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Explainer: the role of budget deficits

Explainer: the role of budget deficits

There continues to be a great debate around Australia?s fiscal position.

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By Expert Panel 10.09.2013

By Guay Lim, University of Melbourne

There continues to be a great debate around Australia’s fiscal position. Yet, budget deficits are, in fact, a natural outcome of the business cycle. In a policy brief, co-authored by myself and colleagues Dr Edda Claus, Dr Viet Nguyen and Dr Michael Chua, we argue that deficits are crucial in their function as fiscal stabilisers, and help to counter the negative effects associated with market downturns.

Australia’s public gross debt to GDP ratio of 33% is low compared to other countries. In 2012, the OECD average in 2012 stood at 109% of GDP, and countries with gross debt as a share of GDP in excess of 100% included:

 

Country Debt (as a share of GDP)
Japan 219%
Greece 166%
Italy 140%
Portugal 139%
Ireland 123%
United States 106%
United Kingdom 104%

 

The general reason to be concerned about deficits is that public debt, like all types of borrowings, has to be serviced. Interest is charged on the amount borrowed and interest charges need to be paid to avoid being caught in the trap of borrowing to pay off borrowings. However, servicing the current level of debt is not a problem for Australia, as net government interest payments as a share of GDP has been below 0.5% since 2001.

When considering whether a budget deficit is cause for concern, it is important to remember that budget balances are generally cyclical. Surpluses tend to occur and rise during times of strong GDP growth when receipts are up and government expenditures are down. Deficits, on the other hand, tend to occur and rise during times of economic slowdowns because receipts fall (driven by declines in income tax due to job losses) and expenditures rise (driven by increased unemployment insurance claims, again due to job losses).

Fiscal deficits are thus natural outcomes of business cycles and are important economic mechanisms that help moderate booms and busts. These automatic fiscal stabilisers counter the negative effect of job losses on consumption and mitigate the fall in GDP through increased unemployment and welfare payments.

Another reason to avoid fixation on the size of deficits in an environment of low growth is the potential tension with monetary policy.

In this regard, monitoring the budget deficit is crucial because it is also about monitoring the stance of fiscal policy. Monetary policy in Australia is currently geared towards stimulating the economy. In contrast acting to decrease the deficit in a climate of low growth is equivalent to adopting a tight fiscal policy.

This means that both levers of policy are now working in opposite directions — tight fiscal policy and loose monetary policy. To use the analogy of driving a car – one foot is stepping on the accelerator while the other foot is stepping on the brake! The outcome for the economy, as in a car, is that both actions cancel each other and, just like a car, the longer it is done the greater the likelihood of damage.

Operating a budget deficit is difficult at the best of times, and operating a deficit during an economic slowdown is especially difficult as closer scrutiny is paid to the components of revenues and expenditures. The view presented within our study is one that argues deficits need to be sustainable.

Deficits also reflect fiscal policy surrounding taxes and expenditures and as such should coordinate with monetary policy (not contradict it, as when the stance of fiscal policy is contractionary while the stance of monetary policy is expansionary).

Deficits do not, necessarily, need to be converted to surpluses. Deficits have an important role to play in stabilising the state of the economy by mitigating against unnecessary hardships associated with downturns. Conversely, surpluses are opportunities for safeguarding the economy.

Guay Lim does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

The Conversation

This article was originally published at The Conversation. Read the original article.

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