Wednesday, February 27, 2008

Pruning The Bush

There is no doubt that the new federal government confronts a significant challenge in dealing with the legacy of increasing inflation left behind by the previous government. Higher inflation means higher interest rates, and homebuyers and business owners don’t want to see that. It can also be argued that higher interest rates can actually contribute to inflation through the threat of increased wage and price pressures as people try to keep up. Then at some point the bubble bursts and demand falls away, taking the steam out of the economy. The trouble is that the bursting bubble can be too dramatic and trigger a recession.

That’s why interest rate policy is often described as a blunt instrument. It often punishes people who are already the victims of the inflationary problem, and the results can be unpredictably messy. If inflation can be contained by means other than interest rate increases that must be a good thing. Or is it?

Wayne Swan has made no secret of his intention to reign in government spending, despite the fact that there remains a record surplus projected to reach as much as $30 Billion in the coming budget. The problem is that cutting government spending not only reduces the money flowing into the economy, it reduces the services performed by government. Notwithstanding the fact that it must be possible to identify clear areas of waste which can be tidied up, there is a risk that excessive budget restraint is also going to hurt the people who depend most on government services. In fact, it is possible to underfund services to the point where they actually become less efficient. I like to refer to that effect as “pruning the bush so far back that you kill it.” On top of that there is also the risk, as with interest rates, that if taken too far the policy can actually provoke a recession.

Then there is the question of what to do with the $30 Billion. It is now accepted wisdom that infrastructure and skills are the two areas of our economy that have been the victims of dramatic underinvestment. Our inflationary problems are not so much driven by demand but by capacity constraints. That’s why the $30 billion could be productively invested in better infrastructure, along with more education and training. I’d like to add one more suggestion: I’d like to see some of that surplus going into our superannuation funds as a co-contribution. Now that’s a real investment in the future.

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