Frydenberg is Australia’s Kamikaze MMT Pilot

Frydenberg is Australia’s Kamikaze MMT Pilot

By all accounts, the May 2021 (or FY21-22) Federal Budget will go down as perhaps the most infamous federal budget in Australian history.

The Federal Budget handed down by Australia’s Treasurer Josh Frydenberg on Tuesday, 11 May 2021 was radical and extreme in both its underlying, theoretical economic basis and its profligate spending.

Frydenberg has set the Australian Government on a path of extreme debt and deficit, which has little to do with the COVID-19 pandemic and has more to do with protecting vested interests and placating noisy political constituencies who questionably feel aggrieved ahead of the upcoming federal election.

Moreover, this path of extreme Federal debt and deficit is occurring at the same time when the most extreme form of lax monetary policy in Australian history is being implemented, in large part to help finance this extreme debt and deficit.

The likely negative medium-term economic, political and social ramifications for Australia from the fiscal course that Treasurer Frydenberg has set cannot be overstated.

Without perhaps the most extreme reversals in the history of Australian fiscal policy via the implementation of severe fiscal austerity, the Australia Government will possess little fiscal capacity to respond to future economic shocks (such as a financial crisis) and will be extremely vulnerable to weak or negative economic growth, runaway inflation or rising interest rates.

A lack of curiosity from the general public, coupled with a lack of robust analysis from professional economists as well as economic journalists and commentators, means that the overwhelming majority of the Australian people currently have little idea of the grave economic risks, even horror, we face on our horizon.

This horror will dwarf the severe financial distress and hardship that approximately one third of Australians are already experiencing.[1]

The embrace of Modern Monetary Theory

To understand the spending and debt profile of the Federal Budget, its underlying economic premise requires examination.

As noted by John Kehoe in the Australian Financial Review on 10 May 2021 in an article entitled: “How Josh Frydenberg was convinced to target unemployment”,[2] the central economic objective of the Federal Budget is to reduce Australia’s rate of unemployment to a pre-determined level of under 5 per cent.

This objective, according to Mr Kehoe, originated from the leadership of the Reserve Bank of Australia (RBA) and was supported by the leadership of the Federal Treasury.

Moreover, this objective is confirmed in the rhetoric of the Federal Government’s own budget overview website, which states:

“More people are in work than ever before and unemployment is on course to settle below 5 per cent for just the second time in almost 50 years.”[3]

As noted in the article, “The Madness of Modern Monetary Theory”,[4] the use of fiscal policy through enlarged government spending and fiscal deficits to reduce ‘involuntary unemployment’ is the central tenant of the radical heterodox economic thesis called Modern Monetary Theory (MMT).[5]

Reducing unemployment in this manner is a complete departure from classical economics, which advocates for reducing unemployment over the medium term through expanding the supply side of an economy via increased thrift and investment, coupled with structural microeconomic reform that improves investment and price signals and lifts productivity.

This latter approach was a large component of the overall economic program of the Government of John Howard when unemployment fell below 5 per cent in 2006 and 2007 (in both original and seasonally-adjusted terms). It also characterised many of the Hawke-Keating Government reforms.

Why embrace Modern Monetary Theory?

Given that MMT is a radical departure from classical economics, the question arises as to why the RBA and the Treasury advocated for a further expansion in fiscal policy – accommodated by further, record central bank money printing with few, if any, broad-based supply-side measures – to target an unemployment rate of 5 per cent (or below) as the centre piece of economic policy, in contrast to promoting market-tested, value-adding employment that generates economic wealth?

This question is worth asking, given that selecting a pre-determined rate of unemployment as the political and public policy test for fiscal policy effectiveness has never been attempted before in the history of Australian national economic policy.

While neither the Morrison Government nor Australian economic officials have to date elaborated on this question, the broader Australian macroeconomic environment must be taken into account, especially in the context of Australia’s record household debt bubble.

As noted in “The RBA prepares to defend debt bubble at all costs”,[6] a high or rising level of unemployment has the risk to cause a widespread systemic default of household and other debts through an insufficient ability to meet cashflow obligations.

Thus, in order to ensure financial stability, the RBA Governor for several years has advocated for national fiscal policy to be used as a counter-cyclical macroeconomic policy tool to ensure that Australian households are able to generate a particular level of cash flow in order to meet their debt servicing obligations.

Risks of Modern Monetary Theory

Given that Treasurer Frydenberg has embraced a demand-side driven fiscal strategy – with accommodating central bank money printing, to buy the Federal government debt bonds that few private investors want at such low interest rates – to drive unemployment lower with virtually no program of structural microeconomic (supply-side) reform, the real question facing Australian federal fiscal and macroeconomic policy is, “how financially sustainable is this current policy approach?”

MMT advocates argue that the economic and political emphasis on governments to maintain sustainable public finances is both misguided and redundant, given that they cannot ever face bankruptcy or insolvency.

