Macroeconomic Policy

1. INTRODUCTION ⁽¹⁾

This chapter was written late in 1986, with no knowledge of the timing of the 1987 or 1988 election and therefore without knowing whether the Mandate Government's first Budget would be for 1987-88 or 1988-89.  Nor were the 1987-88 Forward Estimates available.  The 1987-88 Budget will either be the Mandate Government's first, or it will be an election Budget and unlikely to make a determined assault on the long-term problems, which will therefore be at least as pressing when the Government takes office.  Consequently the following discussion is likely to be valid for a first Budget in 1987 or 1988.

2. A SNAPSHOT OF THE ECONOMY

From 1982 to the latter half of 1986 Australian Governments pursued economic strategies designed to maintain or increase economic growth.  By 1986 the growth rate achieved in 1984 and 1985 had declined so far as to be negative in some quarters, although renewed growth was expected in 1987.  Essentially, economic growth was sustained or augmented by borrowing by the private and public sectors, especially by borrowing from abroad:  the combined consumption of public and private sectors has been greater than our national output.  Specific features of recent economic policy and conditions have been:

• A quick spurt of growth in 1983-84 and 1984-85.
• Public sector outlays of over 43 per cent of GDP.
• Public Sector Borrowing Requirements averaging 7 per cent of GDP.
• Historically high Commonwealth Budget deficits.
• A downturn in our terms of trade.
• Wage indexation to the CPI (now abandoned?).
• A weakened currency (beginning before the severe downturn in our terms of trade).
• Increasingly heavy on-costs in a labour market already burdened by inflexible and anachronistic work practices.
• A money supply often accommodating to excessive private and public demand.
• Inflation and interest rates very much higher than the average of our major trading partners.
• Continuing high taxation -- increased by more than 11 per cent in the 1985-86 Budget.
• State governments increasing spending and borrowing faster than the Commonwealth.
• Generally poor private fixed investment.

3. THE HAWKE GOVERNMENT'S POLICY

The Hawke Government's policy was until well into 1986 apparently based on the following beliefs:

1. The key to economic recovery is the stimulation of aggregate demand while cost increases are controlled by political means (in particular, the Accord).
2. Public sector investment and consumption are just as valuable as those of the private sector.
3. Public sector debt will become manageable through the growth created by expansion of the public sector.
4. The ACTU is the necessary partner of any realistic Australian Government -- as witness successive versions of the Accord.
5. Keeping the union leadership on-side normally involves indexation of wages to the CPI, no enforcement of arbitrated decisions on unions, and the granting of legal privileges to the union class.
6. High taxation for increased government services does not seriously inhibit growth.
7. Money supply policy should not operate to restrict demand unduly.
8. Regulated labour and product markets do not conflict with deregulated financial markets.

Underlying these themes has been an orchestrated system whereby the trade union leadership needs and gets immediate access to the committees of government.

4. THE ACCORD AND WAGES POLICY

The awards which regulate the private sector set minimum wages.  In small businesses, where most of the workforce is employed, many, perhaps most employees are paid above this formal minimum.  In its last year in office the Fraser Government maintained the "wages pause", during which award wages were not increased.  This is often thought of as a wage freeze, but the real effect was to reduce the influence of centralised awards in the labour market and increase the importance of over-award payments.  Had awards been frozen at low enough levels, wages would have been determined in a free market.

Before the 1983 election the ALP negotiated its Accord with the ACTU, and this has been maintained with variations since the first Hawke Government took office.  The Accord permitted some award increases but, it was claimed by the government, kept wages down -- in effect continuing the Fraser policy.  The ACTU claimed at its 1985 conference that the Accord had kept wages higher than they would otherwise have been.  Given the state of unemployment and wage trends in other countries the ACTU was probably correct.  If it is still in effect when the Government takes office, the Accord should be abandoned.

The policies in the Labour Market chapter provide a way of opting out of the compulsory arbitration system, but cannot all be implemented immediately.  Centralised awards will continue for those who want them, so continued government participation in national wage cases and the like is necessary.  The Government's first national wage case will be very important.

The Government should argue before the Arbitration Commission for a one-year award freeze.

5. MONETARY POLICY

For most of the last seven years expansionary monetary policy has caused higher inflation and Australian inflation is now several times higher than that of some of our OECD partners.  Competitiveness has been regained by currency depreciation, but this feeds back into domestic costs and, if accommodated by increases in the money supply, will cause further inflation, requiring further depreciation and so on in a vicious spiral.  It is therefore imperative that downward pressure operate on costs, inflation and inflationary expectations.

