Should Australians be more concerned about budget deficits or big government?

We live in strange times. A few months ago, when the Australian government had little hope of achieving its promised budget surplus, it seemed likely to face severe punishment for fiscal mismanagement. Since then the short term budget situation has worsened, but the treasurer has been able to mount a plausible argument that this has happened as a result of factors beyond the government's control. Wayne Swan has been able to argue that 'we've had this sledgehammer smash into our revenues' as a result of the high dollar and lower commodity prices. The federal opposition, fearful of being labelled as favouring 'mindless austerity', has now walked away from its commitment to have a surplus in its first year of office. So, the government seems to be off the hook!

Rather than showing contrition, Wayne Swan seems to be taking advantage of the situation to engineer a change in public attitudes towards deficits. His recent criticism of European finance ministers for their austerity policies must have been intended largely for an Australian audience. Wayne must know that the Europeans have not chosen austerity. With few exceptions, European finance ministers would love to be able to follow his example of ongoing increases in government spending. Austerity has been forced upon them as a consequence of decades of profligacy.

I suspect that Wayne Swan is denouncing option A (austerity) so severely because he favours option D (deficits for a decade). The next budget should confirm whether or not my suspicions are well-founded. The big test is whether it presents a plausible route to budget surplus within a few years, or whether he tries to make ongoing deficits look respectable.

How might Mr Swan attempt to make ongoing deficits look respectable? He would probably find it difficult to argue in favour of never-ending fiscal stimulus: even Keynesians would have to acknowledge that fiscal stimulus for more than 5 or 6 years in a row could be difficult to justify. Perhaps he will attempt to advance a dodgy argument along the lines that low world interest rates provide Australia with the opportunity to borrow at low cost in order to pay for increased investment in human capital (implementing Gonski proposals for increased education funding) and help us to meet the challenges of the Asian century (whatever that might mean). He could suggest that such a policy would raise productivity and thus generate income streams that would enable the debt to be serviced without any problems. (I think the argument is dodgy because the Gonski proposals are unlikely to have much impact on productivity – but that is another story.)

Would the electorate buy such an argument for ongoing fiscal deficits? Jacob Greber has an interesting article in this weekend's Financial Review ('Swan changes his tune', p 16) in which he argues that voters may care about budget deficits far more than the government anticipates. He points to a Nielson poll suggesting that the percentage of voters viewing a surplus as a high priority rose after the government abandoned its promise of a surplus in the current fiscal year. A poll in February suggested that 54 percent of voters viewed a surplus as a high priority (up from 49 percent before the promise was abandoned), and 41 percent (down from 45 percent) viewed it as a low priority.

I hope Greber is right, but I think public opinion is likely to become more favourable to dodgy arguments for increasing government debt if a surplus can only be achieved during the next few years through tax increases or substantial cuts in government spending. I suspect a majority for voters would favour increasing debt to fund additional education spending if an option was presented to them in those terms.

In my view, Government debt is still at a sufficiently low level in Australia that it could not plausibly be argued that servicing that debt is likely to present a problem in the near future. The government's failure to achieve a budget surplus this year is only of consequence because it is muddying the waters about the importance of maintaining fiscal discipline as it runs away from that stupid promise. Irresponsibility is being heaped upon stupidity.

In my view there is reason to be concerned that the cautious attitudes that Australians have shown toward increasing public debt in recent decades could be quite a fragile phenomenon. John Daley has expressed a similar view in his report for the Grattan Institute, Budget pressures on Australian governments:

'There are concerns that this public attitude may be eroded by several years of budget deficits, and the accompanying rhetoric justifying this in both Australia and overseas. Public concern about deficits may also be affected by promises for specific costly programs and political attitudes projecting a belief in the ability of government to cure all social ills'.

Daley's report provides an excellent overview of the contribution of increases in different forms government spending to budget deficits. Growth in spending on health seems to present the biggest challenge.

However, Daley seems to be more concerned about the potential for budget deficits to increase than about the growth of government spending. He is at pains to point out that budget deficits can be a problem in countries with relatively low levels of government spending as a percentage of GDP and that size of government in Australia is relatively low by OECD standards. He argues on historical grounds that 'successful budget repair invariably involves both tax increases and expenditure reductions'.

