WEEKEND ECONOMIST: The great hoarding

This week’s data were a mixed bag for the inflation and interest rate outlook. March housing finance fell off a cliff, reflecting the impact of back-to-back rate rises in February and March. While such sticker shock is not uncommon following interest rate rises, it foreshadows further weakness in building approvals, dwelling investment and housing supply.

At the same time, the March quarter wage price index came in much weaker than we had any right to expect, given rising inflation and inflation expectations, as well as still strong labour demand. This still leaves annual wages growth sitting just below the equal record highs set in the previous quarter. In the absence of a pick-up in productivity growth, wages growth remains unsustainably high and a continued source of upside inflation and interest rate risk, but the March quarter outcome could certainly have been much worse.

The 2008-09 Budget was mildly contractionary, with a fiscal impulse of -0.3 per cent of GDP, assuming you take the Budget estimates at face value. In recent years, actual budget outcomes have invariably ended up being much tighter than the budget estimates, even after new spending commitments and additional rounds of tax cuts. With the new Labor government having given an undertaking to hoard additional revenue in excess of the forward estimates and failing to fully fund its ‘aspirational’ tax cuts, this could set the stage for an unprecedented fiscal contraction. However, as argued in this space previously, the budget balance is largely irrelevant to inflation and interest rate outcomes. If budget balances mattered to interest rates, New Zealand would have the developed world’s lowest interest rates and Japan the highest, the exact opposite of what we observe in practice.

Australia’s terms of trade are forecast by Treasury to rise 16 per cent in year average terms during 2008-09, driven by higher commodity export prices and declining import prices. The terms of trade boom has driven revenue growth in excess of recurrent expenditure as the economy shifts to what may well be a permanently higher level of national income (and by implication, higher equilibrium real interest rate). With federal net debt having been completely repaid in 2005-06, the government expects to have a negative net debt position equal to a massive of 7.6 per cent of GDP by the end of the projection period in 2011-12. A large share of the proceeds of the terms of trade boom are thus being sequestered by the Commonwealth government. This has left the government struggling to find ways to recycle growing budget surpluses, given that debt retrenchment is no longer an option.

The previous government allocated budget surpluses to a combination of tax cuts and hoarding revenue in Australia’s sovereign wealth fund, the Future Fund. The Future Fund was originally mandated to meet previously
unfunded liabilities in relation to public sector pensions. But these commitments were soon fully funded and additional contributions to the Fund would have seen it purchasing more assets for no apparent purpose. The new government has now established additional ad hoc funds to warehouse budget surpluses, notionally allocated to future capital spending in relation to infrastructure, health and education, but with no specific investment program yet in place.

Unless you think that the current and future governments will hoard budget surpluses without limit, then it should be clear that the Future Fund and its new sister funds are simply holding vehicles for future government spending. Of course, governments could also cut taxes in future, but which of these scenarios is more likely? This future spending has the potential to augment the supply-side of the economy if well invested, but with the investment share of GDP at post-war record highs, the private sector is already undertaking the bulk of this task and the historical record of public spending does not exactly inspire confidence that the revenue being hoarded by the government today will be well spent in the future.

One could argue that the government is pre-funding the fiscal gap identified in the Intergenerational Report (something the New Zealand sovereign wealth fund does explicitly), but the case for current taxpayers to fund future government spending is weak. The best way to close the prospective fiscal gap is to grow the economy as fast as possible today, which will provide the resources that might be needed to meet budget commitments in the future. The prospective fiscal gap doesn’t argue for higher taxes today, but instead highlights the need to put government spending programs on a more sustainable long-term footing. Government revenue hoarding actually reduces the incentive for future governments to take the tough fiscal decisions that will be needed to respond to future demands on the budget.

There is a light calendar in Australia and New Zealand next week. The minutes of the May RBA Board meeting are released Tuesday. Treasury Secretary Ken Henry also gives the traditional post-Budget address to
Australian Business Economists on Tuesday. Consumer sentiment and inflation expectations are also released. In New Zealand, the 2008-09 Budget is handed down on Thursday.

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com