The welfare state is not to blame for the Euro crisis

Bob Carr wrote a strange post advancing the conservative canard that the Euro crisis is a crisis of the welfare state, caused by high taxes and/or welfare spending as a proportion of GDP. He’s wrong.

A ‘tax reform commission’?

A persistent theme at the Tax Forum was the call to create an independent tax reform commission. I am deeply wary of such processes which purport to take the politics out of an inherently political topic, for much the same reasons as I am not comfortable with proposals for a strong-form Parliamentary Budget Office (though I think the more limited model that the bipartisan Parliamentary committee advocated is eminently sensible).

Did the stimulus work?

John Howard’s biographer, David Barnett, has a piece in the Drum today arguing against the use of fiscal stimulus in recessions and against Keynesianism in general. Setting aside the philosophical and theoretical arguments he makes, I’d like to examine his empirical claim, namely that fiscal stimulus has not worked, and the somewhat peculiar methodology by which he comes to this conclusion.

Barnett writes:

“It hasn’t worked…. In Australia, unemployment has just gone up, instead of down. At 5.4 per cent it is more than a percentage point higher than it was when the Howard-Costello government went out of office. That is around another 130,000 people without jobs.”

He knows, or should know, that the appropriate comparison isn’t between what was and what is, but rather between what is and what otherwise would have been. To assess the efficacy of a particular course of action we need to know the counterfactual: what would unemployment be today if the government had not implemented its fiscal stimulus? Economists can and do differ about the answer to that question, but to evade it entirely by making a comparison between 2007 and 2010 and thereby imply that all other things remain equal is disingenuous at best.

Interestingly, though, Barnett seeks to establish a counterfactual of sorts by drawing a comparison with Canada. He praises the Canadian Government, saying “Canada did not stimulate. The Canadian government responded to the GFC by cutting back on its expenditure. Canadian exports rose”. Notice how he shifts the goal posts, using exports rather than unemployment as the metric to evaluate the efficacy of macroeconomic policy.

Nevertheless, his argument about Canada provides us with the opportunity to follow Barnett’s own chosen methodology by comparing 2007 (pre-crisis) unemployment with present unemployment and imputing the difference to a failing of public policy. To be clear, I think this approach is not particularly useful, but Barnett seems to be of the view that it is appropriate, so we will follow it.

If we follow this approach, we see that unemployment increased by a greater amount in Canada than in Australia, off a higher base, both in absolute terms and as a proportion of the labour force.

	Unemployment rate – November 2007	Unemployment rate – October 2010	Number of additional unemployed people
Australia	4.5%	5.4%	141 700
Canada	5.9%	7.9%	417 500

So, on that measure, it certainly seems odd to suggest that a simple comparison of pre-crisis and post-crisis macroeconomic aggregates in Canada and Australia demonstrates the folly of fiscal stimulus.

But what if we accept Barnett’s suggestion that it is international trade that should be the barometer of policy success or failure? Well, our balance on goods and services (our exports less imports) looks pretty healthy to me:

 

The Wire and horizontal fiscal equalisation

Like most people I know, I’m obsessed with the Wire. I’ve watched the entire five-series set from start to finish twice, and I’m itching to do it again. One of the strengths of the show is the way it manages to make extremely powerful political points in a subtle way – characters don’t give moralising sermons that are directed at the audience. Instead, we’re left to see for ourselves how the interconnected web of rotting institutions that comprise David Simon’s Baltimore conspire to keep its citizens down.

One of the more heartbreaking storylines concerns the Baltimore school system, which is depicted as a bleak, bureaucratic wasteland in which talented students, teachers and administrators labour in vain to overcome the inherent limitations of the system. A big part of the problem is simple: money. Specifically, they don’t have enough of it.

The school system’s lack of money, in turn, is due to the structure of the American tax system. In the US, a lot of the functions of government like education are devolved to the local level. The amount of money that’s available for schools, police and all the other vital functions of government therefore depends on the amount of tax revenue that the local government is able to raise. That means that poor areas, in which few people work and there are no significant businesses, can’t devote much money to these services, simply because the tax base isn’t there. Thus begins the horrible vicious circle in which poor areas stay poor.

In Australia, we’ve sought to overcome this problem by equalising the funds available between states. The idea is that each state or territory should have enough resources to fund an equal standard of government services, so that citizens can expect decent schools and hospitals no matter which state they happen to live in. This principle is known as “horizontal fiscal equalisation” and it underlies the Commonwealth Grants Commission’s calculations of the share of GST revenue that each state will receive. Formally, the CGC defines horizontal fiscal equalisation as:

a distribution of GST revenue to State governments such that, after allowing for material factors affecting revenues and expenditures, each would have the fiscal capacity to provide services and their associated infrastructure at the same standard, if each made the same effort to raise revenue from its own sources, operated at the same level of efficiency and maintained the average per capita net financial worth.

