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Fiscal Deficit on Economic Activity Last 4 Years in Australia

In: Business and Management

Submitted By PRADEEPKT
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Economic Context of Management

Name: Pradeep

Essay:
“The Australian government has been running with too large a fiscal deficit during the past 4 years particularly in light of their projections for the Australian economy which were made when the first stimulus package was announced in 2008". Discuss this assertion and the consequences of this fiscal deficit on economic activity during the past 4 years. What are the implications of your analysis for Australia's fiscal policy during the next 3 years?

EXECUTIVE SUMMARY
Global Financial Crisis (GFC) evolved from its origin in subprime mortgage crisis of United States and affected almost every country in the world. Australia entered into GFC with a strong position, as compared to the other OECD countries. Australian government implemented stimulus packages in order to deal with the situation. This reports looks at the consequences of the fiscal deficit on economic activity and its implications for Australia’s fiscal policy. Its direct impact on Australia was small – mostly increases in bank borrowing costs
The case for fiscal stimulus was based on Keynesian model, which proposes a short term government spending to stimulate the economy during the recessionary period. However, Basic Keynesian model assumes that the exchange rate is fixed. The analysis shows that significant contributor for GDP (expenditure) was net exports over that period, not the consumption. This increase in demand was due to the depreciated Australian dollar and the strong demand for resources from China.
Further, recent Australian National University (ANU) study shows that the cash bonuses provided to households were saved by majority of people (60%) who received the payments, either by paying off debt or by direct saving. Analysis of Australian stimulus package implementation and its impact on government budget reveals that Australia did not benefited greatly from this, as it was originally announced. It shows that major projects like Building Education Revolution (BER) and Home Insulation Program (HIP) were implemented inefficiently and did not add any valuable asset to the nation. As per Keynes any government spending should be used efficiently and wisely in order to have the intended effect on the economy. So it is important for the government to do cost-benefit analysis and to have the plan in place before rolling out the projects of this kind. With the floating exchange rate, which was introduced in 1984, the stimulus package was ineffective for Australian economy. Therefore it was unnecessary. Historical evidence from the Asian crisis case provides us the great example of how the floating exchange rate in Australia provides insulation from overseas crisis.
The improvement in saving by the households and businesses, during GFC, did significantly reduce the Current Account Deficit (CAD), which otherwise would have been enormous. The current appreciation of Australian dollar, despite the fall of commodity prices is due to the reduction in savings. The data from retail sales which shows the increase and the drop in superannuation saving shows that we are not saving as much as we were during 2008-09. Consequently, Australian government need to take saving measures and also encourage households and business to save in order to minimise the current account deficit, there by reduced overseas borrowing and unpleasant appreciation of Australian dollar.
Government should put the revenue from mining tax into some savings fund, which can be used for useful cause in future (like education, medical research and developing work force etc.). This will not only assist Australia to develop alternative industries, when Australia run out of commodities, but also positively affect in pushing down exchange rate. Also, it should not implement the measure like reduction concessional superannuation cap for people, from $50000 to $25000, as this is one of the contributor for increased superannuation saving (KPMG, Superannuation Trends and Implications, November, 2011), which will lead to reduction in saving and that will not be good for the country from economic perspective.
Further, the domestic and economic outlook presented in Mid-Year Economic and Fiscal Outlook 2012-13, points to challenging times ahead, and will have to be dealt with disciplined actions, as the fall in commodity prices, slowdown in China’s growth and Euro zone and US, which will have a direct impact on China and that will put downward pressure on Australia’s terms of trade. In order to reduce the CAD and budget deficit in coming years, government should take measures for government saving by actions like savings fund for mining tax revenue public sector re-organisation, cost cutting in illegal immigration area, look at tax cut to increase tax revenue etc. as well as influencing business and household savings in a way that does not affect economic activities and also avoiding deadweight losses.

