Attention deficit

It’s apparently really hard for the press gallery group mind to make sense of what the government deficit means. That’s OK, it’s confusing and there are a lot of unknowns. But in the absence of a clear framework for thinking about it, it’s tended to fall into what it thinks it knows: deficits are bad, governments are always waiting for an opportunity to slip into comfortable habits of profligacy, stimulus might seem like a good idea now, but we’ll be paying for it for years, etc. Since most of the deficit is due to a collapse in revenues rather than deliberate stimulus, the line is tempered somewhat, but because the Coalition is insinuating at every opportunity that the deficit, by its very existence, somehow reflects badly on the government, a ridiculous position has to be taken seriously.

Even prior to the deficit predicted for the coming year, the move from a 1.5%-of-GDP surplus in 2007-08 to a likely 2.5%-of-GDP deficit in 2008-09 is the biggest one-year turnaround since World War II. It is indeed a big deal. But unless you think the private sector has been chomping at the bit for more action but was ‘crowded out’ by government – in which case rush your manuscript on the real story of the Great Financial Crisis to a vanity press post haste – an attempt to balance the budget with 4%-of-GDP less spending would have just meant 4% less GDP, or worse, and almost certainly left us with a deficit still, as revenues collapsed further.

Again, government debt is always and everywhere a macroeconomic issue and not something to think about as if government were a household or a firm. There are limits to deficits, but they are very fluid and less tangible than a debt collector at the door or a bankruptcy court. They are macroeconomic limits, not balance sheet limits.

What makes the issue so confusing, besides sheer unpredictability, is that it has two relatively independent sides. There’s the problem of aggregate demand, unemployment and inflation, and then there’s the distributional problem of who’s paying in real terms in the long run.

The first side involves the question of how much the government can borrow, because if it gets into difficulties there it has to cut spending, which could aggravate the downturn. The Treasury comes to market as if it were a normal borrower, though the interest rates it pays are lower than the private sector on account of the certainty of repayment. The bond market is fairly global, so the yield on government bonds depends on global conditions. The ‘limit’ to borrowing doesn’t appear as a point where the government suddenly finds it can’t sell its bonds; rather, it manifests through higher interest rates. The stock of government debt ultimately determines the supply of government bonds, though the term make-up of the bonds (i.e., how many are 3-, 5- or 10-year bonds) may vary. (However, even in the years when the Commonwealth government had pretty much completely paid off its debt and was consistently running a surplus, it continued to maintain a $50 billion supply of bonds, because of their importance as an asset to the financial sector.)

Demand for Australian government bonds depends on the demand for government bonds as a whole, and on how bond-buyers rate the Australian government bonds relative to the debt of other governments. Though the government is pretty certain of repaying its debt, movements in the Australian dollar relative to other countries change the effective return, so expectations about the future value of the currency make a difference to the present demand for Australian bonds.

So there are two things at play here: how much demand is there for government bonds, and how is Australian government debt rated relative to that of other governments? The answer to the first question is, lots but it has started to fall, and to the second, pretty well so far. Ever since the credit crunch began, investors have piled into government debt and away from private sector debt. Consequently, the price of government bonds has risen and therefore the yield has declined. Here is a chart made from Reserve Bank data showing the yields on Australian government bonds: they have fallen 2 to 3 percentage points compared to the 6 per cent average that has prevailed since the taming of inflation in the 1990s. (The spread between 10-year and 3-year bonds has also opened up, reflecting the expectation that in the long run rates will rise again.)

Notice, though, that there has been an uptick this year, reflecting both the huge amount of government debt around the world flooding onto the market, and to some extent the beginning of a shift in demand back to private bonds. There have been reports of ‘horrible auctions’ in the US, UK and Europe where governments have not been able to sell what they wanted at the price they wanted, but that doesn’t mean they haven’t been able to borrow, only that they have to do it at a higher interest rate. Inevitably investors will move back towards private lending and government bond yields will rise, but at present they still enjoy an historically-low cost of borrowing, and it seems highly unlikely that private borrowing will reach pre-crunch levels any time soon.

There is a continual rumble in the press about the potential for Australia’s government deficit to take us into ‘banana republic’ territory. This reflects a myopia – endemic to Australian political culture – of the same kind that sees the Whitlam government represented as to blame for the stagflation of the 1970s. In both cases, the crisis is global, and at this point in time Australia is relatively well-off. Treasury and the Reserve Bank are now projecting that the ‘worst crisis since the Great Depression’ will be milder for Australia than the recession of the early 1990s. This may be optimistic, based on projections of a quick recovery in China and elsewhere. But when it comes to financial markets, perceptions matter, and presently the market is rating Australian debt highly.

People (like Bernard Keane in Crikey) who are laughing about Rudd accepting vindication from the same ratings agencies he was so scathing about vis-a-vis their bubble ratings miss the point entirely. The ratings have power, whether they’re rational or not. It’s true that government finances are always held hostage by capital, which is prone to irrationality, and which, at its most rational, keeps a tight rein on the political possibilities. (Jeopardise the exchange rate or look like you’re going to spark inflation, and bam.) A few variables a percentage point or two the wrong way, and things would be looking very different, as they are in many parts of the world. But that’s capitalism, and that, of course, could not make it into the narrative structures of the faux-cynical Canberra press gallery or the business press.

The second side of the whole thing is distributive. Much of the fall in government revenue is a consequence of the evolution of the tax structure during the resources boom which left the finances structurally dependent on abnormally high minerals prices. It’s not just a cyclical development that will be automatically reversed by an upswing (unless commodities prices go crazy again). Exacerbated by inevitable pressures to pay down the debt, and the slowly-erupting volcano of superannuation, a good old-fashioned distributional struggle is upon us over what gets cut and/or who pays more tax. But I’ll leave that for another post.