Behind that dense, nearly impenetrable fog of bureaucratic obfuscation is the simple idea that all Australians should be able to expect decent government services. In practice, this means that wealthier areas, which can derive a lot of extra revenue from activities like mining, transfer funds to states without the same ability to raise their own revenue. The Northern Territory is the prime recipient state, but Tasmania and South Australia both also receive more GST revenue than their citizens pay.

With the mining boom in full swing, the West Australian government is able to raise a lot of revenue from mining royalties, as well as from increased payroll taxes and stamp duties. That means that its citizens pay more in GST than the state receives back from the Grants Commission, as some of the funds are sent to the Northern Territory and elsewhere.

Colin Barnett, the WA Premier, does not support this system. He has suggested that WA’s diminishing share of the GST funds could incite a “Tea Party style revolt” in the West.  Let’s set aside the fact that WA still received more GST revenue than its citizens paid as recently as 2005/06, when the rivers of royalty gold were already flowing strongly into State Treasury’s coffers. Let’s also forget the inconvenient truth that the Grants Commission and the principle of horizontal fiscal equalisation were created for WA’s benefit when the state was a struggling economic minnow back in the 1920s.

Barnett’s position is morally reprehensible not just for its hypocrisy, but for its callousness. The notion that there should be a special deal to allow WA to retain a greater proportion of its GST payments would imply, necessarily, that WA residents would be entitled to expect better quality schools and hospitals than residents of poorer states. Poor kids in the Northern Territory or Tasmania would have a lower quality education than citizens lucky enough to be born in WA, thus further entrenching and amplifying regional inequalities in future generations.

It’s this sort of ruthless indifference to poorer areas that underpins the American approach, illustrated so vividly on the Wire. I’m not claiming that a recalibrated Commonwealth Grants Commission funding formula would lead us to a situation like Simon’s Baltimore, but I am suggesting that any deviation from the principle of citizens’ equal entitlement to government services would be a disastrous and repugnant step, however tentative, in that direction.

Until January this year, I had never lived anywhere other than Perth. It’s a great city and a great state, but the collective indignation about the state’s share of GST revenue is unedifying and does the state no credit.

The IMF makes sense

In recent days the IMF has publicly argued that “markets need to end their addiction to credit ratings”. They suggest:

[t]he real solution lies in reducing the reliance on credit ratings as much as possible. This should start with removing the mechanistic use of ratings in rules and regulations, which some countries are already beginning to do. Investors must be weaned off credit ratings too. Policymakers should persuade the larger ones, at least, to perform their own risk assessments as part of deciding what to buy or sell.

I wonder what our State governments will make of this advice, given that they behave as if their sole task is to maintain the public balance sheet in a state that will please Standard and Poors.

The IMF has also examined the evidence in favour of fiscal austerity, assessing when and to what extent governments should begin to repair their balance sheets in the wake of a recession. They end up finding that fiscal contractions are contractionary, and fiscal expansions are expansionary, a vindication of Keynes. This might seem obvious, but it’s far from the ‘Washington Consensus’ view imposed on various nations throughout the 1990s.

The results suggest that recessions associated with financial crises tend to be unusually severe and their recoveries typically slow. Similarly, globally synchronized reces- sions are often long and deep, and recoveries from these recessions are generally weak. Countercyclical monetary policy can help shorten recessions, but its effectiveness is limited in financial crises. By contrast, expansionary fiscal policy seems particularly effective in shortening recessions associated with financial crises and boosting recoveries.

I’m not sure what has happened to the IMF, but this sudden rash of common sense is definitely a good sign.

An independent budget office?

The idea of an independent budget office has been gathering steam for a while. Nicholas Gruen has been a long-term advocate of the creation of such an office, as has Christopher Joye. The controversy about the process of costing parties’ policies under the Charter of Budget Honesty has caused the argument to flare up, with the libertarian twosome Chris Berg and Sinclair Davidson joining in the calls for a budget office that reports direct to Parliament.

As I see it, there are a few different (perhaps complementary) conceptions of the role of such an office, in ascending order from the ‘weakest’ to the ‘strongest’:

1. it could be responsible for costing parties’ policies in an election campaign;
2. it could be an alternative source of economic and fiscal forecasts and projections, allowing us to evaluate the veracity of the Budget;
3. it could appraise the likelihood that fiscal balance targets will be met given prevailing Government policy settings;
4. it could be responsible for adjusting parameters (like tax rates) up and down in response to the business cycle, much like a fiscal equivalent of the RBA’s role in monetary policy; and/or
5. it could set fiscal parameters within which the Government of the day must operate, for example stipulating a fiscal balance target.