Importantly, however, MMT advocates such as Australian economic academic Professor Bill Mitchell (of the University of Newcastle) down-play the risks and economic costs of runaway inflation and even hyperinflation, which may result through sizeable and ongoing budget deficits.

Rather, they argue that historical episodes of hyperinflation such as Germany and Zimbabwe were a result of a sharp and significant fall in economic output and productive capacity which therefore caused a skyrocketing in the nominal value of goods and services relative to the existing supply of locally-denominated money.

As noted in the “The Madness of Modern Monetary Theory” article:

However, these arguments regarding declining productive capacity, in and of themselves, cannot empirically justify an annualised inflation rate in Zimbabwe skyrocketing to 231 million per cent or a monthly rate of inflation in Germany of 322 per cent.

Thus, it is important to note that the use of fiscal policy to target a pre-determined level of unemployment according to the MMT school of thought does have its financial limits. Where these limits are not adhered to, substantial inflationary risks (and therefore economic costs, e.g. price volatility leading to much uncertainty in investment, saving, business and hiring decisions) may be realised, especially when government deficits are financed through extreme forms of monetary policy.

Neither of these points were publicly acknowledged by Treasurer Frydenberg in his release of the FY21‑22 Federal Budget.

New Spending has little to do with COVID-19

Having established the underlying, theoretical economic underpinnings and core economic objective of the FY21-22 Federal Budget, it is now time to examine the key budget parameters to understand how Treasurer Frydenberg and the Morrison Government hopes to achieve an unemployment rate of less than 5 per cent.

New Government Spending

At the heart of the Frydenberg budget is a commitment to significant sums of new spending from July 2021 onwards (i.e., FY21-22 to FY23-24) beyond what was initially projected in the FY20-21 Budget released in October 2020.

Table 1 details the change in spending (in underlying cash terms) between the FY20‑21 and the FY21‑22 Federal Budgets (i.e., from the October 2020 to the May 2021 Budgets, just seven months apart).

Table 1: Change in Spending from the FY20-21 Federal Budget to the FY21-22 Federal Budget

What can be witnessed in Table 1 is a lower amount of government spending in FY20-21 (to the tune of $AUD 16.6 billion) than initially anticipated, given that the anticipated COVID-19 induced economic recession and the associated level of unemployment was less severe than initially estimated.

However, the additional cumulative spending of $AUD 66.7 billion, which has been budgeted from FY 21-22 to FY23-24 demonstrates the scale of the additional, largely-discretionary spending that Frydenberg has budgeted for.

Importantly, the overwhelming majority of this spending has little to do with the COVID-19 pandemic directly, with the exception of acquiring and deploying the Government’s COVID-19 vaccine program and specific industry related support packages such as for the aviation and tourism industries.

Rather, the overwhelming bulk of this additional new spending relates to policy announcements in politically sensitive areas that may materially influence the outcome of the next Federal election.

The politically sensitive areas that received additional commitments of government funding in the FY21-22 Federal Budget include:

• Aged care;
• Mental health;
• Disabilities (the NDIS);
• Women’s safety, health and economic security (including further childcare subsidies);
• Climate change and clean energy;
• Infrastructure (which mainly seeks to reduce urban congestion); and
• Indigenous affairs.

Perpetual Annual Budget Deficits

Mammoth new government spending coupled with:

• a less than severe economic recession;
• booming iron ore prices (among other commodity prices); and
• the delivery of personal income tax cuts and business tax incentives

have all impacted the projected deficits during FY20-21 and across the forward estimates through to FY24-25 (the final outyear).

The budget papers outline that, over the coming financial years, the Australian Government is on track to deliver consecutive budget deficits through to FY24-25. The size of each of these annual deficits (in underlying cash terms) are outlined in Table 2.

Table 2: Annual Expected Fiscal Deficits from FY20-21 to FY24-25

As Table 2 demonstrates, over six financial years from just prior to the start of COVID-19 through to FY24-25, the Australian Government is expected to incur consecutive deficits accumulating to $AUD 588.7 billion.

Moreover, Table 2 demonstrates that there is no realistic prospect, or even any planned attempt, to balance the federal budget in the coming years.

Importantly, compared to the fiscal deficit estimates presented in the FY20-21 budget in October 2020, a worse deficit position can be witnessed in FY22-23 and FY23-24, as demonstrated in Table 3.

Table 3: Change in the annual deficit from the FY20-21 Federal Budget to the FY21-22 Federal Budget

As Table 3 demonstrates, while experiencing a better-than-expected budget outcome in FY20-21 and FY21-22, the budget papers reveal that the budget deficit is expected to worsen by $AUD 24 billion over financial years FY22-23 and FY23-24.

