Fiscal spending: Cycles and structures

No, I’m not talking about the cycleway – although if Bill English does want to cut “nice to haves” surely this is a place to start 😉

I’m talking about this comment from Ganesh Nana, where I both agree with him and disagree with him simultaneously.

The plans (to cut spending) were criticised by BERL chief economist Ganesh Nana, who said cutting more state sector jobs and squeezing spending further at this point in the cycle risked keeping the economy down for longer.

It is true that when we have a cyclical downturn, cutting spending without a coordinated cut in interest rates from the central bank is likely to exacerbate the cycle.

And it is true we are in a cyclical downturn – output in the economy is below its potential level.

However, there are three factors that could well justify SOME cuts to government spending – as long as they don’t try to close the deficit immediately.

  1. The Reserve Bank still has the ability to respond by loosening monetary policy (although the effectiveness of cutting at current lows is a matter of debate),
  2. The cuts are focused on extremely low productivity elements of spending, as a result the contractionary impact will be smaller than in the case of indiscriminate cuts.
  3. Most importantly, the focus of the cuts are to remove the “structural” deficit.

The third point needs more explanation.  Fundamentally, the “potential size” of the New Zealand economy is now believed to be smaller than it previously was.  As a result, in order to have government taking up the same share (a share that is determined by the tax take, which is hopefully set according to the share society desires) the level of government spending does need to be lower – or else we run a structural deficit.

Structural deficits are not cool, it implies that the government won’t balance the books over the economic cycle and will cause unnecessary disruption to economic activity when it does try to – and as a result, it is often seen as a good idea to minimise them.

Now, for an economist I am actually relatively comfortable with short-term structural deficits.  I believe that estimating “potential” is tough, and as long as spending is transparent small structural deficits and surpluses are hard to separate from cyclical ones.  However, while the government should buffer the economy over the “cycle” it is true that in its structural sense it does need to balance its books like a household.

As long as any tightening is based on the three points listed above, I don’t think Dr Nana needs to be too concerned regarding the impact on the broader economy.  However, if they do go further just for the kicks, then his concerns are very relevant.

5 replies
  1. Eric Crampton
    Eric Crampton says:

    Did Ganesh give any warnings back in 05 about how we should be saving surpluses against a future downturn rather than spend it all out in WFF?

    He’s reliable for Radio NZ though. Whenever they want somebody to argue against cuts in spending or against inflation targeting, just call up ol’ reliable Ganesh.

  2. Matt Nolan
    Matt Nolan says:

    @Eric Crampton

    We all have different priors, what can I say. I am sure I come off as overly dogmatic in defense of inflation targeting.

    His comment in this case is definitely justifiable – however, I feel it required more context. I see economists of ALL stripes railing against deficits or for them, without splitting the conversation into “structural” and “cyclical” elements. It is an important, nah essential, thing to do when looking at spending in a “macro” sense.

  3. Matt Nolan
    Matt Nolan says:

    @Eric Crampton

    They had mentioned it previously, and when tax revenues were down they did say they were looking at moderating spending. To be fair, compared to the US government, NZ has been willing to say that it will target a medium term balanced budget – that is why National keeps on going on about the target of getting back in surplus in 5 years.

    Now 5 years may look like a long time, but when you see their forecasts it seems that we don’t really get back to potential for some time. Now I’ve noticed that the Reserve Bank has the output gap closing in two years – I would suggest that the structural deficit might be a bit more problematic if that is the case …

  4. Harry C
    Harry C says:

    I think your second factor lets down the argument, in the sense that National is not approaching spending cuts in a rational way. I guess in an ideal world they would be looking at the cost-benefit ratios of all government programmes and then whittling down the least productive areas of spending, but that’s evidently not what they’re doing! You just have to look at the ‘roads of national significance’, which quite often have cost benefit ratios of less than one and yet are still funded at the expense of other things, to see that they’re not doing this sensibly. Instead, the cuts are at least partly a politically driven process where they just cull things that they don’t agree with. Yeah, so it’s a dangerous assumption, I think, that the areas being cut are extremely unproductive…

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