The economics of a change in government

On 18 May, Australian citizens over the age of 18 will be required to vote to elect members of the 46th Parliament of Australia. As always, there is a chance of a change in government. Indeed, this time around, that chance appears meaningful. Whether one consults Newspoll surveys or the betting markets, the data is pointing to a meaningful probability that Labor will displace the Liberal/National Coalition to form a new government.

What could this mean economically? The conventional wisdom is that a new Labor government would increase government expenditures at a rate significantly above the Coalition. Assuming this is correct – and leaving aside any discussion on the social equity of additional expenditures – what is the likely economic impact of such increased government spending?

First on the negatives: increased government expenditures will most likely need to be funded via increased government borrowings. This means higher interest expenses for the government and future debt repayments – potentially via higher future taxes or lower future government expenditures. Furthermore, excessive government spending can create inflation if the economy does not have the capacity to absorb it. While a little inflation is healthy in an economy because it drives consumption and growth; too much inflation is never a good thing. High inflation acts like a regressive tax on everyone.

Now, to the positives: government expenditure boosts economic growth. And it just so happens that the Australian economy is deteriorating at present. Recently, the RBA revised down its forecast for domestic economic growth and inflation. CPI inflation is expected to be running at just 1.25 per cent per annum over the coming months and the RBA’s cash rate remains at its lows of just 1.50 per cent. These data point to an economy which is operating below its capacity and weakening. Therefore, should the federal government increase its expenditures, the probability of this spending being excessively inflationary is very low – at least in the short term.

Finally, it is worth observing that Australia’s net-debt-to-GDP ratio, at around 20 per cent, is very low when compared with other developed nations around the world. Said another way, Australia’s public balance sheet does have capacity to grow its borrowings to fund higher government expenditures.

So why didn’t the Coalition take advantage of the government’s balance sheet capacity to boost government spending and drive higher economic growth? Prudence. And this should be lauded. You see, a government can only use up its balance sheet capacity once. Once this capacity has been depleted, the financial flexibility of the government reduces significantly. And in order to regain new balance sheet capacity, government indebtedness needs to be reduced. Typically, the process of reducing government indebtedness creates headwinds for economic growth. The temptation for politicians is to spend today – and leave the process of balance sheet repair for future politicians (or even generations) to deal with.

But with the Australian economy operating below its capacity and continuing to deteriorate, there is a valid argument to be made that Australia’s healthy public balance sheet be utilised to stimulate domestic growth. It’s simply a question of striking the right balance.

To recap: the probability of change in Australia’s federal government is significant. If Labor forms a new government and significantly increases spending, this would likely boost the domestic economy in the short run. Australia’s public balance sheet could easily absorb such additional spending in the short run, though it would not be in the interests of future generations to utilise this capacity in its entirety. For a new Labor government, a little Liberal prudence would go a long way.