Issue: 339
Sent: 15-05-2013 12:53:06
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Australia in Need of a New Budget CharterThe Essential SMSF Guide 2012-13US Carbon Emissions Continue Decline
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Australia in Need of a New Budget Charter

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

Australia's fiscal position is unravelling at a speed few suspected would be possible but in a way that is consistent with the reaction of a highly cyclical economy. It might be too late for Wayne Swan but prospective Treasurer Joe Hockey should consider changing the way forecasts impact budget outcomes.

As the Treasurer grudgingly concedes another loss of forecast revenue, it is easy to characterise Australia's current fiscal problems through the prism of party politics. Labor has never had a budget surplus while surpluses are in the DNA of the Liberals, according to the chief party protagonists.

While politicians must eventually take responsibility for fiscal outcomes, more light needs to be shone on those in the background who, in some respects, have led the current government into the fiscal cul-de-sac in which it has found itself.

While recently announcing a cut in anticipated tax revenues, Treasurer Wayne Swan referred repeatedly to forecasts having been undertaken by 'professionals'. This was partly out of the need to shield himself from some of the political flack but was also a statement of fact. In all material respects, politicians are simply spokespeople for the forecasts. Their own input is negligible.

In general, this approach makes sense. Rarely do politicians have the skills to engage with officials as technical equals. Perhaps John Hewson, a former professor of economics, is the unique example in recent political history of someone who could have engaged at this level of proficiency. Even if the politicians did have the requisite skills, they would always be suspected of tweaking the numbers to get outcomes favouring their short term electoral standing. Consequently, by common consent, politicians are kept away from the forecasts.

All of that makes sense as long as the forecasters are doing a good job.

Unlike previous administrations, officials in the Rudd-Gillard governments seem to have been unusually influential. In economics, Glenn Stevens and Ken Henry have been prominent. More broadly, without Angus Houston the government might still be floundering over a response to the influx of refugees by boat.

The reliance on officials has left politicians vulnerable to mouthing ideas without a full understanding of the consequences. Politicians have, as a result, hung their fortunes on three mistaken views of the world.
" That Australia's exchange rate will always track commodity price movements providing an automatic adjustment mechanism in the event that commodity prices return to lower levels.
" That commodity price cycles are slow to turn and little influenced by global supply responses to higher prices.
" That talking to business leaders offers a good guide as to the direction of investment or market conditions.

The correlation between the exchange rate and commodity prices appeared obvious during the 2000s but, from a longer perspective, is less evident. Much of the exchange rate weakness in the 1980s and 1990s was due to structural faults in the Australian economy unrelated to the level of commodity prices.

Implicit in the argument of those urging economic reform at that time was that structural change would result in a higher exchange rate which would advantage everyone buying goods. That is what has happened.

In talking about the outlook for commodity prices in 2010, Governor Stevens said "It is our assumption that prices for key resource exports will not remain this high, but will instead decline over the next few years". That indicated a reasonable view of the direction but also reflected the tendency of all forecasters to underestimate the speed of market adjustments.

An alternative view of the commodity markets is that cyclical turns occur precipitously with most of the price adjustment happening within the first few months of the cycle peak. More than three quarters of the adjustment is likely to have been completed within 12-15 months.

In 2010, as official forecasters were concluding that the economy was near a turning point, they should have been warning the government about a potentially dramatic collapse in commodity prices, not giving them an excuse to assume an easy transition. No matter how much companies might have protested at the time, this would have also implied a sharp contraction of investment funding. It always happens that way.

Investors understand that risk preferences are not symmetric. The risk of lower prices (i.e. protecting ones wealth) is more important that the risk of higher prices (i.e. getting surprising upside returns). Portfolio choices are, consequently, skewed to take account of this risk preference.

There is a direct equivalent for government policymaking. Governments of all persuasions should have been budgeting for sharply lower commodity prices, a continuation of relatively high exchange rates and they should have been applying a discount factor to what business had been saying about their investment intentions.

In 1998, the then government moved to mandate "budget honesty". The legislation was politically motivated but the charter was to enshrine fiscal rectitude by offering everyone greater transparency about the state of the budget.

But budgets continue to rely on a set of assumptions that largely go untested. Indeed, the government has refused to disclose the key commodity price assumptions used to forecast mining industry revenues and tax receipts.

As we consider a new budget in the coming week, nothing will have changed. The budget outcome will continue to depend on the accuracy of its underpinning forecasts. For the most part, these will be within acceptable bounds. However, the more cyclical elements of the economy, such as commodity prices (and the cost of carbon), require more daring and are more susceptible to error. Assuming gentle adjustments will almost certainly lead to budgetary and economic tears.

On the assumption that Wayne Swan is fast losing relevance, an important reform for potentially new Treasurer Joe Hockey to contemplate is greater transparency in the assumptions underpinning the forecasts. This could be his contribution to budget honesty.

Perhaps the new parliamentary budget office could have a role in publishing alternative budget outcomes under different assumptions. A debate about the assumptions would represent a valuable improvement in helping to understand our inherently cyclical economy and its associated risks.

Successful budgeting may require us to ditch the faceless professionals pretending they can get it right in favour of an approach that recognises how the risks are best managed in the same way investment managers seek to diversify their portfolio risks. That way, politicians can also participate. In a democracy, there is nothing wrong with them understanding the risks and tailoring their policies accordingly.

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