With the benefit of hindsight it is possible to see that the money supply during 1983-84 and 1984-85 was too accommodating to high and rising inflation at a time when our trading partners were looking to zero inflation.  The result of the loose monetary management was an outburst of government spending and consumer spending.  This spending increased our current account deficit and our overseas debt, since imports surged and the competitiveness of our exports declined.  This caused the exchange rate to depreciate in the first months of 1985, before the serious downturn in our terms of trade.

The "go for growth" policy meant our current account was in its worst shape for years just at the time our terms of trade really turned sour.  Money supply was eventually reined in towards the end of 1985.  Interest rates jumped, and the policy was eased again in February/ March 1986.

The 1985 Budget speech spoke of "allowing sufficient room for strong but sustainable growth".  In the event we were allowed strong and sustained inflation which has already wiped out much of the benefit that might have been gained by the depreciations of the dollar.

Late in 1986 it appeared the authorities were aiming to keep broad money around an 8 per cent growth rate target.

Most measurements of money supply have been affected recently by financial deregulation.  This adds to the difficulty of monitoring monetary policy;  but the additional difficulty arises not so much from the new circumstances as from the fact that circumstances are changing.  As the new regime settles down we can expect the money supply measures to become more useful.  Money management will, however, remain a technical matter which is best avoided by politicians and left to the Reserve Bank.

Conservative monetary policy is a necessary but not sufficient condition for sustainable economic growth.  Without reduced government spending, reduced public sector borrowing, and dynamic gains from labour, transport and product market deregulation, monetary policy can control inflation but will not produce the necessary economic growth. ⁽²⁾

Projected targets for M3, M4 and other money supply indicators are a useful guide for the financial markets and discipline for the authorities.  Monetary targets dampen inflationary expectations and, like "trilogy" commitments, help control the temptation to use irresponsible monetary policies for short-term political objectives.  Market reaction can invalidate targets by changing the circumstances on which they are based and any projection is subject to revision.  If targets are missed the Reserve Bank should have to explain why:  the discipline this transparency imposes on politicians and bureaucrats is more important than hitting a target.  The reformed Economic Planning and Advisory Council recommended in the Government and Administration chapter will also play a major role by publicly monitoring macroeconomic management.

It is clear that policies on interest rates, demand stimulation through the Budget, exchange rate manipulation, and money supply are often in conflict, partially cancelling one another out, sending confusing signals to national and international markets, and increasing the possibility of another disastrous run on the dollar.  More mutually consistent policies would have similar net economic effects with less confusion and risk.  Nevertheless, there is no easy macroeconomic solution to Australia's economic problems.  The fundamentals of the economy need the attention which is given them in other chapters.

The Government should set a target for inflation of 3 to 4 per cent within two years, and allow the Reserve Bank to set broad monetary targets to match and to conduct monetary policy accordingly.

The setting of such targets, accompanied by appropriate fiscal, deregulatory and labour market policies, will ease pressure on the exchange rate and encourage investment.  Increased investment will improve the current account figures and lead to the growth that allows money supply to be realistically eased;  but for now cautiously tight monetary policy is necessary.

6. FISCAL POLICY

Until the 1986-87 Budget outcome is known it is impossible to say anything definitive about the 1987-88 Budget and still less about the 1988-89 budget.  Many recommendations for savings are made in following chapters.  The importance of expenditure reduction and deficit reduction is so great that cuts to some of the biggest items should be made not on the basis "How much will this cut save?" but on the basis "How big a saving is needed here to achieve our promise of a balanced budget?" (See the Government and Administration chapter).  The process of cutting spending should of course be begun as early as possible, but it is not realistic to base predictions on the hope for significant cuts before the 1987/1988 election.

The tendency for budget deficits to spill into trade deficits has become known as "the twin deficit problem".  Some economists dispute whether there is a causal link from the budget to the current account but neither this text nor political decision makers can settle that argument.  At least until it is settled the only responsible course for politicians is to assume that the present public sector borrowing requirement is not consistent with cutting the current account deficit to 2 or 3 per cent of GDP from the present 6 to 7 per cent.

Consider the following:

• The projected 1986-87 deficit of $3.5 billion is unlikely to be achieved and the figure could increase by anything from $500 million to $1 billion.
• The Commonwealth Treasury seized $2.6 billion from the Reserve Bank's funds for the 1986-87 Budget transactions and $2 billion in the same way the previous year.  The average Reserve bank contribution for the five years before was not much over $400 million a year.  It is unlikely that the Bank will have anything like $2 billion available for future Budgets.
• Hundreds of millions of dollars of expenditure "cuts" this year were really deferrals and do not affect the actual rate of spending.
• Similarly another $600 million was "saved" by deferring income tax cuts by three months.
• Hundreds of millions were gained by higher than usual payments from other sources (the Australian Airlines superannuation fund etc.).
• Revenue from the Crude Oil Levy is expected to fall.
• In addition there is the promised income tax reduction from 1 July 1987.

