Why a 'back to the future' budget will fail

A federal budget surplus based on the logic that created overheated asset classes pre-GFC will only promote new finance and real estate bubbles... and the signs are already emerging.

If you were told the following graph showed two indicators of Australia’s economic health, and one of them had to be addressed urgently, which one would you expect politicians and economists to try to bring under control first?

Figure 1

If you picked the blue line, you’ve obviously not a politician. The blue is the ratio of private debt to GDP in Australia; the red line is the ratio of government debt to GDP (debt to the banking sector only; both series come from RBA table D02). The red line is the one that both sides of politics in Canberra are obsessed about; the blue one they both ignore.

You might be an economist though, because even though most economists can’t understand my obsession with private debt, plenty are willing to say that the emphasis politicians are putting on reducing government debt now is misplaced. Even Warwick McKibbin, an economist with impeccable conventional credentials, has derided the political obsession with returning the Australian budget to surplus by 2013, saying succinctly that "rational economic analysis does not suggest that there is a fiscal sustainability problem in Australia”.

McKibbin argued that government spending should be counter-cyclical:

"But no serious economist argues that fiscal policy should be used to accentuate the business cycle and to make economic slowdowns even more severe. Thus from a counter-cyclical fiscal policy position, the budget will be a success if it is at least neutral or to some extent anti-cyclical. It will be a failure if it is pro-cyclical; that is, removes demand from the economy when the economy is forecast to slow relative to trend. This policy would accentuate the business cycle and cause excessive economic losses in future years."

Prior to the global financial crisis, quite a few serious economists would have argued against this -- or proposed that surpluses were stimulatory and deficits contractionary -- in the delusional argument known as "Ricardian equivalence". But the disastrous experience of the EU countries that have had austerity imposed upon them has thrown that idea into the dustbin where it belongs, and today McKibbin is right: most economists, looking at the trends in Australia’s economy, would argue for deficits now rather than a surplus.

So where does this obsession with returning the budget to surplus coming from? It appears to be a consequence of the puppet show that passes for political leadership not just in Canberra but globally, where mainstream parties of both progressive and conservative persuasion vie with each other over who would be best at balancing the country’s fiscal books.

The question of whether and when the books should be balanced doesn’t get a look in when this contest is afoot. Both mainstream contenders -- Liberal or Labor in Australia, Democrat or Republican in the US -- concur that the best budget is a balanced one (and the best of all is one in surplus). This shows that there is no real contest of ideas in modern politics: parties instead compete over who would do a better job of managing the economy according to the neoliberal rulebook.

That rulebook has two overriding principles: that government should be as small as possible, and that asset price bubbles are a good thing -- though heaven forbid actually calling them that. The first principle is why a surplus is seen as being better than a balanced budget, since then government can be downsized. The second, which is described as increasing private sector wealth, makes it easier to justify downsized governments since a wealthier private sector has less need of public largesse.

That rulebook appeared to work right from the early 1980s until the crisis of 2007, and when something appears to work, few politicians question why. Instead they strive to take the credit for it. This made governments of notionally Left and Right persuasion complicit in the debt bubbles that actually finance asset bubbles.

This is why there is no Left/Right pattern to political economics in the last three decades: a notional progressive in Bill Clinton signed in the abolition of Glass Steagall; a notional progressive in Tony Blair extended the City-favouring policies of his notionally conservative predecessors Thatcher and Major; and a card-carrying conservative in John Howard simply built on the finance-friendly policies of his notionally progressive predecessor Paul Keating.

In fact, the neoliberal rulebook worked because both rules encouraged the growth of the FIRE economy (FInance and REalestate), where the engine of growth was exploding private sector debt. When that engine burst past maximum revs and seized up in 2007, the crisis we are now in erupted.

An optimist might hope that politicians would learn from their mistakes, and abandon the rulebook that caused the crisis. But that would involve admitting that mistakes were made in the past, and it seems that politicians -- and the public too -- would rather return to the past than to examine it more closely. After the initial 'born-again Keynesian' responses to the immediate crisis, policies have attempted to take us "Back to the Future” when asset markets were rising and all seemed well with the world.

Can we do it? The short-term answer is "Yes We Can”: the dynamics of the private debt engine can be restarted after a crisis if debt accelerates, and that can occur even when debt is still falling. Accelerating debt will lead to rising asset prices, and the FIRE sector economy can spring back into life again.

There are worrying signs that this is happening right now -- and not just in Australia. Independent analyst Jesse Colombo -- hailed as one of the economists who predicted the GFC -- has identified burgeoning house price bubbles in Europe; while mortgage debt is rising again in the US, as are house prices, and in Australia, an acceleration of household debt is fuelling a reversal of the trend to falling house prices that began in mid-2010.

Figure 2: Private debt acceleration turns positive again in Australia


Once this process begins, it can be a self-fulfilling one for a while: accelerating debt causes rising asset prices, which in turn encourages more people into debt to ride the bubble, and so on. But it also has to fail, since acceleration of debt can’t go on forever.

Which brings me to the long-term answer of "No We Can’t”. This process of boom and bust driven by accelerating and then decelerating private debt has been going on for five decades now, with each revival leading to a higher aggregate level of private debt to GDP than the previous one. Had governments not intervened to try to take us "Back to the Future” -- had they let the shareholders and bondholders in the FIRE economy lose their shirts (while protecting the depositors, who are the innocent if somewhat complicit bystanders in this process) -- then this crisis might well have been the final gasp of the FIRE dragon.

Now the dragon might get the chance for one more gasp -- thanks to government policy that has kept it alive when it should have died. But with debt levels as high as they are now, the potential for sustained acceleration in debt is limited. Prepare for a possible economic recovery followed very soon afterwards by a return to crisis.

Figure 3


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