WEEKEND ECONOMIST: An average report card

The latest budget highlights the strong risks to the economy from commodity prices, and their impact on the terms of trade. There is also very little being contributed to the overall economy by government savings.

Below are some comments on a number of the key issues around this week’s budget.

1. How dependent is the targeted surplus of $3.5 billion by 2012/13 on forecasts and, in particular, the terms of trade?

The budget papers include a section on the sensitivity of the fiscal forecasts to the economic parameters. Of most importance is the sensitivity of the fiscal forecasts to the outlook for commodity prices.

The papers note that a 4 per cent fall in the terms of trade by 2011 will imply a permanent fall in nominal incomes of 1 per cent. That would imply a lower surplus in 2012/13 of $6.3 billion. Recall that the government has, reasonably, forecast an increase of 19.25 per cent in the terms of trade for 2010/11. That increase has been significantly driven by the expected increase in coking coal (45 per cent); thermal coal (33 per cent) and iron ore prices (23 per cent) between March and June. In the case of coal prices, these "stunning" increases have been largely due to the supply disruptions stemming from the Queensland floods.

If we refer back to the November MYEFO, the government was at that time forecasting a 15½ per cent terms of trade rise for 2010/11, compared to the new forecast of 19.25 per cent. For 2011/12, the terms of trade forecast has been upgraded to a fall of –0.25 per cent from a fall of –4.25 per cent at MYEFO. Over the two years, the government is now seeing the terms of trade 8 per cent higher that it expected at the time of MYEFO.

With a permanently higher terms of trade of 4 per cent being worth an extra $6.3 billion on the surplus, the risks (and the current windfall) from the terms of trade are clearly highlighted.

2. How tough is the budget?

There is no doubt that the budget will impose a contractionary influence on the economy (Figure 1). This influence is almost entirely due to the government allowing the cyclical improvement in the economy to work through to the bottom line without seeking new spending initiatives to soak up the cyclical windfall. With the improvement expected to be rapid (particularly due to the surge in the terms of trade) the fiscal position will improve by 3.8 per cent of GDP over only two years – this is by far the sharpest two-year drag on the economy in the fiscal position since 1970 – it compares with the previous sharpest contraction of 2.4 per cent of GDP in 1985/86 – 1987/88. It follows the largest two-year deterioration in the budget position (see chart).

Very little (around $2 billion out of $53.4 billion) is being contributed by government net savings.

However, by our figuring, (Figure 2) there have been very few years since 1996/97 when governments have made net savings for the third year of the forecasts. This budget represents forecast net savings in 2012/13 of 0.1 per cent of GDP. The first budget of the Howard government in 1996/97 generated net savings of 1 per cent of GDP, but there have only been two other years (1997/98 and 2008/09) when net savings have been achieved, in the third year of the forecast period – both around a comparable 0.1 per cent of GDP.

In the last four Howard/Costello budget periods the forecasts were for net spending of around 1 per cent of GDP for the third year of the forecasts.

3. How "admirable" is the restraint on spending growth?

The government has made a major point of the forecast growth in real spending. Over the five years from 2010/11 to 2014/15 real spending is forecast to grow at an average rate of around 1 per cent – that includes 1.9 per cent in each of the last two years of the forecast period. That makes a stunning comparison with the last five years of the Howard government when real spending growth averaged 3.7 per cent.

But the comparison is distorted by the years 2008/09 and 2009/10 when, during the global financial crisis, real spending grew by 16.9 per cent over the two years. In creating such a high base the task of slowing the growth rate of spending in subsequent years is not so onerous.

Possibly, one way to assess this "base effect" is to consider spending as a proportion of GDP over the two periods. The average over those five Howard budgets was 23.8 per cent compared to 24.2 per cent for the five years in the current estimate.

The windfall increase in commodity prices since MYEFO allowed the government to achieve its targeted surplus despite the deterioration in the starting point and with only very modest savings.

However, these savings are more than is usually achieved in budgets. Fiscal policy will be responsible for a substantial tightening over the next two years. However the government's restraint on spending growth is significantly assisted by the high base established during the GFC.

Bill Evans is Westpac's chief economist.