Budget cuts will bring on recession

Tim Colebatch -Apr 3, 2012

LAST week was budget week. The government revealed that with growth at just 2.5 per cent, it will reject calls for tough budget cuts, raise spending in areas that need stimulus, and extend its deadline to put the budget back in surplus to 2015-16.

You didn't hear that? Perhaps that's because that budget was in Canada: the country and economy most like Australia, but at the other end of the world. Facing similar problems, it has come up with a very different solution.

Canada is run by conservatives. Prime Minister Stephen Harper's government is the closest thing the world has to the Howard government. Finance Minister Jim Flaherty is a tough, no-nonsense social conservative who earned his fiscal spurs by shutting down the tax break for trusts. In his budget speech, along with familiar rhetoric - ''Canada has outperformed most other industrial countries … Our net debt to GDP remains the lowest in G7, by far'' - he anticipated the criticisms from the right for not cutting more from spending:

''We remain concerned about the number of Canadians out of work … Because of our government's responsible choices, we can eliminate the deficit through commonsense, moderate restraint. We have no need to resort to drastic cuts … We have no need to undertake radical austerity measures … The savings we have identified are moderate, less than 2 per cent of federal program spending.''

I suspect John Howard, were he still in power here, would do the same. And I suspect Tony Abbott, were he in power, would do much the same - whatever he says from opposition.

Take New Zealand: the other country most like Australia, except that its mines are forests and sheep farms. On Sunday NZ Prime Minister John Key declared he will stick to his timetable to get the budget back in surplus in 2014-15. Key, too, is from the conservative side.

Canada and New Zealand do not lack shock jocks and right-wing ideologues demanding a budget surplus ASAP. Rather, as economist Saul Eslake of Merrill Lynch Australia puts it, Labor's leaders are afraid of being seen as being another fiscally irresponsible Labor government:

''Labor craves the approval of the financial markets in a way the Liberals don't need to,'' Eslake says. ''Labor has to show that it can govern responsibly. The Liberals don't.''

It is the only plausible explanation for the tragedy we are about to experience. Next month Julia Gillard and Wayne Swan will give us a budget that will probably send most of Australia into recession.

In one year, we will go from a deficit of 2.5 per cent of GDP or more, to a surplus. By a mix of revenue rises and spending cuts, Labor will pull 2.6 per cent of GDP out of the economy. That is 2½ times the fiscal contraction imposed by the Hawke government in 1986-87, or the Howard government in 1996-97. It is the stuff recessions are made of.

Why do it? Because Labor has pinned its credibility to its pledge to deliver a budget surplus in 2012-13. The promise it made in 2009 has become a mantra, repeated 1000 times over, and to be delivered regardless of economic conditions.

In 2009, Treasury had assumed that by now the economy would be booming, and the government would pass the baton to the private sector to take Australia on. It projected economic growth in 2011-12 and 2012-13 of 4.5 per cent, each year. It projected almost 600,000 new jobs. Would the private sector be ready to take the baton? You bet.

Now 2012-13 is almost here. Growth is just 2.5 per cent, with most of that in outback mines. In south-eastern Australia, except mining areas, activity is weak. Much of the country is close to recession. Job growth has stopped. Retailing is flat, manufacturing is weak, housing in free fall. The high dollar is slowly strangling trade-exposed sectors; high interest rates are cramping the rest.

Is the private sector ready to take the baton? Into these headwinds? No way.

But it won't be that bad, we're told. Treasury points to an IMF study last year of 173 serious ''fiscal policy changes'' in Western countries in the past 35 years. The study, Expansionary Austerity: New International Evidence, found that, on average, budget savings equivalent to 1 per cent of GDP will lower GDP itself by 0.62 per cent after two years. The penalty rises with bigger savings, but more slowly, with each percentage point of extra budget savings cutting GDP by 0.5 per cent.

Assume that our budget savings will be 2.6 per cent of GDP. On the IMF average, that would cut 1.4 percentage points from GDP growth by mid-2014. If you assume that we would otherwise grow at our trend rate of 3 per cent a year, that would still give us growth of 2.3 per cent.

But no: the detail of the IMF study suggests Australia's budget cuts will intensify the divide between mining and the rest. It implies that over two years, domestic demand would shrink by 2.75 per cent. There would be gains in net exports, but the regions and sectors hurting now would hurt much more. And the IMF found the damage was twice as big when the country is seen as low risk - as Australia is. This implies that over two years, we face a loss of almost 3 per cent of GDP, and 5 to 6 per cent of domestic demand.

The study cited to play down the risks of Swan's strategy in fact shows how high they are for the non-mining states and sectors. Which is more important: keeping a promise or keeping us out of recession?

Tim Colebatch is economics editor.

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