Australian Economic Outlook - How to Squander a Once in a Lifetime Boom

In December Treasurer Joe Hockey revealed that the budget deficit was most likely to be near $50 billion.  In a $1.5 trillion economy this works out at around 3% of GDP.  In theory, deficits can be good for an economy when they make up for a shortfall in private demand and provide the impetus for the private sector to grow at a faster rate – better to spend money stimulating job creation rather than fund a larger number of unemployment benefits.  Any budget deficit adds to government debt but it is the type of government spending that really matters. 
 
Welfare payments to the aged, poor and disadvantaged are what define a civilised society.  These payments provide an essential social, rather economic, function.  In contrast, government spending on productivity boosting initiatives provide real economic benefits.  Productivity gains result in higher national incomes that generate more tax revenue to help pay for the additional interest expense on incremental government debt.  As an example, the National Broadband Network is hideously expensive but will create workplace efficiency gains (e.g. reduce time searching for information; allow more people to work from home and provide business opportunities such as online consultations). 
 
Unfortunately foreseeable budget deficits now appear to be dominated by a number of very expensive spending initiatives that are simply unsustainable.  In a perfect world, the Gonski education reforms, NDIS and the paid parental leave scheme, are all laudable initiatives but the economy cannot afford them all.  With the mining boom now over, tax receipts have fallen well behind government expenditure. 
 
The current predicament is a function of short sightedness.  The once in a lifetime mining boomthat helped support a private debt fuelled spending binge over the decade ending in 2007  was largely squandered.  Instead of saving the windfall, governments reduced taxes and increased spending.  Tax cuts were feasible as revenue rolled into government coffers as households splurged on debt like never before and the mining boom rolled on.  But these ill-considered policies were never going to be sustainable.  Booms don't last forever. 
 
And so we roll into 2014 and realise that the incumbent Liberal Government has some very difficult decisions to make over coming years.  In some regards it is lucky as growth is unlikely to slow materially this financial year.  Mining investment, although past its peak, is still providing a significant contribution to GDP.  The investment boom has given way to materially higher volumes and commodity prices, while well below their peak, still remain relatively high by historical standards.  Furthermore, the RBA's wish is gradually coming true.  Materially lower interest rates have given way to a housing boom that is relatively broad based.  Importantly, not only have house prices risen but housing construction is also on an upward trajectory after being in the doldrums for many years.  In addition, the AUD has finally started to fall which should provide some relief for the struggling manufacturing sector.
 
But the current growth resurgence is based on relatively weak fundamentals and is unlikely to last for a number of reasons.  Firstly the current housing boom is unsustainable.  House prices are already significantly overvalued.  Household debt levels are stretched and it is only the current low interest rate environment that provides the illusion of affordability. 
 
Secondly, China's economy remains set for a significant slowdown when the Central Government eventually decides to deal with the vast amount of non-performing loans that banks have provided to State-owned enterprises and local government financing vehicles.  When this eventually occurs demand for Australian resources will inevitably slow.
 
Thirdly, it is unlikely that the fall in the Australian dollar will be sufficient to stimulate the manufacturing sector.  High real wages and low productivity has meant that the sector remains broadly uncompetitive on the global stage.
 
If demand from China falls and the housing boom fizzles out (and let's hope it's only a fizzle - not a bust), it is at this point that Australia's economic prospects (and potential budget deficits) may start to look rather grim.