Expenditure and Expected Expenditure, Australia<\/a> – for the December quarter, which will feed into the National Accounts for December that will be released this Wednesday. This data also confirmed that things are not as rosy as some would think.<\/p>\n

The fall in building approvals has confounded those who believe that monetary policy is an effective counter-stabilising policy tool. The Reserve Bank of Australia has now cut interest rates x times since 2011, as they try to defend the failing economy in the face of on-going fiscal austerity and declining private expenditure growth.<\/p>\n

On November 2, 2011 the RBA target rate was cut from 4.75 per cent to 4.5 per cent. Since then it has been cut 6 times to its present level of 3 per cent.<\/p>\n

The RBA cash rate is now at its lowest level since it was at 3 per cent during the worrying months of May 2009 to September 2009, when the economy was poised on the knife edge of contraction or expansion as the fiscal stimulus was working its way through to aggregate demand.<\/p>\n

The fact that the economy is not rebounding in the wake of all this monetary “easing” indicates that monetary policy is an ineffective aggregate policy tool for counter-stabilisation (influencing aggregate demand in a responsive way).<\/p>\n

In relation to the capital expenditure data release, Fairfax columnist Michael Pascoe wrote (March 1, 2013) – Capital goes on strike<\/a>. The article said that:<\/p>\n

\nI don’t know what happy drug the markets were on yesterday but it must have been powerful to get a positive reaction out of poor private fixed capital investment figures. For mine, the capex numbers do nothing to make a March interest rate cut less likely as capital is close to going on strike outside the resources sector.\n<\/p><\/blockquote>\n

Michael Pascoe emphasises that this dataset not only provides us with “backward-looking” data about capital expenditure, but also projects what firms plan to do in the period ahead, which is a valuable guide to where GDP growth is likely to be over the next 12 or so months.<\/p>\n

This conclusion points to the fact that, while mining investment remains strong but will weaken in the coming year as commodity prices fall of their latest peak, investment in the manufacturing sector is expected to fall “by 16 per cent next financial year after slicing it by 29 per cent this year”.<\/p>\n

Further, the “already weak construction sector” is “expecting to more than halve this year’s capex – down from $4.2 billion to just $1.9 billion”.<\/p>\n

The mining sector data shows that the “construction phase of the resources boom has made to our economic growth is tailing off”. So mining companies will still enjoy strong revenue growth as they sell the ore but the construction industry will contract as the demand for new infrastructure declines sharply.<\/p>\n

What this tells us about the coming year is that unless there is dramatic boost in housing construction (and the latest data is pointing away from that conclusion) then the economy is likely to slow even further.<\/p>\n

That is because private consumption is steady as households maintain their determination to keep the household saving ratio at around 10 per cent (which is a return to their old behaviour before the credit binge) and business investment will contract.<\/p>\n

Dragging all that moderation down even further is the obsession that the federal government has with fiscal austerity in its mad and irresponsible quest to balance the budget over the cycle. Any government that pursued that fiscal rule in the current climate would be further undermining growth and denying the private domestic sector the income support, which will be essential for it to reduce its massive debt burden (following the credit binge).<\/p>\n

The reason I am concentrating on all this data today was to stay calm after reading a column from the Sydney Morning Herald economics editor (Ross Gittins) (March 4, 2013) – Hockey would be no soft touch as treasurer<\/a> – which sought to extol the fiscal rectitude and wisdom of the Opposition Treasury spokesperson (one Joe Hockey), who will be the Federal Treasurer when the abysmal Labor Government is kicked out by the electorate at the upcoming Federal election in September.<\/p>\n

As an aside, our politicians do not seem to be very wired to the opinions of the voters. The Labor Party are heading to another electoral massacre – they were slaughtered in the state elections in Victoria, Queensland, and New South Wales, then the Northern Territory over the last few years – and they still don’t get it. Their leadership and policy framework is deeply flawed and they seem oblivious to that.<\/p>\n

Things have got so bad that the UN Monitor<\/a> – has been called in by the Australian Council of Social Services (ACOSS) and have (Source<\/a>):<\/p>\n

\n… expressed concerns to the federal government over welfare payment cuts to single parents. The UN’s special rapporteur on extreme poverty and human rights is reported to have written to the government following the decision to move about 84,000 parents to the unemployment Newstart allowance when their youngest child turns eight. More than 60,000 single parents now receive between $60 to $100 a week less under the change … The UN monitor is reported to have been waiting for a reply from the government for more than four months. Prime Minister Julia Gillard rejected the UN concerns\n<\/p><\/blockquote>\n

Such is our so-called “progressive” Labor government. The only problem is that with the conservative opposition, things will get worse. A rock and a hard place applies here as well as in all the advanced nations as a result of the dominance of neo-liberalism across the political spectrum. Until that dominance is ended the progressive cause is lost.<\/p>\n

Anyway back to to article about the probable future Treasurer. I am focusing on it because it highlights a basic problem that even the progressives have with macroeconomics. Ross Gittins is no conservative and steers towards the more social conscious side of the debate. But he consistently provides his readers with misleading information at the macroeconomic level.<\/p>\n

