Speeches

Address to the John Curtin Institute of Public Policy

5th May 2009

Thank you Professor Kristjanson (Acting Vice Chancellor, Curtin University of Technology) and thank you Professor Phillimore (Executive Director, John Curtin Institute of Public Policy) for your kind remarks.

It is a pleasure to be here in Perth this morning to deliver the keynote address to the John Curtin Institute's Public Policy Forum.

Today, I am going to speak about the global economic crisis and its implications for Australia's public finances – in particular, the impact of budget deficits and public debt. I will also welcome the opportunity to answer questions following my remarks.

I thought I would start with a few observations about John Curtin.

In my view, Australia's war-time Prime Minister had three lasting achievements: first was his declaration in December 1941, following the surprise Japanese attack on Pearl Harbor that, "Without any inhibitions of any kind I make it quite clear that Australia looks to America, free from any pangs as to our traditional links or kinship with the United Kingdom."[1]

With that statement Curtin set a new course for Australia's long-term national security. Australia would henceforth look to the emerging superpower, the United States, as its prime ally in an uncertain and dangerous world.

This policy has served Australia well during the post WW II period. We have prospered and the world has enjoyed, generally speaking, a lasting peace thanks to the deterrent that the US military represents.

Second, Curtin expanded the role of the federal government by abolishing state income taxes and replacing those State taxes with direct grants from the Commonwealth instead. This arrangement, where the Commonwealth has the power to finally determine State revenues, still exists despite the Coalition government's GST and wider tax reform in 2001, which now delivers just under $50 billion a year to the States. The GST is a tax that can only in practice be altered with the agreement of all Australian Governments.

Nonetheless the States still do not raise sufficient revenues to pay for all their spending, which is increasing. They must come cap in hand, as it were, to the federal government to supplement their budgets.

Third, Curtin was a reformer of the welfare state. He introduced new types of welfare to supplement the age and invalid pensions that were first introduced in 1909. Wife's allowance, Widow's pensions, unemployment and sickness benefits, funeral payments and pharmaceutical benefits were all added to Australia's social security safety net.

Curtin was a true believer. He was committed to full employment. He believed in the empowerment of the working man. He was a proud union man and something of a radical socialist in his early years.

Perhaps, if John Curtin had not died in office, he would most likely have moved to nationalise the banks. His experiences in the Scullin government during the Great Depression appeared to have cemented his view that privately run banks were not in the national interest. Of course, the policy of bank nationalisation was left for his successor, Ben Chifley, to attempt to implement in 1948.

Curtin's view was that the banks were largely to blame for the deprivations of the working man during the Great Depression. His conclusion that banks ought thus be nationalised, so that credit could be expanded in times of economic contraction to support economic activity, is having something of a revival in contemporary economic and political circles.

Indeed, the UK Labour government led by Gordon Brown has embarked on a policy of effective nationalisation of failed banks and the concomitant printing of money to expand the money supply, lower bond yield curves and get credit flowing again for businesses and families with mortgages.

The US government has also put enormous sums of taxpayer money into its banking system. Some of this is to restore the capital positions of the banks, but most has been allocated for the purchase of so-called "toxic assets" – the mortgage-backed securities that have gone sour with the decline and fall of the American housing market.

US government remedies for their banking system are still being worked through. We all trust that the American financial system is able to withstand the recession that is now in full swing.

In a few days the results of the banks' "stress tests" will be made available. These tests are designed to determine how much extra capital nineteen major American banks will require to meet the demands of increasing loan defaults as firms close their doors and unemployment rises.

As history will remind us most downturns come in three stages. Stage 1 is the financial crisis which is mostly linked to the contraction of affordable credit. Stage 2 sees that downturn become an economic crisis as economies contract and unemployment surges. Stage 3 is perhaps the most distressing phase, the resulting political crisis which comes about because people are poor and distressed and are looking for someone to blame.

We are not yet through the first stage – the financial crisis – however we are perhaps half way there if you believe the IMF estimates of the amount of bad debt that the world's financial system will have to write off. More information is yet to be disclosed about the true impact of the crisis on European banks. I will say more about this in a moment.

Stage 2 – the economic crisis, has begun. Production output, world trade, consumer consumption and business investment have all plummeted by staggering percentages. Some nations have experienced declines in GDP not seen since World War II. And even though there are positive economic indicators around they all seem to point to a slowing decline rather than an economic surge.

Disturbingly, the unemployment rates in some European nations are already in the double digits.[2] For example Belgium and Poland have unemployment rates of 11.2% and Russia is 10%.