Stephen Anthony's report for the Minerals Council, A roadmap for fiscal sustainability, seems to imply that we should be concerned about the growth of government spending over the longer term, even if tax revenue could be lifted sufficiently to prevent fiscal deficits from growing. His projections suggest that the federal government will still have a structural deficit a decade ahead even if it manages to restrain spending to a rate below the growth rate of the economy. His recommendations include elimination of up to $15 billion in poorly targeted outlays as well as institutional reforms to re-orient fiscal strategy around a structural budget measure designed to prevent spending from blowing out of control when commodity booms result in windfall tax revenues.

Andrew Baker's report for the Centre for Independent Studies, Target 30 – Tax-welfare churn and the Australian Welfare State, provides some clues as to where poorly targeted outlays might be found. The report suggests that around one-half of government welfare spending in Australia is due to tax-welfare churn, where government taxes middle and high income earners and then returns those taxes in the form of welfare benefits, usually with conditions and requirements attached. Baker argues for reductions in government spending in specific areas of churn, with savings returned to taxpayers through reduced taxes.

In considering whether Australians should be more concerned about the budget deficit or big government, some consideration should also be given to the question of Australia's ability to cope with big government. As I pointed out in Free to Flourish countries differ greatly in their ability to cope with big government. For example, Sweden seems to have been able to cope with government spending that is still around 50 percent of GDP without huge problems so far, whereas the Greek economy was exposed to a great risk of calamity before its government spending reached that level.

Where does Australia stand? It seems to me that the political institutions and public administration of this country are struggling to cope with existing responsibilities. It makes no sense for governments to be spending more and taking on additional responsibilities when they cannot even sort out which level of government has responsibility for what function.

That leaves me more concerned about big government than about the budget deficit. The federal government should be castigated for allowing government spending to increase faster than GDP. 

Does our hope for social progress depend on improvement of human nature?

John Gray's recent book, 'The Silence of Animals' is subtitled: 'On progress and other modern myths'. My main reason for reading it was to see whether it provided a serious challenge to the positive view of progress presented in my book, Free to Flourish.

From what I had read of John Gray's writings over the last decade I had expected that The Silence of Animals would be a book that could only be enjoyed by people who like wallowing in hopelessness. I was pleasantly surprised that I had a positive reaction to most of the book.

Rather than suggesting that we should wallow in hopelessness, the author argues the merits of contemplation, 'as an activity that aims not to change the world or to understand it, but simply to let it be'.  But how has it come about that increasing numbers of humans now have the capacity to devote some of their time to such an activity? Without acknowledging it, the author seems to me to be endorsing the progress that has given more people the luxury of being able to spend time observing the natural world, without having to focus on the usefulness of animals and environments as sources of food, shelter and other necessities of life.

As I see it, this book does not actually make a cogent case that human progress is a myth. The author's target seems to be a rather different beast - the idea that human nature improves along with the growth of knowledge. He writes:

'Science and the idea of progress may seem to be joined together, but the end-result of progress in science is to show the impossibility of progress in civilization. Science is a solvent of illusion, and among the illusions it dissolves are those of humanism. Human knowledge increases, while human irrationality stays the same. Scientific inquiry may be an embodiment of reason, but what such inquiry demonstrates is that humans are not rational animals. The fact that humanists refuse to accept the demonstration only confirms its truth'.

That is beside the point. As the author must once have known (as a person who has read the works of Friedrich Hayek) what most of us perceive as progress can be viewed as a process whereby the evolution of superior social rules has enabled some groups to flourish and for the rules of the more successful groups to become identified with civilization. This process does not depend upon human rationality. In fact, Hayek observed that in view of the rapid changes in human society that had occurred over the last eight thousand years it is not surprising that adaption of the 'non-rational part' of humans 'has lagged somewhat', and that 'many of his instincts and emotions are still more adapted to the life of a hunter than to life in civilization' (CoL, 1960, p 40).

The examples that John Gray gives of irrationality and inhumane conduct under communism and Nazism are also beside the point. The view that we are better people than our Stone Age ancestors can probably be dismissed as hubris, but that doesn't mean that there has been no social progress over the last eight thousand years.

In order for John Gray to persuade me that progress is a myth he would need to establish that the rules of the game of modern societies have reduced the opportunities for people to have happy and meaningful lives.  In my view that would be an impossible task and it is not surprising that the author does not attempt to do this. Our hope for progress does not depend on improvement of human nature. It depends on maintaining rules of the game that enable people to live in peace, to realise their potential as individuals and to enjoy a measure of economic security.

This book would have been much better if the author had defined his target more carefully as the myth of improvement in human nature or the myth of human superiority. Even as it stands, however, the book is not as bad as I thought it might be.  

Why do Australians want to stop the boats?