This again confirms that the spending strategy undertaken by Treasurer Frydenberg has little to do with the COVID-19 pandemic.

Critical Optimistic Budget Assumptions

The deficit projections discussed above are based on optimistic assumptions related to the COVID-19 pandemic and the performance of the Australian economy over the medium term, which are critical to the estimation and forecast of taxation revenue and (particularly welfare) payments.

If these assumptions do not eventuate, this would result in a sharp deterioration in both collected tax revenue and the annual budget deficits.

The critical assumptions in which the Federal Budget makes in relation to the COVID-19 pandemic are outlined in Table 4.

Table 4: Critical Federal Budget Covid-19 Assumptions as outlined in the Budget Papers

Alternatively, as it relates to performance of the Australian economy, the budget assumes that the economic recovery will be underpinned by robust growth in consumption and non-mining investment.

These forecast growth rates, as outlined in the Federal Budget, are reproduced in Table 5.

Table 5: FY21-22 Federal Budget – Key Growth Assumptions

Transitory Inflation?

The one critical economic assumption whose impact cannot be fully comprehended at this juncture is the expected rate of inflation and the flow-on impact that this will have on commodity prices and Australia’s terms of trade.

The budget papers assume that the rate of inflation (as measured by the Australian Consumer Price Index) will be lower in FY21-22 at 1.75% relative to the current financial year (FY20-21) at 3.5%.

These forecasts rates of inflation are consistent with the statements from several international central banks, including that of US Federal Reserve Chairman, Jerome Powell, who has argued that an uplift in inflation in calendar year 2021 resulting from:

• fiscal and monetary economic stimulus released in 2020; and
• relaxing economically-restrictive COVID-19 pandemic measures;

will be temporary or transitory in nature.

Thus, as a result of this assumption, the Frydenberg budget assumes that in FY21-22:

• iron ore prices will fall to $US 55 per tonne from the current level of more than $US 200 per tonne; and
• Australia’s terms of trade will fall by 8 per cent.

Importantly, given the significance of iron ore and other mining and agricultural commodities to Australia’s exports, if inflation does indeed prove not to be transitory and thus energy and other commodity prices (e.g., of metals, food and fibre) remain substantially elevated, then the federal budget may enjoy a significant boost in additional tax revenue resulting from higher export income.

However, a higher-than-expected (and sustained) rate of inflation would likely reduce demand for existing and newly-issued government bonds. Without RBA action (i.e. a monetary response), this would result in lower bond prices and higher bond yields (i.e. higher interest rates) which would, in turn, increase the Australian Government’s future annual interest costs and budget deficits. But if the RBA defends its widely-publicised bond yield curve ceiling or targets – namely, preventing interest rates from rising above their current record-low levels, particularly in the short and medium-term range – then, while interest costs may not rise, private investor interest in government bonds would likely deteriorate further, meaning the RBA would increasingly become the sole buyer of both:

• newly-issued government bonds (to fund the ongoing deficits), and
• existing government bonds sold/abandoned by private bond holders seeking better (less inflation-exposed) returns.

To buy these ever-less wanted bonds (in order to keep interest rates at their current record-low levels), the RBA would need to, in effect, print and issue the money required to pay for them. As the amount of issued money chasing a given set (i.e., real value) of goods and services rises, prices and expected inflation rise too. This leads to more bonds being dumped or eschewed by private investors, more RBA bond buying and money printing and so on until these self-reinforcing effects spiral out of control. Then, such runaway (even hyper-) inflation can only be credibly ebbed by the RBA no longer defending their yield curve ceiling/targets and letting interest rates rise to allow bonds to become attractive to the private investor again – relieving the RBA of its buyer-of-last resort, money-printing and inflation turbo-charging roles. Once this point is reached, interest costs for both government and private debtors begin to sky-rocket (instead of the inflation and related costs that preceded it).

If or when this point is reached depends on the economic, social and political costs of an ever‑increasing and damaging inflation, as perceived/considered by the government of the time and authorities involved (particularly the RBA and Treasury).

When the economic and other costs of (runaway) inflation begin to exceed those of the (eventually necessary) interest rate hikes, the policy switch can – and maybe will – be flicked to inflict a different type of pain (but ultimately, the necessary one) on such an unbalanced, out-of-kilter, teetering economy and its similarly debt-laden populace. But, as the temptation to delay politically-painful budget repair and a hike in one’s own interest costs is great, governments that have fallen into these QE-fuelled inflationary spirals/holes tend to be reluctant and slow to admit the inevitable and pull the chord on the Ponzi scheme.

To limit the resulting interest rate hike and its duration, the need to issue further government bonds, at a minimum, has to be reduced, and greatly so (i.e., significant fiscal consolidation, even austerity). To spread the burden of economic re-balancing and repair, key and broad-ranging economic supply-side, productivity-enhancing reforms should also be implemented. (Note, as tax rises are generally anathema to augmenting supply and productivity, most of the fiscal repair would need to be undertaken on the spending side of the budget (e.g. paring back welfare to its barer essentials)).

