The Death Spiral

There are times when one can’t help feeling sorry for the government. After two years of framing economic policy to please the credit rating agencies – last year’s budget was virtually dictated by Standard and Poor’s – their reward has been a warning last month that our credit rating is on negative watch.

That blow has been followed by the revelation that the government’s deficit has blown out by $2 billion more than forecast. This intrusion of economic reality may not be welcome but it has been salutary.

The government’s response so far to these twin developments has been to maintain a stiff upper lip, and to continue to target a return to surplus by 2016. Others have not been so restrained. The air is thick with urgings – from the Reserve Bank, the Treasury, the Business Roundtable, and not least the Herald’s own leader-writers and columnists – that the government’s deficit must be cut and cut faster.

It is hard to see these warnings as anything more than a knee-jerk reaction to what people think they heard, or wanted to hear. They see or purport to see a substantial connection between the threatened downgrading of our credit rating and the size of the government’s deficit.

A careful reading of Standard and Poor’s statement, however, reveals that the government’s deficit (which remains perfectly manageable by international standards) played only a minor part in their expression of concern about our credit rating. Their focus was on the country’s external deficit – our propensity to finance an inflated consumption by borrowing from overseas.

It is true that the government’s deficit is an element in the country’s overall deficit but it is not the element that is of particular concern to S&P. What worries them – and they are quite explicit about this – is that, if and when a substantial recovery finally materialises, our appetite for imported consumer goods will re-emerge with a vengeance and we will be back to our bad old habits of borrowing to finance a persistent trade deficit.

The real import of their warning is that they see nothing in our current policy settings to suggest that we will avoid this all too familiar outcome. They fear that any revival in economic activity will see the application of the decades-old “remedy” of high interest rates leading to a yet higher dollar, with consequent damage to savings and exports while we binge on artificially cheap imports. Sooner or later, they warn, the willingness of overseas lenders to fund this rake’s progress may be exhausted.

But, say the deficit hawks, the external deficit, our poor savings record, and the narrow base of our export sector – all of which are fingered by S&P as causes for their concern – are problems for the future. Surely – whether S&P say it or not – the one thing the government can do to help is to get its own deficit down faster than planned, even if that means painful cuts that might impact the most vulnerable?

Let us be clear. All other things being equal, it would clearly be beneficial for the government to eliminate its deficit as soon as possible. And the government is quite right to seek savings in respect of public spending that may be wasteful or poorly directed.
But if cutting the deficit is the first and over-riding priority, we need to be sure that it would produce, in today’s context, the desired outcomes – and it is a pity that this realisation did not dawn before the government’s finances were further weakened by tax cuts that mainly benefited the better off.

But there is no evidence that simply taking the axe to government spending would help matters. The main reason for the government’s increased deficit is that tax revenue – already depressed by the recession – is much lower than forecast, and that in turn is a direct consequence of the slowness of our economic recovery. To cut government expenditure, thereby further depressing demand and eventually tax revenue, is not the most obvious solution to this problem.

The paradox is that, as many of us warned at the onset of the recession, the greater the priority and urgency given to cutting the deficit, the more persistent it is likely to be. The most effective course for a government worried about its deficit is – while maintaining proper controls over potentially wasteful spending – to play its part in ensuring that the level of economic activity rises.

As it is, we are in danger of getting caught in a downward spiral. Our export income is being depressed by the high dollar. The consumer is facing higher fuel and energy prices and the threat of continuing job losses, and uses any margin of spending power to pay down debt. The business sector is struggling with inadequate demand and therefore keeping tight tabs on employment and investment plans. If the government, too, cuts its spending further, where is recovery to come from? And how do we ensure that recovery, when it comes, does not take us straight back – as S&P warn that it will – to the problems that have dogged us for decades?

Bryan Gould

15 December 2010