Debt’s day of reckoning is coming
A reality check is due any day now, and word from Canberra’s insiders is it will be a ‘rude shock’ to a reform-shy political class.
The federal budget has virtually receded from public attention, yet there’s a long tail of what one observer described as the “triumphalism” of Josh Frydenberg’s May 11 speech. Amid a tumble of strong economic data, the Morrison government’s yearning for validation, from front pages to credit watchers, endures.
The economy is bigger than it was pre-pandemic. More people are in work, too. But in case you missed it, the government launched another phase of its “Our Comeback” advertising campaign to tell us how far we’ve come and why.
Short answer: $291bn in direct economic support. Future taxpayers, thank you for your service.
At some point, today’s consumption is going to show up in higher taxes or lower incomes, or both, because we haven’t adequately planned for or invested in our future, such is the opportunity cost of stimulus. That’s even before we consider spending quality.
But a reality check is due any day now, in the form of Treasury’s fifth Intergenerational Report (IGR), which Peter Costello instituted as part of the Charter of Budget Honesty in 1998. Word from Canberra’s insiders is the IGR will be a “rude shock” to a reform-shy political class, as it outlines the fiscal task confronting an ageing nation over 40 years.
This week, Productivity Commission chairman Michael Brennan warned against “fiscal complacency”. While Brennan believes budgetary settings are appropriate, for now, he fears there could be policy backsliding if a free money sentiment takes hold.
Scott Morrison is not hiding his joy about the expansion, three quarters old. “Australia is stronger today than before the Covid pandemic hit,” the Prime Minister said on Tuesday after S&P upgraded the nation’s AAA credit rating.
Stronger? The value of your home has gone up, most likely your superannuation balance. Maybe you’ve built up savings, with estimates of $130b squirrelled away over and above what we usually save.
But Australia’s net debt has increased to an estimated $618bn. Another four years of deficits will add $342bn to the tab. There is a loose consensus this is fiscally sustainable, at least in the short run.
In a post-budget speech to the Australian Business Economists group last month, Treasury secretary Steven Kennedy said: “Sustainable fiscal policy needs to balance the use of our resources across time and generations. It involves weighing the cost of servicing and reducing debt in the future versus the benefits of deploying those resources today.”
The 2002 IGR stated that good policy “ensures future generations of taxpayers do not face an unmanageable bill for government services provided to the current generation”.
After being delayed by Covid-19, the IGR will reveal longer-term cost pressures, such as our ageing population, against a projected $1.6 trillion gross debt over the next decade alone.
“We must manage public finances in a way that puts the highest priority on maximising the long-term performance of the economy. Australia has reduced its debt-to-GDP ratio from higher levels in the past,” Kennedy told the economists.
“The key to doing so was a strong economy, restrained government spending and supportive economic reforms. It is worth noting that even when deficits are being used to support economic growth, the quality of decision making is crucial. The cost of wasted spending is no less in a deficit than it is when a surplus is present.”
Yet budget repair is on hold. Frydenberg’s strategy is to get unemployment down to 5 per cent, make sure the recovery is locked in and then, in the second fiscal act, get serious about trimming spending so it is closer to a revenue cap of 23.9 per cent of GDP. The rationale is that as long as the economy keeps growing at a faster rate than interest rates, debt is manageable.
But experts and ex-officials are worried about how we’ll sustain output growth, generate wage rises, keep a lid on public spending, and the ability of our political class to pursue reform policies.
Martin Parkinson, former secretary of Prime Minister and Cabinet and Treasury under five prime ministers, sees a disconnect between the leaders of the “reform era” and incumbents.
“Today’s political class have forgotten, or never bothered to learn about, the contribution of Hawke and Keating, Howard and Costello, whose reforms made Australia more internationally competitive and resulted in almost three decades of uninterrupted growth,” says Parkinson of an era that gave us more productivity growth and dramatically higher living standards. “In contrast, over the past decade, the political class has sat idly by as our productivity performance has wallowed.”
Parkinson says we knew a decade ago, via IGRs and speeches, that the people-based drivers of economic growth – participation and population – had been exhausted. Lifting productivity through structural reform was the key, both for aggregate growth and living standards.
“Instead, today we seem to be being told that structural reform is a ‘vanity exercise’,” Parkinson says of the way Morrison framed large-scale changes in his first major speech of the political year. “Well, if reform is a vanity exercise, it’s a vanity exercise to want to improve the living standards of Australians.
“I don’t think any politician would be prepared to say that explicitly, but that is the implicit message of their dismissal of the need for reform”.
The chancellor of Macquarie University says because of the pandemic we’ll have a population that, in a decade’s time, will be one million smaller than expected, with weak productivity growth, a slower economic growth rate, a smaller economy and a larger debt burden to be serviced by fewer workers than we could have imagined 18 months ago.
“Part of the problem is that reform has been reduced to changing the tax system and industrial relations,” he says. “The real reform areas are around fostering innovation and entrepreneurship and finding ways to grow world-competitive businesses.
“We also need to think about how we digitise the economy, give people incentives to invest and take sensible risks, how to rid ourselves of unnecessary regulatory burdens, some of which have arisen due to the heightened focus on national security, but all of which can throw grit into the mill and undermine our economic prospects”.