There is also the problem of Eastern European loans from Western European banking houses. The IMF estimates that the liability from Eastern Europe may be US$800 billion. Austria, Belgium, Germany, Italy, and Sweden hold the majority of these bad loans. In Austria, Belgium, and Sweden's cases the loans are greater than their GDPs.[3]

This could easily become Europe's home-grown "sub prime" meltdown. The seriousness of the situation is one of the reasons the IMF's capital funding base was tripled to US$750 billion after the last G20 leaders' meeting.

In addition, Governments have provided massive amounts of capital to banks like Hypo Real Estate Bank AG in Germany who have already been provided with  102 billion. I believe this is larger than any other single bank bailout globally. I suspect much more is to come.

As Governments bail out individual financial institutions in order to save the banking system, financial institutions are still credit nervous because they are still struggling to value the assets already secured without embarking on new lending against assets that are unable to be priced.

As an aside I note that credit will only flow more liberally when asset prices have bottomed out. The price of credit is based on pricing risk. Risk is measured by a borrowers ability to repay and the value of assets that secure that repayment. It is simply the case that credit will remain very expensive and hard to get until lenders can identify the value of assets on their own balance sheets, let alone pricing assets in new business.

Whilst I am sure that we will not need to go down the path of William Shakespeare’s Shylock in The Merchant of Venice and secure loans with "a pound of flesh", lenders must be convinced of asset quality before they will make credit affordable.

In today’s world, risk is expensive. If that remains the case then innovation remains very expensive. I am sorry, but my view is that the credit market recovery still has a long way to go until it can fund innovation.

Consumers will not regain confidence on a sustainable basis with unemployment on the rise. In Australia, unemployment has increased from 3.9% at the beginning of 2008, to its current level of 5.7%, although this Thursday's survey results may have Australia's unemployment with a six in front of it. This is still very low. It is the speed of the climb in Australia that is most alarming.

The United Kingdom has been in a deep recession for some time yet its unemployment rate is just 6.7% compared with the United States with 8.5% and Canada with 8%. New Zealand has been in a downturn for some time and its unemployment rate is still only 4.7%.

Data will vary on a range of factors including the structural flexibility of the economy. But unquestionably business confidence has an impact on jobs. I think we continue to feel the pain of last year's government declared "war on inflation", its confused 2008/09 Budget strategy, the ill-considered interest rate increases by the Reserve Bank and the October panic by the PM, declaring it "will be bad, really bad."

Of course a rising level of unemployment is where the political environment starts to change.

If you are in an economy where the population knows there are external challenges but unemployment is low, home mortgage repayments are low and the government is giving your family thousands of dollars of cash to splash…well it's not as bad as it could be – that is until it all comes home to roost.

Stage 3 the political crisis, has not even begun.  In short, I hope we all defy history and it never begins.

In some countries, very high unemployment is forecast. Other countries like Spain (17.4%) already have very high unemployment. We know that when unemployment reaches levels where one in five people cannot find work then there is real pressure on social cohesion. Similarly, when people have lost their life-savings in the financial crash, their political allegiances can change – radically in some cases.

I do not know where these changes will lead us. In all likelihood incumbent governments who make mistakes with their policy direction will be ousted from office. Governments who promise their people that they can create and protect jobs and then fail to do so may find themselves with a growing credibility gap, even if citizens are currently giving them the benefit of the doubt.

Governments who massively expand community expectations and then fail to fulfil them are frequently punished at the ballot box. It is the deep sense of betrayal that hurts the most in voters' minds.

Australia

Given that international round up, I want to leave the big picture and the global scene for a more detailed look at Australia's public finances.

The second Rudd/Swan Budget will be delivered a week from today. It promises to contain news of the biggest deficit in post war history, and for that it needs to exceed the Hawke/Keating record of 4.1% of GDP in 1992-93. In today's terms that means a deficit of $48 billion.

The government is softening up the electorate for a deficit north of $50 billion, but it is by no means inevitable that we need to suffer these huge deficits. The government is driving these big deficits and I will explain why.

The Treasurer has duly warned us to expect truly gigantic deficit numbers as his revenues have declined, but what he doesn't tell us is how his spending has sky-rocketed.

Officially, the federal government has committed to $80 billion in extra spending since the last Budget. And that does not include the $43 billion broadband, the $28 billion Rudd bank (the other $2 billion to be contributed by the four major commercial banks) or $26 billion for infrastructure.

The Rudd government's response to this crisis appears to consist of throwing all fiscal restraint to the wind and spending taxpayers' money from generations yet to be born.

