Deutsche Bank has a radical proposal for fixing Australia’s budget problems

There’s never been a more exciting time to be an Australian federal treasurer.

This would particularly be the case if you were to follow the advice of Deutsche Bank’s chief economist in Australia, Adam Boyton, who believes the federal government could embark on a radical path of deploying fiscal tightening – most likely through cutting spending – when the economic circumstances permit, rather than waiting for the annual budget.

It raises the prospect of the government announcing significant spending cuts – or, conversely, tax increases – in response to improved economic data, dramatically speeding up the fiscal policy cycle.

Here’s the basics, outlined by Boyton in a note to clients today:

… instead of relying solely on interest rates to cool the economy when it starts to grow above trend over coming years, the Federal Government could instead state its intention to tighten fiscal policy once growth had lifted further or the unemployment rate had fallen sufficiently.

Such an approach means fiscal policy settings could rely less on longer-term forecasts and instead respond more flexibly to economic developments.

After all, the Reserve Bank Board doesn’t just meet once a year to set interest rates. Why should fiscal policy be a once a year set and forget?

Of course Australians are used to mortgage rates going up when the economy picks up – and vice versa. It’s been quite a while since fiscal policy has been used this way. And proposals to change either taxes or spending at some point based on the performance of the economy might leave some households or businesses worse off. But interest rate increases also leave some households or businesses worse off than others.

Federal Treasury and governments have been besieged in recent years by the nature of the budget process being tied to political expectations of delivery against targets. Missing targets has been characterised by oppositions, both Labor and the Coalition, as a sign of economic incompetence, when the truth is more complicated.

With Australia’s export-based economy and increased volatility in the global macro environment, budget targets have become moving targets. The unexpected deficits of recent years have, in particular, been driven by collapses in commodity prices which in turn were driven by the slowdown in China and the global economy more broadly. (See: REMINDER: Some key assumptions in Joe Hockey’s budget are now completely wrong.)

At the political level there have been obstacles to responsive changes to the economic environment, ranging from budget dogma to a volatile Senate crossbench. This is part of what Malcolm Turnbull is trying to address by promising more agile government.

Governments already enjoy the upside of a better-than-expected improvement in the economy through improved company and personal income tax receipts as businesses perform better and create more job, and the natural corollary of reduced unemployment benefits.

What Deutsche Bank is suggesting, however, is giving the government the licence through a revamped budget process to magnify this impact over shorter time-frames.

Boyton declines to offer specifics on what areas could be targeted, saying “that would ultimately be a matter for Government to decide”, but he does offer a time frame: two years from now.

“With a period of above trend growth likely to be some time away – the Reserve Bank’s most recent forecasts suggest about 2 years – the Federal Government would also have the luxury of some time to negotiate now any future package of measures with minor parties and independent Senators,” he says.

The fiscal tightening effect would also have the effect of reducing pressure on the RBA to increase interest rates, because the government lever would be doing the job.

Finally, allowing fiscal policy to play a more activist role need have no impact on the Reserve Bank’s independence or the Bank’s 2-3 per cent inflation target. After all, given that fiscal stimulus measures haven’t impacted the Bank’s independence or the inflation target; there is no reason why a fiscal tightening should. Of course if fiscal policy was to be tightened when the economy strengthened that would limit how far interest rates might need to rise.

To be sure using fiscal policy in a more activist way is certainly a departure from current thinking. However given the sizeable budget deficit, the continual delays in returning to surplus and some risk to Australia’s AAA credit rating; perhaps a change in thinking is warranted.

The budget process certainly has some problems. Here at least is an idea to tackle it.

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