So, a Parliamentary Budget Office (PBO) could be anything from a modest institution that performs independent costings through to a bureaucracy that would have the effective power to overrule the Government of the day. Most commentators seem to favour the creation of an office at the ‘strong’ end of that spectrum.

I think that would intolerably undemocratic.

I can see the benefit of an institution at the ‘weak’ end of the spectrum. The Charter of Budget Honesty seems to entrench the benefits of incumbency, allowing the Government of the day to have its policies costed by Treasury and Finance in private prior to the election being called, and then submit those same policies back to the public service to confirm the veracity of their own costings. Oppositions, on the other hand, have virtually no chance of developing policies that are as rigorously costed as the Government’s, because they lack access to the models of the Australian economy and the tax-transfer system that Treasury and Finance rely upon. I should note, in passing, that I have little sympathy for the current Opposition, as it was the Coalition that introduced the Charter of Budget Honesty and used the asymmetry it generated as a political weapon against the then-Labor Opposition at successive elections.

So, option 1 seems reasonable to me. Parties would be free to have their policies costed, without having them publicly disclosed, by the PBO prior to an election being called. This would allow them to refine their policies and amend their costings prior to public release. Then during the campaign, parties could choose to submit their policies to the PBO and have their costings released. I would strongly favour this remaining voluntary, as it is under the existing Charter for Budget Honesty. If voters wish to choose a party that has not publicly released independently-verified costings then they should be free to do so. Parties that choose not to participate in the PBO process will be crucified by the media and will suffer an electoral penalty as a result, so I think this is a sufficient incentive to encourage full participation by all viable parties.

Paul Kelly seems to also  favour a weak-form PBO that would “operate as an independent entity set up by statute servicing the parliament and estimates committees and providing costings during the campaign period”. Option 1 is fairly uncontroversial.

I don’t have any major philosophical objections to option 2, a parallel forecasting office, provided its role remains purely advisory. It could conduct its own forecasts of macroeconomic aggregates, from which forecasts of Government revenue and expenditure could be derived. It would provide these forecasts to Parliament and to the public, and we could have a public debate about the veracity of the Budget. Fine. I do think that perhaps this could end up being a glorified make-work program for economists and public finance experts. We already have two public institutions (Treasury and the RBA) that generate forecasts of future economic performance.

Would it be better to simply require that the RBA make public, as part of its Statement on Monetary Policy, a fuller range of forecasts of macroeconomic aggregates for the next four years? It currently publishes forecasts of GDP and non-farm GDP growth, as well as CPI inflation and underlying inflation. It could extend these beyond the two-year time horizon, and supplement them with a wider range of forecasts for things like WPI, household consumption, private business investment, final demand, exports, imports and so on. It presumably already maintains these forecasts. Releasing them would be a lower-cost option than creating a new economic bureaucracy.

I don’t support the stronger end of the spectrum, options 3 through 5. They threaten the power of the democratically elected Parliament to an extent that is unacceptable to me.  Nicholas Gruen, on Twitter, said “it doesn’t erode democracy any more than property rights or courts do. Democracies come with structures, this is one such”.  I disagree. Clearly he’s right that we have all sorts of institutional and constitutional checks on the will of the democratic majority. I disagree that the creation of a body that would have the potential to veto Government spending, or adjust tax rates, or set the overall fiscal goals of the Government, would be only a minor erosion of the sovereignty of the Parliament.

Supporters of a strong-form PBO might at this point exclaim “aha! but we already have an independent monetary policy authority! Is that not anti-democratic, too?” Clearly it is, to some extent, but I am willing to tolerate it. I don’t regard monetary policy as being as central to the business of elected Government as taxing and spending. I also believe that monetary policy is more easily devolved to a technical, bureaucratic institution, given that it effectively has one target (underlying inflation) and one policy lever (the overnight cash rate). Fiscal policy is much more complex, and setting fiscal parameters involves choosing between a range of competing economic ends, like reducing unemployment vs reducing the deficit.

The whole idea seems to imply that the conduct of fiscal policy can be independently, objectively assessed in some way, that there is some non-ideological set of ‘correct’ policy prescriptions. What would a PBO say in the event that we faced the situation prevailing in the US, Japan and much of Europe, with large budget deficits, weak growth forecast and deflationary fears? Would it advocate deficit reduction, or renewed stimulus? Both of these opposing options are advocated by respected economists, so which way would the PBO fall? It’s my strong argument that choices like these should be the province of elected representatives relying on expert advice, not bureaucrats. Macroeconomic policy-making is not an infallible science, it is inherently political, and it aggravates me to see it represented otherwise.

EDIT: In the original version of this post I implied that Sinclair Davidson would favour a system in which the PBO could disallow political candidates from office. Professor Davidson has made no such suggestion. I withdraw the comment and apologise for it. See the comments for further explanation.