The Rudd government asked the Parliament for permission to borrow $200 billion, but at deficits of over $50 billion a year, as the Treasurer is loudly hinting, the Prime Minister will have to admit his profligacy and ask the legislature for more funds. We expect Mr Rudd will stretch the debt to $300 billion.

The way the government is throwing these numbers out is beguiling because it looks like we can get it all now and pay for it later. The size of the numbers is deceptive. To make real sense of the scale we have to reduce the concepts to sizes that everyone can relate to.

Now, in everyday terms, public borrowings of $300 billion means Kevin Rudd has added $37,500 in debt to every one of Australia's 8 million households.

This $37,500 attracts interest, at an average rate of 6%, but more about that in a minute; so we can see that the cost will be $2,250 a year in interest or $43 a week that each family doesn't have to spend on other things like housing, health and education. Of course that does not include the cost of paying off the principal!!

The Rudd government has been borrowing money from the markets at rates between 5.25% and 6.25%.[4] That is of course less than your credit card, but it is at a rate that competes with private finance, which of course must pay much more in the market than the, currently, AAA-rated federal government.

The effect of the government going into the market to sell hundreds of billions of dollars of securities is that our private firms, who create jobs, will have a harder time raising and paying for loans.

The government entering the debt market in such a major way can only put a halt to the decline in market interest rates, perhaps at a level that is still too high for consumers to have confidence to spend again and for business to have confidence to invest.

In addition to the floor created for interest rates, government borrowing on this scale also diverts money from investing in the creation of new business and thus new jobs and wealth.

Our economic system requires the creative forces of private enterprise to gainfully employ Australia's "working families" – a term I note Mr Rudd has not deigned to use for a while.

Without many competitive, efficient business ventures operating for profit, Australia cannot function at full capacity in the modern world economy.

Business drives jobs growth in Australia and the burden that the Rudd government is placing on that growth by this debt will slow our recovery.

The puncturing of the global debt bubble has had consequences, however the addition of more government debt spreads the pain out to future years via higher inflation, lower growth and less disposable household income. It also has all the ingredients of a significant bond market bubble.

Mr Rudd would be well-advised to listen to the wisdom of a former UK Labour Prime Minister, James Callaghan: “We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists and, in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step.”[5]

The answer to a debt crisis is seldom found by taking on more debt.

The truth is that the federal government debt will not be paid off while Kevin Rudd is Prime Minister. Kevin Rudd will never deliver a surplus Budget.

Mr Rudd will, in my view, bequeath his debt to the Coalition and we will, again, be faced with the task of restoring Australia's public finances, putting the nation back to work to grow our economy and paying for the actions of the Labor Party that so shamelessly proclaims itself as a party of fiscal conservatives…what clap trap.

Some commentators have said that the increase in debt is nothing to worry about. I would like to address their proposition with counter arguments against massive increases in the public debt.

The most frequent refrain I hear is that the Australian government has no net debt and other nations have oodles, so it must be OK to go into debt to the same extent as others in the OECD.

Firstly, let me say, as Wayne Swan says, that it was the hard work of the Coalition government that left Australia in the best possible economic shape. It is true too that very few of the OECD nations could boast of the same results from the Coalition's policy settings for high growth and low unemployment. The Coalition government had a consistent policy to make Australia debt free by being true fiscal conservatives and by delivering real, sustained and substantial Budget surpluses.

Government debt always crowds out private investment because there is a limited amount of capital in the world. If governments sequester these funds then there is less available for business and any recovery will take longer because new business will find it difficult to get start up capital. It is always important to repeat that it is business that drives real economic growth. It is business that employs Australians.

We should not forget too that government borrowings of $300 billion would come on top of our existing net foreign debt of nearly $680 billion.[6] Although that debt is privately held, mainly by our financial sector, and has been used to fund housing and business loans, it is still a drag on our current account as interest payments must be repatriated to foreign investors.

The ratio of household debt to disposable income in Australia is at historically high levels at 153%. This compares unfavourably with an average rate of under 50% prior to the 1992 recession.[7] Other nations have also experienced a rapid increase in this debt to disposable income ratio – most notably Spain at 120%, the US at 140% and the UK at 150%. Countries such as France and Germany, which did not have a housing boom, have had stable debt ratios under 100% for the past decade. Indeed the Euro average is about 80%.[8]

When one considers Australia's debt position in toto it is clear that the nation's balance sheet is already weighed down with significant obligations to overseas interests and Australian households have taken on more debt relative to their disposable income than ever before.

