Reading the economic theories of Rudd and Abbott

That’s the headline for my latest piece in Crikey, over the fold

Kevin Rudd’s suggestion that Opposition budget cuts could cause a recession seems, on the face of it, like just another round of the pointless series of claims and counterclaims that has characterized this election campaign so far.

However, underlying Rudd’s claim and the opposing rhetoric of Tony Abbott is a fundamental disagreement about the way the macro-economy works and how it should be managed. If Rudd’s claim leads to a real debate about these contradictory viewpoints, we could have a real choice in this election, rather than picking which party we dislike and distrust more.

So far, the claims and counterclaims have surrounded the government’s estimate that Abbott will need to make cuts of $70 billion over the period of the forward estimates. The Opposition has disputed this without, so far, offering an alternative estimate. Regardless of the precise numbers, however, it is clear that the Opposition is promising to return the budget to surplus more rapidly than Labor, and that this must involve cuts in public expenditure. The key question is, what effect will such cuts have in an economy that is already showing signs of weakness.

Tony Abbott’s views on macroeconomic management are clear. The aim of fiscal policy should be to deliver consistent surpluses of between 1 and 2 per cent of GDP. Implicit in this target is a recognition that shocks such as recessions will occasionally push the budget into deficit. In such circumstances, governments should exercise even tighter fiscal restraint to ensure a rapid return to surplus. Active macroeconomic policy should be left to the Reserve Bank and focused on maintaining low and stable inflation.

Although Abbott presents himself as favoring ‘practical solutions to practical problems’ rather than ‘market theory’, his position is derived from the ‘classical’ free-market economic theory that held sway before the Great Depression, and was revived as ‘New Classical economics’ in the 1980s. On the classical view, recessions and depressions in a market economy are self-correcting. Government attempts to stimulate the economy can do no good, and may do positive harm by ‘crowding out’ more productive private investment.

The alternative view, put forward by John Maynard Keynes during the Great Depression, is that the economy can remain depressed for long periods, and that, in such circumstances, fiscal stimulus through well-targeted tax cuts and public projects can increase employment and economic growth. The flip side of the Keynesian view is that governments should run substantial surpluses during boom periods, in order to stabilize the economy and balance the budget over the course of the economic cycle.

Keynesian policies achieved great success in the decades after World War II, when unemployment rates fell to 2 per cent or less, economic growth was consistently strong, and income inequality declined to levels never seen before or since. But Keynesianism fell out of favor during the inflationary crisis and remained so, with brief exceptions (such as the Accord period, and the Keating government’s Working Nation program) until the Global Financial Crisis.

Faced with the potential collapse of the global economy, and the absence of any coherent policy response from the classical school, most governments implemented Keynesian policies to some extent in the immediate aftermath of the financial meltdown of 2008. However, most such policies were halfhearted and rapidly scaled down. The eurozone and the UK went further, adopting ‘austerity’ policies focused on (largely unsuccessful) attempts to reduce deficits and debt.

The only major governments to undertake and sustain Keynesian fiscal stimulus were those of China and Australia. It has sometimes been argued, by supporters of the classical view that Australia’s stimulus had no effect, and that our economy was rescued by strong demand from China. This amounts to the nonsensical claim that fiscal stimulus in China was effective enough to provide a substantial flow-on benefit to Australia, but that fiscal stimulus in Australia had no effect.

The outcomes of the GFC speak for themselves. Australia was almost the only developed country to avoid a recession. Where fiscal stimulus was limited and temporary, as in the US, recovery from the recession has been slow and weak. Where classical austerity measures were implemented, as in much of Europe, there has been no recovery at all. In the UK, for example, often taken as a model by Australian conservatives, GDP is still 4 per cent below its peak of five years ago. On present indications, it will take a decade, and quite possibly more to repair the damage done by austerity policies.

The stimulus package introduced in 2009 included, quite appropriately, a strategy for a return to surplus as the economy recovered. Unfortunately, after committing to an optimistic timetable, former Treasurer Wayne Swan treated the return to surplus as an end in itself, not a tool of macroeconomic management. This effectively conceded the ground in the macroeconomic debate to Abbott and the opponents of Keynesian stimulus.

To win the election Rudd needs to move beyond attacks on the specifics of Abbott’s policies (or the lack thereof). He must explain why the Keynesian and social democratic policies he espoused and implemented in his first term as PM are the right way forward for Australia, and why the Howard government policies of consistent surpluses, regardless of economic conditions, represent a recipe for disaster next time there is an economic crisis.

53 thoughts on “Reading the economic theories of Rudd and Abbott

  1. Prof, do you think Rudd can explain how Treasury could chronically overestimate Costello’s surpluses and underestimate Swan’s deficits? (rather than C being prudent and S shifty). Without that, no point in embarking on Macro 101.

  2. JQ: ¨On present indications, it will take a decade, and quite possibly more to repair the damage done by austerity policies.¨
    Is there any non-fairyland scenario in which the Eurozone or UK economies can ever do better than convergence with the previous long-term growth trend? That´s what you would need to undo the damage of austerity. Otherwise the misery of the Great Depression and the Great Recession remain as uncompensated blots on the history of humanity. (That´s without counting the Nazis as collateral damage.) It´s more likely you never catch up, as per deLong/Summers hysteresis: there´s a new, lower growth path.

  3. I am definitely not up to date with the latest literature on economic convergence, but it is fairly obvious to me that one would expect an S-shaped economic growth curve. At low levels of development there is high marginal productivity of capital and is very easy to raise the standards of living. In developed countries, a unique economic shock leads to a reduction in the productivity of the labour force due to (if you’re a neolib, a large chunk of the population choose to take an extended holiday; if you are rational, there are structural issues among them a decreased safety net for all aspects of employment and training) and a concurrent brain drain as the most educated fraction of the population chases economic opportunities elsewhere. Convergence is not an immutable law and must not be assumed.

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