PC chief Brennan sees two dark clouds on the horizon. The first is the renewed promotion of ideas of national self-sufficiency and sovereign capability coming out of the pandemic. It’s an old song, with a new voice. The second is an “overly sanguine view” about ever-expanding debt and deficit.
“Effectively that government can and should go yet further with fiscal expansion in more normal economic times at no effective cost,” Brennan told the Committee for Economic Development of Australia. If inflation did re-emerge, or if bond yields exceeded nominal growth for a period, Brennan said we would need a fiscal consolidation.
He said budget repair was hard in practice because spending proposals tend to look attractive individually, but they add up to an unattractive and unaffordable total. As well, he noted future taxpayers were under-represented by today’s voters. What have our grandchildren ever done for us!
In the budget papers, Treasury tells us there will be a speed limit on growth, with the two-year pause to migration the major factor in near-zero population growth. In October, the Treasury chief said lower population growth needn’t lead to lower income per person.
“However, a smaller and older population may require governments to reconsider how taxation is raised to support essential services,” Kennedy told a Senate committee.
The 2015 IGR was framed with the Abbott government hellbent on budget repair, having mercilessly campaigned to end Labor’s spending waste and new taxes.
That IGR was a political beast in Treasury clothing. “We are living beyond our means,” the report said of the $100m-a-day shortfall. Oh, to have such cheap government!
An older population would see per capita health costs double in real terms, driven by rising technology costs. Based on a “previous policy” scenario (ie, before Joe Hockey’s “horror budget” of 2014-15) spending would have reached 37 per cent of GDP by the end of the 40-year period.
“If left unchecked, this would mean drastic future cuts to payments, higher taxes, or both,” the report said. Scary stuff, with gross debt reaching 125 per cent of GDP, or $5.7 trillion.
The previous IGR projected GDP growth of 2.8 per cent over the coming 40 years, compared with 3.1 per cent for the previous 40 years. Workforce participation would ease, as would productivity growth after the golden age of the 1990s.
“Over the next 40 years, ongoing improvements in Australian living standards will remain primarily contingent upon continually improving our productivity and require us to take every opportunity to increase participation rates,” the 2015 report said.
Participation rates are at a record high, but productivity growth has slumped. What will the IGR show? A recent Treasury working paper by Linus Gustafsson found the aggregate trend participation rate is projected to fall by more than three percentage points from 2020 to 2060.
Another set of clues is in the NSW IGR released this week. The state’s population is projected to grow by 40 per cent to 11.5 million in 2061, with the median age rising from 38 to 44, as families have fewer children and people live longer, healthier lives.
“As natural population growth slows, migration will become increasingly important for population growth and for slowing population ageing,” the report said. There will be 2.4 people of working age for every person aged 65 or older, compared with 3.9 today. Rising health costs will eat more of NSW’s budget, from 29 per cent to 38 per cent in 2061. Education spending is expected to fall from 22 per cent to 18 per cent.
These dynamics, with spending outpacing revenue growth, lead to a fiscal gap of 2.6 per cent of gross state product (although this excludes earnings from NSW’s sovereign wealth fund).
NSW Treasurer Dominic Perrottet says the IGR “calls out problems we face decades before they may eventuate”. “It’s very clear we need to act now to not just physically inoculate ourselves from Covid-19, but also from the economic consequences of the pandemic,” he tells Inquirer.
“NSW is one of the very few sub-sovereign jurisdictions in the world to have set up a wealth fund for its citizens.”
The NSW Generations Fund is expected to reach $430bn by 2061. “This provides a substantial guard against debt levels for future generations,” Perrottet says.
“Demographics don’t lie. What is clear is that driving productivity growth and participation rates will be areas of increasing importance for every state and the commonwealth.”
Perrottet has championed reform of stamp duties, which he argues promotes home ownership and could boost the economy by billions of dollars by making it easier and cheaper to transact property.
“The states have the most scope for reform, but one thing holding us back is a federal tax system that penalises progress, especially the GST carve-up,” he says. “NSW is ready to do the heavy lifting, but we could overcome future challenges a whole lot faster with support from the federal government that incentivises reform, rather than penalises it.”
Parkinson argues that the way the fiscal strategy is framed over the next 10 years, the economy has to grow, without being hit by any negative shocks. Any extra spending, not already in the budget, has to be offset.
“Our nominal growth rate has to be above the interest rate. Are all of these likely to hold over the next decade? I’d argue that it’s not likely,” he says.
“Whoever wins the next election will have to rein in the debt stock and build up the fiscal buffers. We needed them in this crisis and we’ll need them for the next one, but we start with net debt at around 40 per cent of GDP. Sure, other countries have higher levels of debt but that’s not the right comparison for us.
“The right benchmark is do we have the right flexibility to act in a crisis? We have to be efficient, adaptable and flexible, and have adequate buffers. I’m not suggesting we have to do fiscal consolidation in the next few years. But if you have a political class that comes to believe that there is no budget constraint – that debt and deficits are not a problem, and they can spend whatever they want – at some point there will be a reckoning.”
We’ll soon learn how serious Morrison and Frydenberg are about project future, which is never a vanity exercise, no matter when an election is due, who is in power, what the price of iron ore is, or how cheap borrowing money appears to be.
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