While it is true that Australia's federal government debt is low by OECD standards, it is not true for households, or even for the States, which will borrow $200 billion according to media reports yesterday. I assume much of this borrowing will be done using the Commonwealth's guarantee.

Economists I have spoken with have estimated the contingent liabilities that the Commonwealth has guaranteed have now reached $1 trillion.

As Niall Ferguson states in his authoritative text, The Ascent of Money, when a government runs a deficit and it issues bonds to make up for the shortfall, as interest rates on bonds go higher the deficit becomes even larger. As a result the bond market raises its eyebrows even higher and the bonds sell off again. The interest rates go up again and so on. "Sooner or later the government faces three stark alternatives. Does it default on a part its debt, confirming the bond market's worst fears? Or, to reassure the bond market does it cut expenditure in some other area, upsetting voters or vested interests? Or does it reduce the deficit by raising taxes? The bond market began by facilitating government borrowing. In a crisis, however, it can end up dictating government policy."

This issue of the government losing control of its own Budget is a matter for more detailed discussion at a later time. I can say however, with experience, that the larger the debt the less flexibility is available for policy movement.

We can get through this downturn. We can come out of it stronger and more energetic.

When the economic recovery begins Australia needs to be in the best possible situation to take full advantage of new opportunities.

We have come into this recession later than others, but we must not be in a position to be the last out at the other end.

We need to be first out of this recession, but we can only do that if our public finances are not in such a parlous state that higher taxes, reduced services and growing interest payments to foreigners determine future federal Budgets.

It will cost a lot to make amends for the economic policy mistakes of Kevin Rudd.

The good news is that it is not too late to change tack from this disastrous path. Fortuitously, the nature of the Rudd government's top-heavy administration means that most of the money is yet to be spent. The government is quick with the announcement and the media release, but is less able to actually do anything except send cash out through the Tax Office and Centrelink at this point.

The cash splash, the government must now admit, was a wasted opportunity. Our leaders have freely distributed over $22 billion in an attempt to gain popularity and they used the now discredited cover story of creating or supporting 330,000 jobs.

So much more could have been done with those funds that would have provided Australia with the productivity increases that we will need to actually grow our economy and create jobs. Instead of investing in our nation's future the Rudd government bought some time and succour in the polls.

Many market economists (who are talking their own fixed interest books) and media commentators have said that it is necessary to go into substantial debt to fund the stimulus programs that will get us out of the recession. This is a fallacious argument. Only through our productive effort can we create real wealth. The temporary stimulation of demand for goods and services that is paid for by debt is merely postponing the day of reckoning.

At this time the government ought be making efforts to reduce the structural inefficiencies faced by business so that they are more competitive and better able to make headway in the global economy.

Australia needs to have a tax system that is fairer, simpler and with lower rates. Fortunately the government has committed to the Coalition's tax cuts this year and next that will deliver lower income taxes for Australian families.

I hope they will keep their word, but I am hearing some very nasty things from Canberra about the top marginal rate being adjusted upwards in this Budget.

Not only does the tax burden need to be modest for any economy to grow, but also government services need to be running at their most efficient if the taxpayer is to get the best value for their money.

Many taxpayers do not believe that they are getting value-for-money from their government. They see waste and inefficiencies. They see mind-numbing bureaucratic red tape that slows things down and adds more costs to everything. They see outdated and Orwellian regulations that appear to have no function other than to employ bureaucrats by the thousands in Canberra's departments, agencies, boards, commissions, committees and taskforces.

We can do better and we must do better.

There is no greater duty for a government, after the physical defence of the nation, than to secure the nation's public finances. Just as nations can be destroyed by invasion, they can also be bankrupted by fiscal irresponsibility. History is littered with examples of rulers who have debased their monetary systems and eviscerated their citizens' wealth.

The nation is, in many ways, just a larger version of our self. We all know of people who have come into money and have spent it unwisely or rashly. They generally end up with nothing to show for the spending. Some end up broke and destitute. We also know of others who are prudent with their money – who invest wisely. Those people generally prosper and create more wealth for themselves and their family.

At the national level, if we invest taxpayers' money wisely for a long-term productive benefit, Australia will continue to prosper for future generations. If we allow money to be splashed around on gambling, wide screen TVs and overseas holidays, then we will suffer the consequences when the bills eventually fall due.

So these are the real impacts of deficits and debt. These impacts are not as abstract as people might think. And I hope people bear that in mind when they see the huge holes, stretching as far as the eye can see, in Wayne Swan's Budget next week.

o0o