Given the importance of macroeconomic constraints on individual behaviour, many fundamental errors of reasoning are made if we ignore those constraints.<\/p>\n

Take this appraisal of the probable future Treasurer and those allegedly giving him advice:<\/p>\n

\nHockey is much underestimated. If you’ve been watching you’ve seen him progressively donning the onerous responsibilities of the treasurership, the greatest of which is making it all add up … As a former cabinet minister, Hockey knows it’s hard for governments to get away with such wishful thinking. If you’ve been listening carefully you’ll have noticed Hockey quietly taking an economic rationalist approach while others demonstrated their lack of economic nous. Those who doubt the strength of Tony Abbott’s economics team should note that Hockey would be backed by Senator Arthur Sinodinos, a former senior Treasury officer. I believe Sinodinos played a key part in formulating the “medium-term fiscal strategy” – “to maintain budget balance, on average, over the course of the economic cycle” – which the Libs developed when last in opposition.<\/p>\n

If so, Sinodinos deserves induction to the fiscal hall of fame. There have been few more important or wiser contributions to good macro-management of our economy.\n<\/p><\/blockquote>\n

“Few more important or wiser contributions to good macro-management of our economy” … which tells you Ross Gittins, either doesn’t know what the implications of that fiscal rule are or is choosing to mislead his readership.<\/p>\n

To explore what this means, we can invoke the sectoral balances framework, which summarises, in a succinct accounting relationship, the basic interactions between the broad sectoral flows in the economy. At the most aggregate, it captures the relationship between the government and non-government sectors. It is sometimes useful to decompose the non-government sector into the private domestic sector and the external sector.<\/p>\n

In turn, the private domestic sector is typically disaggregated in macroeconomics textbooks into the household and firm sub-sectors. From behavioural perspective, households consume and save (these are flows) while business firms produce and invest (also flows).<\/p>\n

A flow is measured the unit of time, whereas a stock is measured at a point in time. We don’t talk about the “stock” of water flowing from a tap. We express the flow in terms of so many litres per minute or whatever. This water flow can fill up a swimming pool and we would say that at the current time, the pool has X thousand litres of water in it.<\/p>\n

Using the three sector model (government, private domestic and external), we consider the spending flows derived from the National Accounting relationship between aggregate spending and income. So:<\/p>\n

(1)\t     GDP = C + I + G + (X – M)<\/p>\n

where GDP is total national output and income, C is final consumption spending, I is private investment spending, G is government spending, X is exports and M is imports (so X – M = net exports).<\/p>\n

The spending flows perspective (in Equation (1)) highlights the sources<\/strong> of aggregate expenditure or demand, which drives total output and national income determination.<\/p>\n

We can take another perspective of the national income accounts, by focusing on how the final GDP or income (Y) that is generated by the spending flows is used<\/strong> by households. GDP (national income) ultimately comes back to households who consume it (C), save it (S) or pay taxes with it to government (T), once all the distributions are made.<\/p>\n

So:<\/p>\n

(2)\t     GDP = C + S + T<\/p>\n

where S is total household saving and T is total taxation.<\/p>\n

This says that households pay taxation to the government, which then leaves them with disposable income (GDP – T). Households then choose to consume a proportion of their disposable income. The disposable income that remains after the flow of consumption spending is what macroeconomists call saving<\/strong>.<\/p>\n

So the basic national accounts that provide income and expenditure data can be conceptualised in (at least) two ways: (a) from the perspective of the sources<\/strong> of aggregate expenditure; and (b) from the perspective of the uses<\/strong> of the national income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances for the external sector, the government sector and the private domestic sector.<\/p>\n

Remember the national accounts is built on the fact (an accounting identity) that total expenditure equals total output equals total national income.<\/p>\n

We can bring the two perspectives (sources and uses) of GDP together (because they are both just “views” of total output or national income) to write:<\/p>\n

(3)\t     C + S + T = GDP = C + I + G + (X – M)<\/p>\n

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.<\/p>\n

(3a)      S + T = I + G + (X – M)<\/p>\n

We can convert this into the familiar sectoral balances accounting relations by re-arranging Equation (3a):<\/p>\n

(4)\t     (S – I) + (T – G) – (X – M) = 0<\/p>\n

or:<\/p>\n

(4a)      (S – I) = (X – M) – (T – G)<\/p>\n

The sectoral balances equation (4a) says that Total household savings (S) minus private investment (I) has to equal net exports (X – M) minus the budget surplus (T – G). The external surplus (X – M) represents the net saving of non-residents. So if (X – M) < 0, that is, in deficit, the local economy is using the net saving of foreigners.\n\nEquation (4a) tells us that for an external balance of zero (X - M) = 0, the private domestic surplus will be exactly equal to the budget deficit or another way of saying this (which follows more closely the way I have expressed the balances here) is that the private domestic deficit increases as the government surplus increases.\n\nAll these relationships (equations) hold as a matter of accounting and are not matters of opinion. As a result of all the balances being sensitive to national income movements (for example, saving, taxes and imports rises with national income), the economy ensures this accounting relationship is maintained through GDP movements. That is the three balances have to sum to zero.\n\nThe sectoral balances derived are:\n\n\n