Introduction:
Global Financial Crisis (GFC) evolved from its origin in subprime mortgage crisis of United States and affected almost every country in the world. Australia entered into GFC in a relatively strong position.There has been a wave of stimulus packages globally. Australia implemented a fiscal stimulus, a total of $62 billion, in the light of rapid slow down in economy and the projected high unemployment rate. Consequently, Australia has been running with too large a fiscal deficit during the past 4 years (Refer appendix A).
Analysis of Stimulus and Its Impact on Australian Economy:
Gross Domestic Product:
Fiscal stimulus is aimed at increasing the aggregate demand in the economy, during recessionary period. The argument for the stimulus package was that the projected slowdown in the growth and high unemployment forecast, due to the contractionary effect in the economy and the aggregate demand need to be increased by government spending. According to Keynesian model, the government spending to boost economic activities should be spent wisely and effectively to have a multiplier effect. This is true in case of a fixed exchange rate regime. But in Australia has a floating exchange rate, which insulates the economy from external shock. GDP (expenditure) during the impact period tells us that the significant contributor for the GDP is the net exports. The increase in net exports was due to the fall of exchange rate over the period of December 2008 and March 2009 due to the strong demand from our Asian trade partners, especially from China. Refer appendix B for details. It is important to note that the reason for China’s demand for our commodities is due to their stimulus package, which has a fixed exchange rate in the short term. However, the stimulus drove the exchange rate up from March 2009, which made export industries less competitive and reduction in net exports.

Exchange Rate:
Floating exchange rate has a strong co-relation with the commodity prices. The increase (reduction) in commodity prices will cause the exchange rate to rise (fall), with same savings rate. The theory is that the reduction in exchange rate allows the currency to depreciate, which improves the net exports and stimulates the economy. The detailed analysis shows that Australia did not benefit from its fiscal stimulus. Analysis of the exchange rate and commodity prices over the last 4 years * * * * * * * * * *
Source: Valentine T, March 2011, You tube, ‘The Effect of the Fiscal Stimulus on the Australian Economy’
From the above data, it is clear that at the end of 2008 the automatic adjustment process was starting to happen, the Australian dollar fell sharply, the commodity prices (Australian dollar) is lifted which somewhat protected Australia GFC.
The effect of stimulus caused an appreciation of Australian dollar from March 2009 which reduced our competitiveness and blighted our export industries. As a result unemployment went up during that period. The reason for this is the need to borrow offshore and inflow of funds caused Australian dollar to appreciate, and it is very clear it was appreciated due to fiscal stimulus, although the commodity prices were relatively low. Refer Appendix C for details.
Employment rate: * One of the ways to judge the fiscal expansion is reduction in unemployment rate. The projections as per the updated were to rise 7% in 2010 from a rate of 4.6 in Dec 2008 due the contraction in economy. Australian Government’s nation building programme was aimed at increasing the aggregate demand in Australian economy (Budget, 2008-09). * * * Source: Valentine T, March 2011, You tube, ‘The effect of the fiscal stimulus on the Australian Economy’ * This graph shows how the unemployment rate is affected by exchange rate. They tend to go in opposite direction. *

From the ABS statistics, the stimulus created some jobs (in retail, health care etc.), but destroyed more jobs in export industries, predominantly in mining, agriculture, etc. (ABS, 6291.0.55.003), as the stimulus pushed the dollar up making Australia uncompetitive, leading to job losses in those industries. As a result, the unemployment rate went up over that period, which shows that stimulus did not create jobs in net terms. Refer appendix D.

