Monday, November 24, 2008

Government budget deficits - cyclical versus structural: lessons from the 1970s

There is considerable discussion in Australia at the present time about the Australian Government's apparent reluctance to run a budget deficit. There is also criticism of the Government's apparent desire to still cut costs at a time of downturn. To a degree, the discussion confuses different issues.

The first key thing to note is the difference between cyclical and structural deficits.

In simple terms, a cyclical deficit comes about because revenue rises and falls with changes in economic activity. With given spend, the budget is in surplus at one point, then goes into deficit, then comes back into surplus. This provides a cushioning effect. Counter cyclical spend fits within this definition because it is specifically time limited.

A structural deficit is different. Here changes to the pattern of revenue and expenditure occur such that a deficit appears independent of the level of economic activity, continuing even at times of higher activity.

The 1970s saw the end of the old concept of the welfare state. One reason for this was that Government spending patterns in many countries ended up with specific built in features that ensured growth in spend faster than could be supported by the longer term trends in economic activity. This could not be accommodated through increased taxation, leading to persistent structural deficits. This crowded out private sector activities and helped build in inflation.

We do not want to go there again. So the issue about deficits is not just the immediate impact, but also the nature of the deficits themselves. We need to avoid the creation of structural deficits.

This leads me to my second point.

The need to control spending, to get the best value from Government spend, continues independent of the state of the economic cycle. We need to prune fat just as much during downturns as at other times. More so in fact, because in this type of downturn financial disciplines can easily become relaxed. Further, Government has a continuing need to re-set priorities as needs change

Pruning spend has an economic impact. In times like this, every dollar we save is simply a dollar that we can then spend in another way.

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