There are some questions that I have tended to put in the too hard basket because I don't have answers for them. The problems of refugees and the attitudes of Australians toward people seeking asylum in this country fall into that category. So, what I am about to write doesn't reflect any deep insights. The main message I would like to convey is that all humans deserve the opportunity to live happy and meaningful lives. People become refugees primarily because they are not free to flourish.

The number of people who come to Australia each year on refugee boats is apparently now greater than at any time since the Vietnam war. Nevertheless, as Julian Burnside, QC, pointed out in a presentation in September last year, the rate at which boat people have been coming here in recent years represents a tiny annual increment to Australia's population – about a quarter of one percent. 

It is fairly obvious, however, that a high proportion of Australians want to stop the refugee boats and that the main political parties in Australia are competing to establish who has the best policies to do this. That means, I think, that those who would like their fellow Australians to do more to help refugees need to be sure that they understand why so many of us want to stop the boats.

In the paper just referred to, Julian Burnside expressed the following view of why Australians want to stop the boats:

'Xenophobia lies just below the surface in most Australians, and it is easily scratched, and politicians who are cynical enough are willing to scratch it to the surface and then exploit it for their own political end'.

If that had been said about Australian attitudes 30 or 40 years ago I would have had no difficulty in agreeing. Less than 50 years ago, xenophobia was very much on the surface in this country. In the first half of the 20^th century the level of xenophobia in Australia must have been among the highest in the world. How else could anyone explain the support of the majority of the Australian people for the government's shameful history of using a dictation test in the most cynical and offensive manner imaginable to exclude non-white immigrants?

However, recent evidence on Australian attitudes seems to me to suggest that, in general, people in this country are no longer particularly fearful or hostile toward foreigners.  A fact sheet on public attitudes toward asylum seekers, based on a survey by the Scanlon Foundation conducted in 2012, suggests that about three-quarters of Australians feel positive about refugees who have been assessed overseas and found to be victims of persecution coming to live in Australia as permanent or long term residents.

Attitudes toward boat people were more negative, with only 23 percent suggesting that they should be allowed to apply for permanent residence. The most common response (38 percent) was that they should be allowed to apply for temporary residence only; 26 percent suggested that their boats should be turned back and 9 percent suggested that they should be held in detention until they could be sent back.

The negative attitude toward boat people seems to be associated with scepticism about their motives for coming to Australia. Responses to an open-ended question on this topic suggest that Australians more commonly perceive that boat people are coming in search of a better life, rather than fleeing persecution or driven by desperation.

Julian Burnside suggests that the negative public attitude toward boat people could be turned around by courageous political leadership. He suggests that we need leaders to stand up and say:

'These people are running for their lives. They're doing nothing wrong. They're doing what you would do. We've got the space, we've got the wealth to make them safe. Let's do that'.

I think it would be good if more political leaders said that kind of thing. But I don't think it would do much to change attitudes toward boat people. It is possible to recognize that boat people are fleeing persecution and driven by desperation and still to regard them as queue jumpers - and to be concerned to avoid encouraging more refugees to take the risk of putting their lives in the hands of the people smugglers.

Cartoon by Nicholson from “The Australian” newspaper:www.nicholsoncartoons.com.au

I have to admit that I am sympathetic to such concerns, even though I know that the queue metaphor is not appropriate. As Fr. Frank Brennan has pointed out, in some parts of the world (like Pakistan) 'there is only mayhem'. The Hazaras fleeing from Afghanistan via Pakistan may not perceive that they have the opportunity to join an orderly 'queue' with a predictable waiting time, even after they reach Indonesia and are given the opportunity to have their claims processed. Nevertheless, it seems to me to be undeniable that those who choose the hazardous option of coming to Australia on an over-crowded and leaky boat are seeking an advantage over similarly placed persons who wait in Indonesia in the hope that they will eventually be allowed to come to Australia.

So, that kind of reasoning leaves me in support of a 'no advantage' policy. Unfortunately, however, the 'no advantage' policy that the government foreshadowed last year, with the re-introduction of off-shore processing in Nauru and PNG, hasn't stopped the boats. That is probably because boat people perceive the 'no advantage' rule, as currently applied, to be a bluff. They may think that the Australian government lacks the resolve to maintain a 'go slow' policy in processing their claims – and if so, they are probably correct.

As noted at the outset, I don't have any deep insights to present. I doubt whether we will be able to stop the boats until we are able to negotiate an appropriate bilateral arrangement with Indonesia, whereby the Indonesian government allows boat people to be returned to that country for processing, in exchange for Australia's agreement to contribute to accommodation and processing arrangements, and to provide an increased quota of resettlement places from Indonesia. As Frank Brennan says:

'We need to set up a workable, transparent, honourable queue in Indonesia'.