* The recent ANU study on the household cash bonuses also shows that most of the households (60%) did not spend the money that was handed out under stimulus programme (Leigh A, 2012) . Instead, 60% people of the recipients saved the money, either by saving or pay off debt. The government was saved from a huge CAD due to the budget deficit, as people saved during this period. * Also, the Australian government stimulus package was not spent wisely and there was a lot of mismanagement during the implementation, and consequently, the benefits that we got out those programs were less value for money. Refer Appendix E.
Over the period from Jun 2008 to Feb 2009, RBA reduced the cash rate from 7.25 to 3.25% in order to influence the interest rate to stimulate the economy. This has yielded some positive result during the time, as it caused the dollar to depreciate to 0.6454 in Feb 2009. Refer Appendix C for the detailed analysis.
An increase in the business investment during GFC made the difference and that increase could be attributable partly to the low interest rates and others like business sentiment, surge in mining etc. * * Fiscal policy: * Saving and fiscal policy, particularly fiscal stimulus (government spending or government budget deficit) are interlinked, because the impact of fiscal policy depends on what is happening to saving. Over the period of 2009-10, the impact of fiscal stimulus was that there was a large budget deficit was created, in fact, offset by savings to some extent. *
The Twin-Deficits Relationship:
M-X = (I-S) + (G-T).
This shows the relationship between Current Account Deficit (CAD, which is M-X) and Government Budget deficit (G-T).In Australia, it is largely by borrowing offshore through banks, as banks gets about 50% of their funding from offshore. However, that amount we borrow is related to saving, because private saving(S) is equal to household saving plus business saving, and government saving is T-G. This suggests that, all other things equal (in this case Investment I), saving will reduce the CAD. This is preciously what was happened during GFC. The budget deficit went up, as government expenditure went up due to the stimulus package; however, at the same time the business as well as household saving went up as people and business started saving. This actually offset the huge CAD that would have occurred. Saving is important because exchange rate is negatively related to saving, all other things equal.
If the budget deficit increases CAD will change by same amount if (I-S) remains same. The Twin Deficits Relationship (1996 - 2012) | | | | surplus (-) / | | | | deficit (+) | | CAD | I-S | GB | Jun-1996 | 20455 | 15454 | 5001 | Jun-1997 | 16194 | 18745 | -2551 | Jun-1998 | 22628 | 39096 | -16468 | Jun-1999 | 32450 | 45155 | -12705 | Jun-2000 | 31483 | 53654 | -22171 | Jun-2001 | 17684 | 29019 | -11335 | Jun-2002 | 19160 | 21323 | -2163 | Jun-2003 | 38223 | 45480 | -7257 | Jun-2004 | 46355 | 53939 | -7584 | Jun-2005 | 57523 | 70000 | -12477 | Jun-2006 | 54243 | 68439 | -14196 | Jun-2007 | 61029 | 87774 | -26745 | Jun-2008 | 72735 | 100916 | -28181 | Jun-2009 | 36724 | 5388 | 31336 | Jun-2010 | 56901 | 384 | 56517 | Jun-2011 | 33280 | -17826 | 51106 | Jun-2012 | 40785 | -6238 | 47023 |
Source: RBA Statistical Tables
Refer appendix ? for details .
If there is drop in saving, and the government is not in surplus, CAD will go up and the value of currency will go up and Australia will face the problem with higher value of dollar and its impact on tax revenues and reduced profitability of manufacturers.
Recently, despite the significant fall in commodity prices, Australian dollar is staying high. This is due to the fall in savings. The increase in retail sales and the drop in superannuation savings show that the domestic saving is going down. (Refer Appendix F ) Source : ABS, Cat No. 8501.0 - Retail Trade, Australia, Sep 2012.
The data shows that the retail sales are going up, which reduce the saving

Source: APRA, June 2011 annual superannuation bulletin, issued on Feb 2012.
Superannuation contribution is less as compared to Jun 2007 to Jun 2008 period. The retail sales increase and decrease in superannuation contribution reduces the total domestic saving, which reflects in the exchange rate. This causes to keep the Australian dollar exchange to stay high,, although the commodity goes down.
Further, as per KPMG study, one of contributor for the superannuation saving is the tax advantage associated with superannuation (KPMG, Superannuation Trends and Implications, November, 2011). The proposed reduction in concessional superannuation cap for people, from $50000 to $25000, will lead to reduction in saving and that is not good for Australian economy.
Government’s model forecast budget surplus next year, while independent economists take the view of budget deficit.<< MOVE to somewhere>>
For future, Australian Government should take measures that would encourage saving by people or government. Mining tax should not be used for day to day activities, as it is a good tax for saving purpose, not day to day activities. Government should put the money from the mining tax into savings, which can be used to something useful (education, medical research, develop work force etc.) so that when we run out of current commodities, we can have other industries to replace it and will also improve future productivity. Further this saving will have a positive effect in pushing the exchange rate down, due to less money borrowing offshore. If saving increases by any form, $1billion surplus or $4billion budget deficit does not make much difference.
Also, the monthly instalment of income tax, will lead to more deadweight loss and the actual revenue increase is yet to be seen. Government need to look at saving by public sector re-organisation, cost cutting in illegal immigration area, possible tax cuts to increase tax revenue.
Australia’s expected GDP growth is lower in 2013 and 2014 compare to 2012. Also, China slows down in its growth, and it cannot grow the rate at which it is growing currently. China’s slowdown will definitely have an impact on Australia. This points to the fact that the way the Australian economy was dependent on China so far, cannot be expected to be the same in the coming years and therefore Australian government should take into account this fact for Australia’s fiscal policy.
The current volatility over euro zone, and US, will impact on Australia’s commodity exports to china, will slow down as compared to previous years as China is heavily dependent on Europe as well china’s expected slowdown in growth will put downward pressure on Australia’s terms of trade.
Source: RBA
Conclusion:
Fiscal stimulus is ineffective with the flexible exchange rate regime, like Australia as the flexible exchange rate provides insulation for the economy from overseas crisis. Australia gained from China’s stimulus package for its growth rather than its stimulus package. Saving by business and households avoided the huge CAD that would have created by the stimulus.
In order to reduce the CAD and budget deficit in coming years, government should take measures for government saving as well as influencing business and household savings in a way that does not affect economic activities and also avoiding deadweight losses.

