No matter how economically fallacious an argument is someone somewhere will ceaselessly parrot it. The latest one is that there is no reason for the Reserve to raise rates because of the country's huge surpluses. On hearing this I was reminded of the glowing report Terry McCrann, business correspondent for the Herald-Sun, gave Costello's 2005 budget for giving us "sustainable stabilising surpluses" (Crowning glory for Costello, 11 May 2005).

McCrann was not the only one to fail understand the nature of our surpluses. David Uren, so-called economics correspondent for The Australian made the same error, when he asserted that "new spending and tax cuts . . . will not force interest rates higher" because of accumulating surpluses. George Megalogenis, economics writer for The Australian wrote in a similar vein, saying that "Mr Costello wanted a big surplus, to assure the Reserve Bank that domestic demand was not about to run ahead of the economy's capacity to supply it".

The old Keynesian view was that governments accumulated surpluses in the good times so that they could spend them when the bad times arrived. This was called counter-cyclical. What is overlooked is that the surpluses are the product of loose monetary policies which in themselves are the cause of the so-called business cycle.

In plain English, loose money raises nominal incomes which in turn raise tax revenues. So when someone argues that a surplus is needed to make sure demand does not "run ahead of the economy's capacity to supply it" he is, whether he realises it or not, arguing that the central bank has printed too many dollars. Clearly it would have been better if the money supply had not been expanded.

This leads to the conclusion that spending a surplus in an attempt to alleviate or prevent a recession is no different in principle from the Reserve simply printing the dollars and then giving them to the government of the day to spend. This is something that Megalogenis should know.

Uren's argument that the surpluses would prevent tax cuts from driving up interest rates was just plain silly and the current interest rate regime proves it. True tax cuts cannot drive up interest rates. In fact, it's even possible for them to drive rates down. A true tax cut occurs when there is a genuine transfer of purchasing back from the government to the taxpayer.

In short, the tax cuts are not funded by borrowing or inflating the money supply. In such circumstances it ought to be clear that it is impossible for tax cuts to raise rates. Moreover, if the cuts are saved then they can actually drive rates down, depending on the social rate of time preference. The Howard Government was banking on the expectation that the tax cuts would not flow into consumer spending. This is because Treasury and Reserve Bank officials assured Costello that some households saved the additional income from the 2004-05 budget.

According to the budget papers "This trend is likely to continue with further income tax cuts and measures to support saving in the 2005-06 budget". This led some economic commentators to assert that increased savings will lower consumption and drag the economy down. For instance, Megalogenis, claimed that "the economy is sluggish because consumers are frankly exhausted by spending. . . . Last year's tax cuts do not appear to have been spent. They were saved".

As I said earlier on, a true tax cut involves a transfer of purchasing power back to the taxpayer. This also means that aggregate spending must therefore remain the same. (Forget the Keynesian multiplier effect: it's just another economic fallacy). Moreover, as Ricardo said to Malthus: "To save is to spend". Our commentators have once again fallen into the old economic fallacy of confusing savings with cash balances.

All the commentators seemed to have agreed that the budget assumed that the Chinese and US economies would continue to rapidly expand. The Chinese expansion has given us the biggest minerals boom in 30 years, driving the terms of trade -- the ratio of export prices to import prices -- to a 30-year high. Basing the budget on continued Chinese expansion was not a smart move. Costello evidently did not know that the Chinese economy is in a highly unstable condition, and still is.

What the economic commentariat overlooked -- and still does -- is the money supply. From Howard's first election win in March 1996 to May 2005 currency expanded by 76 per cent, bank deposits by 109.6 per cent and M1 by 102 per cent. These are terrible figures and things have not got any better. From May 2005 to January 2008 bank deposits rose by 36.5 per cent and M1 by 33 per cent. Unfortunately, our economic commentariat can see no significance in these figures, For them, monetary theory and capital theory just don't matter.

Gerard Jackson
BrookesNews.com

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© 2008 Gerard Jackson

ABOUT THE AUTHOR

Gerard Jackson is an economics editor at BrookesNews.com.

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Surpluses Won't Save the Australian Economy by Gerard Jackson

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