If such a solution is possible it will probably require a substantial increase in our total refugee intake. But I don't think that a future government would have huge problems in gaining public acceptance for such a policy. Most Australians have fairly positive attitudes towards helping those whom they perceive to be victims of persecution. 

Would it be costly to require banks to raise equity to 30 percent of total assets?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig make a strong case that in order to reduce the risk of insolvency in major financial institutions, shareholders should be required to fund their lending and other investments to a much greater extent.

The authors argue that government regulation to reduce the risk of insolvency of major financial firms is desirable because failure of such firms has adverse effects that are analogous to those that can arise from accidents in nuclear power plants. When I discussed that analogy in an earlier post, I accepted (somewhat reluctantly) that it is appropriate. As a result of the interconnectedness of financial markets, it would probably not be possible to avoid major economic disruption if large financial institutions were allowed to fail when they became insolvent. That makes it desirable to find the least cost way of regulating them to make it less likely that they will become insolvent. Governments are thus presented with problems that are similar to those involved in regulating the nuclear power industry to reduce the risk that serious nuclear accidents will occur.

Admati and Hellwig suggest that the best way to reduce the risk of insolvency of major financial institutions is to require them to raise shareholder equity from current levels (which under Basel III can apparently still be as low as 3 percent of total assets) to 20-30 percent of total assets. The higher ratio of shareholder equity to total bank assets would provide greater scope for any future fall in the value of bank assets to be accommodated without insolvency.

The authors suggest that requiring banks to rely more on equity funding would impose little, if any, cost to society. In this post I want to focus specifically on the reasons they give for that view. I encourage readers who are interested in a broader discussion of this important book to read John Cochrane's review.

The authors argue that requiring banks to rely more on equity funding would impose little cost on society because it would offset the bias in favour of borrowing provided by government guarantees and tax systems. Banks and their creditors benefit from explicit guarantees to protect depositors as well as implicit guarantees associated with the 'too big to fail' concept. These guarantees enable banks to borrow on more favourable terms than would otherwise be possible. Tax systems tend to favour borrowing because they make interest paid a tax deductible expense.  (The dividend imputation system in Australia reduces this bias to some extent but, as acknowledged by the Henry Tax Review, there is still a bias in favour of foreign borrowing and Australian banks rely heavily on this source of funds.)

The authors point out that equity ratios of banks were generally much higher in the 19^th century, prior to the existence of government guarantees.  In the US, until the middle of the 19^th century, equity levels around 40-50 percent of banks' total assets were typical and early in the 20^th century it was still common for banks to have equity of around 25 percent. The picture seems to have been broadly similar in Australia. Data presented in an article by Charles Hickson and John Turner shows (apparently) that the average equity to deposit ratio of Australian banks declined from around 60 percent in the 1860s to around 20 percent in 1892. The subsequent depression would presumably have substantially depleted the equity of those banks that managed to remain in business. Adam Creighton, a journalist, implies that the surviving banks re-built their capital ratios following the depression, so that a century ago they maintained capital ratios of between 15 per cent and 20 per cent. (See: 'Time to Force the Big Banks to Hold More Capital', 'The Australian', 23 November, 2012.)

Admati and Hellwig point out that the proposed increase in bank equity would not interfere with core banking functions of accepting deposits and making loans. Given the current structure of balance sheets, the increase in equity levels would tend to displace additional borrowing from sources such as money market funds rather than bank deposits.

The authors point out that bankers' claims that equity is more costly than debt are flawed because they don't take account of the effect of increased equity in reducing the risk of bank failure and thus reducing the rate of return required by shareholders. Equity only seems costly because government guarantees provide an implicit subsidy on debt. The increase in equity could be accomplished without significantly disadvantaging existing shareholders by requiring banks to retain earnings rather than pay dividends, until equity levels have reached the minimum level.  

I am normally sceptical of claims that governments can improve matters when they attempt to offset the adverse effects of previous interventions by adding a further layer of regulation. It seems, however, that Anat Admati and Martin Hellwig have found an instance where the theory of second best provides a valid guide to policy action. There are strong grounds to argue that if governments cannot credibly bring the 'too big to fail' policy to an end, they should take decisive action to offset the effects that policy has had in encouraging banks to become more fragile.  In my view the authors' proposals deserve strong support.