The past three recessions have seen a peak to trough deterioration in the Budget position of between 3.5 per cent and 5.5 per cent of GDP. If this normal cyclical pattern is observed in the current downturn, the Budget could be expected to deteriorate from a peak surplus of around 1.7 per cent of GDP in 2007-08 to a deficit of around 2.5 per cent to 3 per cent of GDP within a few years. This implies that the Government will be running deficits of around $30 billion or more beyond 2009-10.
This process is already well advanced. On the Government’s latest estimates from the Mid-Year Economic and Fiscal Outlook (MYEFO) released last November, the expected Budget surplus for the current year (2008-09) has shrunk from an originally estimated $22 billion to $6 billion, largely the result of the $10.4 billion fiscal package but also due to weaker economic growth forecasts underpinning the calculations.
Just 10 weeks later, these economic projections look too optimistic. Leading indicators of domestic spending have slumped while the news flow out of our major trading partners has gone from bad to worse. Employment is a critical variable in determining Budget outcomes due to the dual impact on personal income tax collections and transfer payments. Most forecasters are expecting the unemployment rate to rise from a low of 3.9 per cent in 2008 to around 7 per cent in 2010, but there are considerable risks to these forecasts.
Furthermore, over the past five years the commodity boom has increased the Government’s reliance on income taxes from resource companies. If the profits of mining companies slump in line with the global economy, this will take a huge chunk out of the Government’s revenues.
So while we are expecting a mild recession by Australian standards, expectations for the Budget position should be less optimistic. If indeed the looming recession turns out to be worse than anticipated and the demand for our commodity exports remains subdued for an extended period, we could see a worse peak-to-trough decline in the Budget position than in previous recessions.
Also portending a rapid and substantial deterioration in the Budget position is more pre-emptive and activist approach to fiscal policy from the current Government. Not only has it executed the fiscal stimulus package late last year, it has increased funding for state and local governments. It has played an active role in guiding industry support, such as motor vehicle financing and support for the credit quality of the banking system. More direct fiscal stimulus will surely come with rumours circulating of another substantial announcement within days.
This approach would be consistent with the emerging view amongst policy makers the world over of the importance of fiscal policy in offsetting the worst of the downturn when that downturn has at it’s root cause an impairment of the financial system. Put simply, monetary policy is unable to tackle this downturn alone.
Budget deficits mean issuing bonds and increasing the public debt. This will keep the Australian Office of Financial Management (AOFM) busy. This is the arm of Treasury charged with managing the Commonwealth Government’s activities in financial markets.
This is where the good news starts. First of all, the government has a strong starting point. Government net debt is -3.9 per cent of GDP depending on how you measure it. This is well below the peak in the mid 1990s of 18.4 per cent and low compared to countries such as the USA, Germany and the UK which have net debt levels of between 40 per cent and 60 per cent of GDP.
The Government can afford to run Budget deficits for some years and still only get up to levels comparable to our peers. As such, the Government credit rating, all important in a period of rising bond issuance and extensive Government guarantees for the banking system, is unlikely to be under serious threat.
Helping too is a modest financial buffer built up in recent years. We estimate the Government has around $15 billion on deposit with the RBA, which could be deployed into the funding of a deficit. The Building Australia fund and the Higher Education Endowment fund add up to just over $15 billion as well. With this buffer, the AOFM is unlikely to have to flood capital markets with Government bonds to fund the Budget deficit.
But once Budget deficits set in, they are hard to get rid of and eventually a large fiscal deficit will result in a large call on the private sector savings pool by the public sector.
Warren Hogan and Katie Dean are senior economists with ANZ.