Why modern monetary theory won’t work for Australia
19 Nov 2021|

Budget deficits used to be seen as proof of profligacy, but a new permissiveness has swept the world, partly in response to the Covid-19 pandemic, but also reflecting new economic thinking about the sustainability of government debt.

In ASPI forums, I get asked if this means that Australia’s defence spending could rise beyond 2% of GDP—first targeted by former prime minister Tony Abbott when he was opposition leader in 2012 and recently achieved—to 3% or 4%.

Further increases are in prospect. Defence Minister Peter Dutton didn’t demur when asked last month if the AUKUS deal meant spending would rise to 2.5% of GDP. ‘I think in all likelihood that will be the reality but certainly north of 2%,’ he said, adding that the forthcoming mid-year budget update would provide further information.

Australia has been an outlier among advanced countries in the strength of its budget management, which is why Australian government bonds have only eight peers with a AAA credit rating from each of the major rating agencies.

The International Monetary Fund reports that even with the big outlays on Covid programs, the Australian government’s net debt at 34.5% of GDP is less than half the advanced-country average of 88%.

It is a performance that owes much to Peter Costello—treasurer in John Howard’s Coalition government—who used the demonisation of debt and deficit to tar Labor’s economic credentials.

This concern with fiscal rectitude was unusual. Historical data published on the Reserve Bank of Australia’s website shows that the federal budget was constantly in deficit between 1953 and 1987, after which the Labor government achieved four brief years of surplus.

However, surplus budgeting was always an idea supported by a strong current of economic thinking. While followers of economist John Maynard Keynes argued that deficits were helpful to stimulate economies during downturns, his critics held that deficits encouraged capital inflows, which pushed exchange rates higher, making the private sector less competitive and neutralising any stimulatory effect. This was the debate in Australia and overseas in the wake of the global financial crisis.

Most governments opted for the Keynesian stimulus—a step endorsed by the IMF—on the understanding that efforts to work off debt would be pursued once economic conditions improved.

Over the past five years, a radically different perspective has gained currency in the US on the left of the Democrats on the political spectrum. Presidential aspirant Bernie Sanders in 2016 and 2020 had as his principal economic adviser Stephanie Kelton, who is a theorist behind what is known as ‘modern monetary theory’, or MMT.

It contends that the only constraint on spending for the government of a country that controls its own currency should be inflation in an overstretched economy.

The starting point for MMT is that governments are in a radically different position to households and businesses. Households and businesses are users of money, while governments create it. While everyone else has to earn, borrow or invest to obtain money, governments simply create currency every time they spend.

Governments don’t tax in order to cover spending; they tax so that spending doesn’t create excessive demand and hence inflation. MMT holds that a government which borrows in its own currency is never in a position where it can’t finance something.

The theory was ridiculed by mainstream economists. No one in US President Joe Biden’s administration would endorse it publicly, but there are echoes of MMT in its multitrillion-dollar spending plans.

However, thinking about budget economics was upturned in 2019 in the citadel of the economic mainstream—the American Economics Association—with its annual presidential lecture delivered by former IMF chief economist Olivier Blanchard.

Blanchard showed that over most of the post-war period, the interest rate on US government debt was less than the economy’s nominal growth rate. The same was true of most other advanced nations. Since the budget size increases in line with the economy’s nominal growth, this meant that debt didn’t carry a net positive cost to the budget.

‘If the future is like the past, this implies that debt rollovers, that is the issuance of debt without a later increase in taxes, may well be feasible. Put bluntly, public debt may have no fiscal cost,’ Blanchard said.

This is in sharp contrast to the earlier work done jointly by Blanchard’s predecessor at the IMF, Kenneth Rogoff, and the current World Bank chief economist, Carmen Reinhart, who argued that once a country’s debt surpassed around 90% of GDP, its economy stagnated. The Rogoff–Reinhart thesis was influential in the austerity programs adopted after the global financial crisis but has been much criticised, including the strength of its empirical and statistical analysis.

Blanchard’s work grants licence for the new permissiveness. In follow-up work, he argued that Japan should embrace permanent budget deficits rather than seek to strengthen budget finances with increases in its consumption tax.

Australia has special reasons for distrusting this thesis. A key measure in Australia’s relations with the rest of the world is the ‘terms of trade’—the relationship between the prices we receive for our exports and the prices we pay for our imports.

For most advanced countries, the terms of trade (which are measured as an index) are relatively stable—the prices of the manufactured goods and services they import and export vary little from one year to the next. By contrast, the prices of the commodities that account for almost 80% of Australia’s exports can swing wildly.

For 55 years up to 2004, the index measure had three troughs of between 50 and 55 points and three boom peaks of between 70 and 80 points. The average, to which the terms of trade always returned, was 63 points.

However, over the past 15 years, it has been off the charts—soaring as high as 123 points in 2011 and 2021. There has been nothing like this since the gold rush of the 1860s. This is the China-powered resources boom and its aftermath.

The danger for Australia is that any return of commodity prices to their long-term average—due to a recession in China, for example—could turn a large deficit into a gigantic one. That would scare investors both globally and domestically and could force a brutal economic contraction.

The takeaway for those wanting to raise defence spending is that the new thinking on budget deficits delivers no licence for spending in Australia. The alternatives are cutting spending elsewhere or raising taxes.

The difficulty of attacking spending was shown by the excruciating experience of the Abbott government’s first budget, when it tried to achieve a relatively modest reduction in spending of 1% of GDP with a range of cuts including a co-payment for Medicare, reduced indexing of aged pensions and welfare benefits, and cuts to health and education payments to the states. The only significant cut that survived was to foreign aid.

The difficulty of raising more from taxes was shown by Labor’s failed 2019 election campaign when voters rejected its platform of tax increases, including changes to negative gearing, family trusts and franked dividends, even though it was aimed mainly at high income earners.

Analysis by Deloitte Access Economics suggests that the combination of overly generous tax cuts, rising defence spending—it agrees with Dutton that it will reach 2.5% of GDP within a decade—and rising unfunded costs for the National Disability Insurance Scheme will leave a budget hole of $60 billion, or around 3% of GDP.

To underline the dimensions of such a hole, the firm estimates that it could be closed by raising the GST rate to 17%, raising every personal marginal tax rate by 5.5%, raising the company tax rate from 30% to 50%, or halving spending on education and disbanding the defence force altogether.

The bottom line is that defence spending could only be raised to 3% of GDP or more if voters were convinced that Australia was facing an existential emergency.