Gillard mustn't bruise a budget surplus

In light of favourable polls, Labor may be tempted to soften its budget stance. This would be a mistake for many reasons, not least the flow-on effect of higher interest rates.

Labor must not use its recent recovery in the polls to alter its big picture macroeconomic policy agenda of tight and targeted spending and a return to budget surplus.

With the polls showing Labor closing in on the Coalition, there might be a temptation for some in the government to flick the economic policy switch to some populist agenda to try to build on this favourable political news.

This would be a mistake. The hard heads of the government, led by Prime Minister Julia Gillard, need to come out and nip any such talk in the bud.

Populist economic policies rarely work for the economy and it is even rarer that they work politically.

Just ask former Prime Minister John Howard who, at a time of strong private sector activity, cranked up government spending in a desperate effort to hold electoral support. Not only was his government swept from office after that spending spree, but Howard lost his own seat. This was no doubt influenced by the pro-cyclical fiscal policy which forced the Reserve Bank to crank up interest rates to very uncomfortable levels. The extra spending was easily painted as reckless and unproductive because it was.

The Gillard government needs to hang tough in the next year and make sure its spending cuts are locked in and that come hell or high water, the budget returns surplus. New spending areas will need to be funded by saving offsets elsewhere. Market distorting tax breaks should be ended.

There are several reasons why the budget surplus is critical.

Politically, the 2012-13 budget outcome will be released around September 2013, right in the middle of the election campaign (I am using a working assumption that the election will be held on either 12, 19 or 26 October). To deliver a budget deficit would be fatal for Labor as it would also mean that the turn down in government debt currently forecast for June 2013 would not occur.

Furthermore, the record cuts in government spending and significant fiscal tightening more generally have been a critical factor reducing capacity constraints in the economy and have allowed the Reserve Bank of Australia to cut interest rates. There is a simple, yet easy to understand trade-off between fiscal and monetary policy. A tight budget equals lower interest rates. Simple.

Indeed, it was just 18 months ago that the RBA was poised to hike interest rates. Yet the fiscal tightening, together with global events, saw inflation fall and this allowed the RBA to start a quite aggressive interest rate easing cycle. There seems to be scope for more interest rate cuts in the months ahead but this will require the government to hold a tight reign on spending.

It is worth noting, on that score, the Reserve Bank said in its August Statement on Monetary Policy that "a range of estimates suggests that … the Australian government budget may subtract around ¾ –1½ per cent from growth in real GDP in 2012-13.”

The RBA in that statement went on to forecast GDP growth of 3 to 3½ per cent for 2012-13 which, in other words, points to GDP growth of around 4-5 per cent if government demand made zero contribution to GDP. If the RBA was forecasting GDP growth of 4 per cent or more, it would be hiking interest rates.

A vital aspect of holding the line on spending and fiscal policy more generally is the rolled-gold value, economically and politically, of Australia’s triple-A credit rating from the three major ratings agencies – Standard and Poors, Moody’s and Fitch. It is a valuable debating point for the government to have as it deals with irrational ranting about the sustainability of Australia’s public debt and it is keeping borrowing costs lower.

Like the cost of missing the budget surplus, any loss of the triple-A credit rating would be a political and economic problem. There is something tangible and beneficial from getting that surplus locked in and the triple-A rating affirmed.

The political and economic game plan that the Labor Party strategists should have pinned to their "October 2013” election cork board might include the following points.

Announce the 2012-13 budget result, that is a surplus, in early September 2013.

Keep fiscal policy tight so that mortgage interest rates are no higher, but preferably a little lower, in late 2013 than now. Note there is an RBA board meeting on 1 October 2013.

Even with modest employment growth ahead, there is a good chance that around the time of the 2013 election, employment will be one million higher than in November 2007, when Labor won office. Note there will be a jobs report released on 8 October 2013.

Labor should keep pointing out that this is a low taxing, low spending government compared with all others over the last 40 years. Keep it that way for when the pre-election fiscal and economic outlook is issued 10 days after the election has been called, these sorts of numbers will be raked over.

It is a classic example of where good economics is good politics. It is to be hoped the government sticks to good economics as it prepares for what looks like being a close election result.

Stephen Koukoulas was senior economic policy advisor to Prime Minister Julia Gillard between September 2010 and July 2011.

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