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How to be a ‘Fiscal Conservative,’ Without Really Trying

Prime Minister Kevin Rudd is promising budget surpluses of 1.5% of GDP, as part of the government’s ‘war on inflation.’  Relative to the forward estimates contained in the previous government’s Mid-Year Economic and Fiscal Outlook, this represents a fiscal contraction of a mere 0.2% of GDP.

Contrary to popular perception, Commonwealth fiscal policy is already the tightest it’s been in two decades.  Looking at actual budget outcomes, as opposed to the forward estimates or the arbitrary counterfactuals the commentariat love to play with, the fiscal impulse (ie, the change in the budget balance as a share of GDP) has been either neutral or contractionary for the entire period since 2001-02.  The underlying cash surplus has ranged between 1.5-1.6% of GDP since 2004-05, a GDP share not seen since the peak of the last cycle in the late 1980s.  The automatic stabilisers would probably cough-up another surplus of 1.5% of GDP anyway, regardless of any contribution from discretionary policy actions.

The fiscal impulse has been largely irrelevant to inflation and interest rate outcomes in recent years.  Today’s announcement suggests that is not about to change.

posted on 21 January 2008 by skirchner in Economics, Financial Markets, Politics

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The best approach in this situation is to cut income taxes aggressively and leave the central bank free to use the policy rate to target inflation as aggressively as necessary (preferably in a proactive rather than reactive manner; the RBA is now flat-footed, as you’ve pointed out earlier).

This approach gives people the extra income to cope with increased interest payments, without having to throw prices to the wind (by leaning on the central bank to hold the policy rate down).

A low policy rate encourages the accumulation of debt, which doesn’t make excess debt formation any less likely, and thus aggravates the initial problem of high debt-servicing costs.

Speaking of which, and further to Rajat’s comments the other day from Lawson’s memoirs, it would appear that the more indebted a society becomes, the more likely it is to be the case that the policy rate transitions from being an instrument of policy to being an object of policy (thus worsening the alleged problem of excessive household debt formation).

The conclusions are that central bank independence didn’t come a moment too soon, and that this is not a panacea anyway, because of other factors (apart from said independence) which are now being shown up as inadequate (in particular, the RBA’s inexcusable lack of a separate policy committee).

Posted by benson  on  01/21  at  08:49 AM



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