The Treasurer -- whoever he is -- will be looking at a potential deficit of anything between $6 billion and $9 billion when he faces up to the numbers for the 1987-88 Budget -- and with much less prospect of windfalls.  To achieve zero Commonwealth Government growth in outlays then or in 1988-89 will require very substantial cuts in programmes;  an actual reduction in real terms will need a firmer hand still.  This will in turn require substantial reductions in the big ticket items such as payments to state and local governments, social security and welfare, health, education, and general public and economic services.  Unless very real cuts are made the Public Sector Borrowing Requirement and interest rates will once again fly through the window.

The process is made more difficult but more urgent by the fact that paying interest on government debt is now, at about 10 per cent of Budget outlays, the third largest obligation of the Treasury, ahead of Health, Education and Defence.

6.1 REVENUE

The Australian tax system is poorly designed to raise any sum -- eventually the tax bases must be broadened and the scales flattened -- but both major parties have locked themselves into positions, such as tax exemption for gold mining, that are inconsistent with the sort of reform needed.  For some time to come, any reform package is likely to meet the fate of the Keating package at the 1985 Tax Summit.  Other problems should have prior call on the Government's political will, skill and ingenuity.  For the immediate future the task of the tax system is to raise enough revenue to eliminate the deficit, the one change recommended being tax indexation.  In the long run, the most desirable tax reform is to reduce the need to collect so much tax:  this will make the redesigning of the tax system a much less difficult job.  These points are discussed in the Tax Reform chapter.

6.2 EXPENDITURE

The Hawke Government planned for zero growth in real terms in total budget outlays for 1986-87.  The increase in overall public sector final demand was estimated to be the lowest in seven years.  Relative to GDP, outlays were projected to decline by 0.6 per cent.  The objective of zero growth in 1986-87 followed three years during which outlays increased by 16 per cent in real terms.

There are now some doubts about whether these and various other Budget targets will be achieved.  These doubts arise from the belief that the economy is in at least mild recession, bringing increased unemployment, reduced income tax revenue and greater welfare spending.

Recovery will be greatly assisted if the government competition in capital markets is reduced, allowing lower interest rates, if taxation on savings and investment is lower, and if there is more incentive to expand and diversify economic activity.  The public sector bite into the national cake has been well over 40 per cent for the last five years.  It should be reduced below that figure and state and local government must share in the reductions.  Public sector consumption has consistently been growing faster than private consumption.  The public sector has not lived up to government rhetoric about the need for restraint, so the burden on the private sector is commensurately greater.

In the current climate it may not be politically possible for the Government to achieve more than a 1 per cent real reduction in Commonwealth outlays for each of the first three years.  A better result is certainly desirable, but although the potential economic gains are great the policy adjustments necessary to achieve and manage the suggested figure will be difficult for an Australian administration.  Among the reasons are:  none of the major parties is united on the need for spending cuts;  the cries to heaven from wounded interest groups will test the will of any politician;  and resistance can be expected from the public servants who would have to implement the cuts (see the Policy Management chapter).  There is no public consensus yet on the need for big cuts in major spending programmes such as pensions, education and health care (while there is one for labour market deregulation).  Such a consensus will have to be built.

6.3 PAYMENTS TO THE STATES AND LOCAL GOVERNMENT

The States depend on the Commonwealth for a large part of their income.  This is a result of the imbalance of financial power in the Constitution, ⁽³⁾ exacerbated by the Commonwealth monopolisation of income tax since the Second World War.  A major disadvantage of this state of affairs is that State governments can take credit for the spending while the Commonwealth government is blamed by the people for the taxation and by the Premiers for not giving them enough.  This division of spending power and taxing responsibility encourages irresponsible government spending in the States.  The desirable principle is that each level of government should as far as possible be responsible for raising the money it spends;  this principle must be given due weight in revisions to the tax system (see the Tax Reform chapter).

Meanwhile, Commonwealth grants to the States should be subject to at least the same restrictions as the Commonwealth's own spending, especially since States' spending and borrowing has increased even faster in recent years than the Commonwealth's.

In the 1986-87 Budget general purpose revenue payments rose by 10 per cent, and specific purpose assistance by 4 per cent.  An agreement has been reached whereby the Commonwealth provides a 2 per cent real increase (measured by the CPI) in financial assistance grants to the States this year and in 1987-88.  It should be noted that most of the States have substantial reserves, some invested in Commonwealth securities.

Tighter restrictions should be placed on State borrowings and the present "global" formula should be abandoned. The 2 per cent growth formula should be terminated.

Commonwealth payments to local government are expected to rise in line with movements in the CPI, although the present formula does allow for some extra increases.  For 1986-87 General Purpose assistance to local government is estimated to rise by 8.7 per cent.

