Working Papers

Good and Bad Reasons for a Budget Surplus

The government’s stated motivation for returning the budget to surplus next financial year is to give the Reserve Bank ‘maximum room to move’ on interest rates. Yet a fiscal contraction is no more effective in restraining the economy than a fiscal expansion is effective in stimulating it. In an open economy with a floating exchange rate and an inflation-targeting central bank, changes in fiscal policy do not have significant macroeconomic implications. That is why the reaction of financial markets to budget statements is so negligible. The Reserve Bank’s statements also make clear that fiscal policy is a very minor consideration in its decision-making.

During the financial crisis, the government tried to have it both ways, arguing that its fiscal stimulus saved us from recession, but had no implications for interest rates. The second part of the argument was correct, but not the first. If the first part had any truth, then monetary policy must have been much tighter during the financial crisis as a result of the government’s stimulus spending.

The government should have no concern over the macroeconomic implications of changes in the budget balance, so long as it is balancing its budget over time and conducting fiscal policy in a sustainable manner. This should free the government to focus on what fiscal policy can do effectively, namely, changing microeconomic incentives to work, save and invest.

The government and opposition’s mistaken belief in a trade-off between fiscal and monetary policy is dangerous, because it leads to fiscal policy decisions that are more about window-dressing the budget balance and claiming credit for reductions in official interest rates that would have happened anyway, rather than improving incentives. For example, the mistaken belief that tax cuts stimulate demand and lead to higher interest rates can prevent sensible tax reform that has positive implications for the supply-side of the economy. Similarly, the fiscal stimulus of 2008-09 was bad primarily because it misallocated resources. Take away the macroeconomic rationale and the stimulus measures look indefensible on microeconomic grounds, even if the spending had been administered perfectly (which it was not).

A budget surplus target can be defended as a fiscal rule designed to impose additional discipline on government decision-making that might otherwise be absent. But there is no reason to subordinate fiscal policy to monetary policy and fiscal targets should not be pursued at the expense of the microeconomic incentives that are the ultimate source of both economic growth and long-term fiscal sustainability.

posted on 09 May 2012 by skirchner in Economics, Financial Markets, Fiscal Policy, Monetary Policy

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In an open economy with a floating exchange rate and an inflation-targeting central bank, changes in fiscal policy do not have significant macroeconomic implications.

The market monetarists agree, but for slightly different reasons. Rather than suggesting an increase in government spending automatically raises the exchange rate and crowds out private demand, they say that if the central bank is doing its job properly, it will act to offset an expansionary fiscal position with tighter monetary policy. People like Scott Sumner argue that both monetary and fiscal policy can (in isolation) affect demand, and that it is the slope of the aggregate supply curve that determines how much of an increase in nominal demand is reflected in increased real output and how much takes the form of higher prices. Your sentence preceding the one quoted above indicates that you think changes in fiscal stance have no material effect on nominal demand. What do you think of the Sumnerian approach?

PS. This is not to say that the objective of the budget should be different to what you suggest or that the government and opposition are not being hypocritical.

Posted by .(JavaScript must be enabled to view this email address)  on  05/09  at  06:04 AM

I agree with Scott, which is why I mentioned the inflation targeting central bank. Discretionary fiscal policy that avoids being crowded-out by NX gets discounted in setting monetary policy. So fiscal stimulus has two hurdles to effectiveness and can completely fail at either one.

One could also mention that fiscal policy doesn’t appear anywhere in the RBA’s published forecasting models, but that’s a post for another day.

Posted by skirchner  on  05/11  at  06:26 AM

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