Appendix A:

Appendix B:
The graphs below show that the Australian exports by destination and major exports items. In spite of the adverse impact of GFC during 2008-09, Australia’s total export rose by 1.8 % in volume terms and import fell by 2.5 percent. The resources were the major contributor for the total exports during that time.

The major destinations were China and Japan. Major portion of China’s stimulus package was for infrastructure (about 72% of 4 trillion RBM) and this increased Australia’s resources export considerably.
Appendix C: Floating Exchange Rate
Floating exchange rate is strongly co-related with the commodity prices. With a floating exchange rate, the economy adjusts to the fluctuations in commodity prices. For example, a commodity price increase leads to appreciation of dollar that reduces the net exports which result in reduction overheating of economy that the increase in commodity price might otherwise cause. Also, the impact of budget deficit is reduced by its effect on exchange rate.
Analysis of the exchange rate, commodity prices over the last 4 years. | Exchange rate (A$ per US$) | Commodity price (US$) | Commodity price (A$) | Unemployment rate | Jun-2008 | 0.9626 | 116.8 | 91.0 | 4.3 | Sep-2008 | 0.7996 | 121.5 | 109.8 | 4.3 | Dec-2008 | 0.6928 | 99.2 | 109.9 | 4.6 | Mar-2009 | 0.6873 | 87.7 | 97.8 | 5.7 | Jun-2009 | 0.8114 | 79.9 | 73.8 | 5.9 | Sep-2009 | 0.8801 | 83.3 | 71.7 | 5.7 | Dec-2009 | 0.8969 | 88.5 | 72.8 | 5.5 | Mar-2010 | 0.9159 | 94.8 | 77.0 | 5.4 | Jun-2010 | 0.8523 | 112.0 | 97.4 | 5.2 | Sep-2010 | 0.9667 | 121.6 | 96.3 | 5.1 | Dec-2010 | 1.0163 | 127.8 | 95.5 | 4.9 | Mar-2011 | 1.0334 | 141.5 | 103.8 | 5.0 | Jun-2011 | 1.0739 | 154.8 | 108.2 | 5.0 | Sep-2011 | 0.9781 | 152.7 | 110.5 | 5.2 | Dec-2011 | 1.0156 | 137.6 | 100.7 | 5.2 | Mar-2012 | 1.0402 | 138.7 | 97.5 | 5.2 | Jun-2012 | 1.0191 | 130.2 | 96.7 | 5.3 | Sep-2012 | 1.0464 | 126.4 | 90.1 | 5.4 |
Source: RBA statistical tables.
From the table, commodity price (CP) fell by 31.59% during Jun2008 to Jun 2009, however, the CP in Australian dollar fell only by 18.90%. But, over the period from Jun 2008 to Mar 2010, CP fell by 18.84% and CP (A$) by 15.38%. This was the result of the appreciation of Australian dollar. The appreciation of the dollar caused this sharp fall. This would have had a contractionary effect on the economy which offset the stimulatory affect by fiscal stimulus. This shows that Australia obtained a little effect from the Australian stimulus.

From the above data, it is clear that at the end of 2008 the automatic adjustment process was starting to happen, the Australian dollar fell sharply, the commodity prices (Australian dollar) is lifted which somewhat protected Australia GFC.
The stimulus caused to appreciate the Australian dollar from March 2009 and that reduced our competitiveness and blighted our export industries and unemployment went up, as a result, during that period. Due to the increased offshore borrowing, the Australian dollar appreciated even though the commodity prices are relatively low. Fiscal stimulus is that only explanation for this.
Alternative option for the government was to take the example of the previous Asian crisis and let the exchange rate do the job. That is automatic adjustment of exchange rate to stimulate the economic activity and to insulate the country from the overseas crisis. During the Asian Crisis, then government did not resort to fiscal stimulus. At that time Australian dollar was depreciated which insulated the Australian economy from the crisis.