There is good reason to phase out payments to local government and end the Commonwealth's attempts to intervene between State and local government.  Rates and

Local government payments should be reduced by 50 per cent (in the old formula about 1 per cent of personal income tax revenue) in the first year and then phased out entirely over a further two years.

Local governments should be encouraged to contract out many of their services to improve efficiency and to save costs, as should the States.  The comprehensive review of Commonwealth activity by a specially-appointed Minister (recommended in the Government and Administration chapter) will set them a very good example.

6.4 OTHER SAVINGS

The box below shows some of the major savings in other chapters.  'Many lesser savings are possible and worthwhile, but need not be detailed here. ⁽⁴⁾

MAJOR SAVINGS IN OTHER CHAPTERS Government and Administration:  Savings from a fundamental appraisal of government activity and the boundary between public and private sectors will be large but not immediate.  Some early savings will come from programme cuts and departmental mergers. Foreign Affairs and Defence:  Savings from administrative streamlining should be used to increase defence capability. Health:  Concentration is on changes to improve the efficiency of the system, which will bring big Budget savings in future.  Some early savings will come from ending bulk billing, along with changes in the method of calculating Medicare rebates. Education:  Initial savings should come from a 12.5 per cent cut in funding for universities and colleges (fees will make up the difference).  Some of this saving should be ploughed back into scholarships. Welfare:  Initial savings should be made by skipping or reducing one or more indexation adjustments of pensions and benefits, by the amount needed to hit the Government's budgetary targets so that welfare recipients share in the general income restraint imposed on the rest of the community following devaluation.  Changes in other welfare areas will produce lasting savings but not immediate ones.  A major revision of the means test will exempt pensioners from income tax and give the Government the opportunity to shape the system to fit budgetary restraints and provide more effective support to the poorest, besides simplifying the system for administrators and recipients. Housing:  Big savings from termination of the Commonwealth-State Housing Agreement and abolition of the Department of Housing and Construction.  Some of the savings should be ploughed back into Family Income Supplement and Rent Assistance. Transport:  Savings from continuation of cost recovery policies for all modes of transport.  Proceeds of sale of Qantas, Australian Airlines and ANL should be counted as capital, not revenue, and used to pay off government debt and not for current spending. Communications:  Some revenue from an auction system for TV and radio station licences.  Immediate savings from rolling back the ABC's 30 per cent real increase in funding in recent years.

7. CONCLUSION

This chapter can do no more than hint at the long-term dynamic gains that will flow from adoption of Mandate policies, by releasing creative forces for faster economic growth and by harnessing private-sector competitiveness and efficiency for public purposes by careful positioning of the public-sector/private-sector interface (see the Government and Administration chapter).  The short-term cuts will be painful but the pain is necessitated by the severity of the crisis, and will be most felt during the Government's honeymoon period, when its political will and momentum are at their greatest.  Most of the longer-term measures will be comparatively painless thanks to faster growth and increased efficiency.

Savings from the short-term measures should amount to several billion dollars in a full year.  It must be emphasised that the measures are flexible and that in the current crisis the biggest spending programmes must be adjusted to achieve the desired budget outcome.  Depending on the unemployment rate, both as it affects tax revenue and welfare payments, the state of economic growth etc., these measures should be sufficient to wipe out most of the deficit in 1987-88, and put the Government on course to keep its promise of eliminating the deficit in its first term (see the Government and Administration chapter).

Total Government Spending as Proportion of GDP *
* Commonwealth, State and Local Government and public authorities

By then there will be the possibility of a Budget in credit for the first time since the 1960s.  This situation, if supported by cooperation from the States, offers the possibility of a much reduced overall Public Sector Borrowing Requirement, and greater national and international confidence in our economic future and our currency.  Interest rates should fall sharply under those conditions and private sector investment would be stimulated.

In 1985-86 total government sector outlays were 43.4 per cent of GDP.  Fifteen years ago the figure was not much over 30 per cent.  The objective should be to return to figures of that order over the next decade.

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ENDNOTES

1.  This chapter is based on a draft written by Brian Buckley.

2.  The importance of faster growth is explained in the Trade and Industry chapter.

3.  Seen by some in the early days:  "The rights of self-government of the States have been fondly supposed to be safeguarded by the Constitution.  It has left them legally free, but financially bound to the chariot wheels of the Commonwealth ... Every extension of political power will ... go to increase its relative superiority." -- Alfred Deakin, letter in London Morning Post, 1 April 1902.  See also the records of the early Premiers' Conferences.

4.  See B. Buckley, "Controlling Government Expenditure in Australia", Economic Witness, 30 July 1986, for a detailed examination of potential savings in the context of the 1986 Budget.