In these ways, a better balance between the money supply and the real value of goods and services produced/available can be credibly and sustainably restored – with maximum economic upside to any ultimate exit from our current, fool’s paradise malaise.

Key Budget Vulnerability – Interest Costs

With the greatest peace-time build-up of public sector debt in Australian history, the key vulnerability to the financial position of the Australian Government is the sustainability of its debt, especially in the context of the interest costs.

The budget papers reveal significant sums of interest that the Australian Government must already pay owners of Australian Government Securities (i.e., Federal Government bonds).

Table 6 outlines the annual interest costs which the Australian Government either has incurred and/or is expected to incur from financial year FY19-20 through to FY24-25, which cumulatively amounts to in excess of $AUD 113 billion.

Table 6: Interest Costs resulting from Federal Government Gross Debt

Perhaps the more frightening aspect of the cost of interest payable on the debts on the Australian Government is the effective annual rate of interest that will be incurred in the coming years.

The annual effective rate of interest that is assumed to be payable by the Australian Government is outlined in Table 7.

Table 7: Assumed Annual Effective Interest Rate payable on the Federal Government Debt

As can be observed from Table 7, the annual effective rate of interest that the Australian Government is expected to incur falls from 2.45% in FY19-20 through to approximately 1.8% over financial years FY22-23 to FY24-25.

Thus, even though the annual amount of interest payable continues to go up consistent with the growth of gross debt, the growth in annual interest costs is reduced through the fall in the annual effective interest rate payable by the Australian Government (as older, higher interest rate bonds reach full term and disappear from the debt stock).

Thus, moving forward, the key vulnerability for the federal budget is the inability to meet the interest-payable obligations, which may rise from either:

• rising interest rates; or
• low economic growth resulting in insufficient government revenue to meet interest costs.

Importantly, as noted by AFR journalist John Kehoe, Treasurer Frydenberg’s fiscal strategy is to ensure that these vulnerabilities do not eventuate:

“Frydenberg’s argument is that, with interest rates historically low, economic growth will generate enough tax revenue to cover the cost of servicing interest payments over the next decade.”[7]

However, a debt overhang that generates low economic growth or rising inflationary pressure from extraordinarily expansionary fiscal and monetary policy could easily realise the Australian Government’s key budget vulnerability.

Conclusion

Using fiscal policy to drive the rate of unemployment (especially involuntary unemployment) to a pre-determined level through demand-side economic management is the core policy objective of MMT.

This is a radical departure from classical economic theory, which argues that unemployment can be reduced through a combination of thrift and investment as well as microeconomic structural economic reform.

In setting an unemployment rate policy target of less than 5 per cent, Australia’s Treasurer Josh Frydenberg has embraced the highest levels of federal government spending, deficits and debts during peace-time in Australian history.

Importantly, the policy target and subsequent government spending has little to do with the COVID‑19 pandemic and has arguably more to do with ensuring sufficient debt-servicing cash flow can be generated by the private sector (both Australian households and businesses) as well as managing political sensitive constituencies in the lead-up to the next federal election.

Over the medium term, the sustainability of the current fiscal, macro and microeconomic approach must be brought into question.

Without the most extreme forms of fiscal austerity, there is simply no way that the Australian Government can balance the federal budget, let alone repay the staggering levels of debt which are expected to be incurred in the coming years.

The key vulnerability that could bring down Treasurer Frydenberg’s fiscal house of cards is either:

• a weaker economy (through runaway inflation hitting supply and drowning those whose earnings do not keep up with cost-base rises), or
• rising interest rates which would increase the difficulty of the Australian Government to meet its interest servicing costs and drown debt-laden, interest-paying private sector entities (those that survived the preceding, strong inflation).

Ultimately, if these costs are made through evermore money printing, runaway inflation if not hyperinflation will be the end result.

John Adams is the Chief Economist for As Good As Gold Australia

[1]https://www.businessinsider.com.au/financial-stress-australia-economic-recovery-2021-3

[2] https://www.afr.com/policy/economy/how-josh-frydenberg-was-convinced-to-target-unemployment-20210504-p57oph

[3]https://budget.gov.au/2021-22/content/overview.htm

[4] https://www.adamseconomics.com/post/the-madness-of-modern-monetary-theory

[5] It is important to note that, under MMT, a pre-determined rate of unemployment is achieved through the implementation of a job guarantee program. Such a program does not exist in Frydenberg’s budget.

[6]https://www.adamseconomics.com/post/the-rba-prepares-to-defend-debt-bubble-at-all-costs

[7]https://www.afr.com/policy/economy/how-josh-frydenberg-was-convinced-to-target-unemployment-20210504-p57oph