Why Swan should deliver a surplus

As the government prepares its equivalent of a mini-budget, the Mid Year Economic and Fiscal Outlook update, the debate about the budget surplus rages on.

Does the government really need to return the budget to surplus in 2012-13 or should it, because of the softer revenue flow and slightly weaker economy, let the budget fall into deficit and worry about the surplus later? Related to that is the question whether the surplus objective of the government is merely a political imperative that has little to do with the economy.

Well the answer to those questions is actually quite straight forward.

The return to surplus is essential from an economic management perspective, particularly with the economy growing near trend, unemployment still low and with the Reserve Bank of Australia having plenty of scope to cut interest rates if needed. It is also quite plainly a political goal given there is an election scheduled for the latter part of 2013 and economic management credentials are, as usual, likely to be a vote determining variable.

In terms of the economic importance of a quick return to surplus, there are a few simple issues underpinning this policy strategy.

Perhaps the easiest to understand is the trade-off as the economy is operating at something close to full capacity. As the government withdraws cash and activity from the economy with what looks like being one of the biggest falls in government spending Australia has ever seen in 2012-13, it is making room for the private sector to expand.

The Government is cutting its demand for jobs, investment and finance which means the private sector can more easily employ, invest and borrow and in doing so, be the driver of the expansion.

Another desirable part of the economic rebalancing occurs through a trade-off between government spending and interest rates. Private sector activity is the interest rate sensitive part of the economy and its ability to grow is aided by cuts to interest rates as public activity shrinks.

This strategy is, so far, working a treat. Since the 2010 budget some two and a half years ago, the RBA has moved monetary policy to a relatively easy setting.

To be sure, the RBA did hike interest rates by 25 basis points in November 2010, a time it had a bee in its bonnet about inflation, but after that rate hike, it realised that fiscal policy was going to be contractionary. As a result of this (plus a range of other reasons to be sure), it has delivered 150 basis points of interest rate cuts with the cash rate just 25 basis point from equaling a 50 year low.

These rate cuts have flowed through to mortgage and business rates and have helped to take some of the heat out of the Australian dollar. There are also some signs of a turning point in the interest rate sensitive housing sector and resilience in private demand more generally.

At this stage of the economic cycle, this is a desirable tilt in the policy weightings.

It is also worth noting that in addition to easier monetary policy, the fiscal tightening and return to surplus means that threats to Australia's triple-A credit rating are all but eliminated. In the current global economic and market environment, the last thing the Australian economy needs is a credit rating downgrade that would threaten funding costs and stability in the currency.

Despite these obvious economic benefits of the budget surplus, there are some who suggest the government should loosen up a little and let the budget slip into deficit.

Unfortunately, these sorts of comments rarely, if ever, include any analysis of the consequences of staying in deficit.
I have not seen anyone who is saying that the government should remain in deficit in 2012-13 articulate how big the deficit should be, nor offer any analysis of what the consequences of remaining in deficit would mean for monetary policy, the Australian dollar or Australia's credit rating.

What size deficit are they advocating? Is $2 billion acceptable, what about $5 billion? $10 billion? $40 billion? You will rarely, if ever, see hard numbers put on the deficit objective.

There is also the legitimate question that if it is okay for the surplus to be pushed back to 2013-14, what if there is another flood, cyclone, war, tax shortfall? Shall we push the surplus back to 2014-15 or 2015-16 or 2016-17?

See the problem? No discipline.

The problem is compounded when those advocating a further deficit fail to say what it and the lesser fiscal tightening would mean for interest rates. Obviously they would be higher than they would otherwise be and with it, the Australian dollar would likely be higher. There would also be some risk that the triple-A credit rating would be vulnerable, depending on the extent of the fiscal relaxation.

And finally, the political side to the budget surplus. The debate is as glib as saying there's a political side to running sound economic policy. The government needs to deliver the surplus for its political wellbeing and it would be foolish to think otherwise. Does anyone really think that the government would be wanting to run into the 2013 election with poor economic policy? If GDP growth stays near 3 per cent and the unemployment rate at 5.5 per cent or lower, a deficit would be poor policy.

Let's see the mini-budget or Mid Year Economic and Fiscal Outlook deliver the policy changes that lock in the budget surplus and leave Australia as one of the best run economies in the world. It's good for the economy and good politically.