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The Economy: Balancing Act

[ The University of Melbourne Voice Vol. 3, No. 2  12 May - 9 June 2008 ]

DAVID SCOTT reports

A new Treasurer and Finance Minister confront our economy with inflationary pressures not seen for decades.

Don’t Panic. It’s a maxim of many of today’s economists and indeed Australian consumers in general. It’s the same message that then Federal Opposition leader Kevin Rudd maintained in the lead up to last November’s poll, despite withering attacks by the Liberal party about Labor’s economic credentials.

However, as easy as it is to say ‘Don’t Panic’, the truth is many Australians are finding the current economic climate difficult.

Petrol prices are still on the rise (the RACV has warned drivers that prices could reach as high 160 cents this month1). And interest rates seem set to keep rising as well, putting more pressure on borrowers, with March quarter consumer price inflation figures hitting 4.2 per cent, well above the Reserve Bank’s efforts to reduce it to its 2–3 per cent band averaged over the economic cycle2.

“In one sense, inflation is no bad thing – it is a sign that an economy is strong”, says Professor Mark Wooden, a labour economics expert based in the University of Melbourne’s Melbourne Institute of Applied Economic and Social Research. “But once inflation gets out of hand, it’s kind of like theft; economies just can’t function when inflation is out of control.

“Having said that, the current rate of inflation is still quite modest. I grew up in the ‘70s and 80s when price inflation was much higher then than it is now,” he says.

The problem, according to Professor Wooden, is that the Reserve Bank does not have many tools at its disposal to rein in inflation, aside from interest rates, which he describes as a very blunt tool.

“It really only affects people who are in debt. We’re raising interest rates because things are booming along in Queensland and Western Australia. And that’s great. It might rein in expenditure over there, but it also reins in expenditure throughout the rest of the country which isn’t going through the boom times.”

It’s a position with which Associate Professor Neville Norman (Department of Economics, Faculty of Economics and Commerce) agrees. “If you want one major reason why interest rates are rising at the moment it’s because the budget isn’t supporting them, and monetary policy (interest rates) is the only real form of restraint.”

The Budget, inevitably Australia’s biggest economic policy statement of the year, in 2008 will be more than usually notable as the first budget produced by a new government in 12 years. And according to Associate Professor Norman it is set to be the first budget this millennium likely to be subject to revenue shortfalls.

“For the first time budget revenue is likely to be lower than the latest revised estimates because of questions about the economy, such as a slowing in the rate of growth and also in the rate of tax collection.

“I think that when the history of all this is written, both political parties will regret that they gave so many tax cut promises,” he says.

While most Australians would never reject the idea of paying less in tax, on an economic policy level the experts are not so sure this is a good thing. Professor Wooden and Associate Professor Norman both believe that by putting more money in the hands of workers, the government will encourage greater spending by households and therefore increase inflationary pressures.

Professor John Freebairn (Department of Economics) goes one step further. He says that the tax cuts hide a fundamentally flawed tax system that is in need of an upgrade, though he is pessimistic consumers will see anything but the cuts in May.

“The real risk is we have a tax system that has favoured over-investment in real estate. If we had a more neutral tax system, with tax breaks distributed evenly across a number of sectors, we would be better off, individually as well as collectively.”

Professor Freebairn says that while Prime Minister Kevin Rudd is committed to delivering election promises cuts to Commonwealth Government spending (relative to the plans of the previous government) to the tune of $6 billion this financial year, Treasurer Wayne Swan has already warned that Australians should brace for a tough budget as the Government tries to balance inflation alongside Labor’s long-term objectives of modernising the economy.

As well as promises of taxation relief in this year’s budget, the Federal Government has flagged that it will take the cuts one step further and significantly trim its own expenditure, says Professor Freebairn, noting that Finance Minister Lindsay Tanner has indicated a number of government services and areas that will be cut completely or pruned significantly over the next 12 months and beyond, including most notably, government spending on advertising.

Australians perhaps should not head into budget night with an expectation of a continued ‘massive’ budget surplus, a surplus that was central to the Liberal government’s claims of strong financial management over the past 12 years, he says.

Professor Freebairn is one who, while in favour of the increased efficiency offered by cuts in expenditure, is not impressed by a slavish policy of ongoing budget surpluses.

“If you have on offer lots of really good public expenditure proposals that will not be undertaken by the private sector because of various market failure reasons, and you have a transparent and sensible cost-benefit analysis saying these investments are worth doing, then not undertaking such investments is just holding up the country,” he says.

It would seem to be a difficult balancing act of financial priorities. Tax cuts take money and resources from the government and place them with consumers to do as they please. Potentially the extra private expenditure adds to inflationary pressure.

To recoup part of that money Labor has to make cuts in its own spending – which Associate Professor Norman describes as “a real razor gang” process. He believes that it is not an impossible balancing act. “The higher agenda is that unless there is restraint from the budget, of which there’s been very little, then there will be further interest rate rises.”

With an eye to the future, Professor Freebairn goes so far as to call 2008 the year of the Berocca budget, with the government aiming for a ‘soft landing’, despite hard yards in the immediate future.

“That’s what the Government and the Reserve Bank are trying to do in aiming for inflation figures closer to two or three per cent. It’s about trying to avoid the possibility of vicious cycles…soft landings are what we all talk about.”

Professor Wooden agrees, saying that in the long run, what both Lindsay Tanner and Wayne Swan will want to do is alleviate the current ‘boom and bust’ cycles by relatively stable, shallow downturns in certain periods, engineering a smoother ride.


FOOTNOTES

1 Ben Packham, Jane Metlikovec and Holly Ife, “Triple Blow on rates, petrol and inflation”, News.com.au, April 24, 2008.

2 Chris Zappone, “Mortgage-stressed borrowers just got more bad news on interest rates”, theage.com.au, April 23, 2008.