Appendix D: Employment rate Source: RBA Statistical Tables

Source: RBA Statistical Tables

Appendix E: There are two ways of judging the fiscal expansion, and one of them is government is adding valuable assets to the nation. Australian government stimulus package was not spent wisely and there was a lot of mismanagement during the implementation, and consequently, the benefits that we got out those programs were less value for money. For example, $2.8 billion Home Insulation programme ended up with not only ineffectiveness throughout the programme, but the death of 4 young installers as well and consequently, was terminated prematurely on 19 February 2010. Similarly, the task force for Building Education Revolution implementation observed a lot of evidence of mismanagement and wastefulness during its implementation. This shows that government did not conduct a thorough cost-benefit analysis for the various programs announced under stimulus package.
Building Education Revolution program, were not achieving ‘value for money’ in terms quality, cost and time.
The Taskforce appointed for investigation observed a number of construction industry wide issues (BER Implementation Taskforce Final Report). “These include: inadequate use of technology to deliver coordinated project design documentation; the potential for conflict of interest of private certification if aligned to the delivery managing organisation; substandard workmanship which may be a result of low completion rates of trade apprenticeships; and a trend to generic skills for project managers rather than technical qualifications backed by significant hands on construction experience”. * * $2.8 billion Home Insulation programme ended up with not only inefficiencies throughout the programme, but also the death of 4 young installers. This programme was terminated prematurely on 19 February 2010 (Auditor General Annual report No 12, 2010-11).

Appendix F: Interest rate effects on Australian economy
The sole monitory instrument is the interbank interest rate and in Australia, it is the Cash Rate (CR). Although, the longer term interest rate is that affect the economy, RBA doesn’t control the longer term interest rate. RBA set the cash rate in a way that it influences the longer term interest rate. The theory is to stimulate the economy, the cash rate us reduced and to slowdown the economy, increase the cash rate. The interest rate also affects the exchange rate. Graph below shows the cash rate from Jun 2008 to Dec 2009.

Over the period from Jun 2008 to Feb 2009, RBA reduced the cash rate from 7.25 to 3.25% in order to influence the interest rate to stimulate the economy. This has yielded some positive result during the time, as it depreciated to 0.6454 in Feb 2009. At the end of Month | Units of US $ per A$ | Jun-2008 | 0.9626 | Jul-2008 | 0.9434 | Aug-2008 | 0.8639 | Sep-2008 | 0.7996 | Oct-2008 | 0.6680 | Nov-2008 | 0.6572 | Dec-2008 | 0.6928 | Jan-2009 | 0.6438 | Feb-2009 | 0.6454 | Mar-2009 | 0.6873 | Apr-2009 | 0.7265 | May-2009 | 0.7912 | Jun-2009 | 0.8114 | Source: RBA Statistical Tables
However, the cut in interest rate alone will not work, as it is not working in US and Japan, for example.
The current interest trend is showing a downward trend which indicates that RBA believes that the economy needs to be stimulated.

Appendix G:
The graph below shows that the savings by households and corporations were high during GFC, while the general government was down to the increased G (RBA, 2012).

If the commodity prices falls further than expected, and the currency did not depreciate, the traded goods and services sector in not going to get the boost which otherwise would be expected. This would lead to lower government revenue, which further increase budget deficit.

Appendix F
Analysis on recent savings shows that the savings are going down. The recent increasing trend in retail sales shows that the saving is going down. Retail sales across all sectors are going up from January 2011, which is a clear evidence that the saving is going down (ABS, Sep 2012). Source : ABS, Cat No. 8501.0 - Retail Trade, Australia, Sep 2012.

Superannuation contribution is less as compared to Jun 2007 to Jun 2008 period. The retail sales increase and decrease in superannuation contribution reduces the total domestic saving, which reflects in the exchange rate. This causes the Australian dollar to stay high, although the commodity prices go down.

BIBLIOGRAPHY:

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