As we move into the Q3 GDP release, the December budget update season, and from there into a new US Presidency, we thought it would be useful to think about how Government spending interacts with economic growth and with bond markets.
The notion that a government budget can be understood in the same way as a family budget is often quoted, but put simply, wrong. There are two fundamental differences that need to be understood. First, is a point regarding longevity and second a point regarding the size. Family budgets are for small groups of regular people who earn, save, retire, spend, and eventually pass away. The Government, in contrast, is exceptionally large and, in a way, immortal.
The first key difference between a family budget and a government budget is that the family budget goes through a life cycle while the Australian Government is (hopefully) evergreen. I hope the Australian Government is still around and still operating broadly as it currently is (which is to say democratic and free) in 50 years’ time. There’s a very slim chance that I will be around to see it, but my children will likely be here. This makes the Government ageless, in a very real and important way. And ageless entities don’t need to save for retirement.
Imagine an investment proposition like buying a business. If you are 25, willing to work hard and ready to give the business a red hot try, it makes a great deal of sense to borrow money – perhaps a great deal of money – to buy such a business. Doing so comes with risk, of course, but sensible and prudent debt usage and investment early in your life can yield great benefits down the track. It comes down to the cost of interest and the return on the investment over a long period. Although it makes sense for a 25 year old to borrow and purchase such a business, it does not make sense for an 80 year old to borrow heavily to buy such a business.
But the Government is always 25 years old, in a sense, because it is always planning for 50 years into the future. So while a family budget shouldn’t be adding more debt year after year, a government can quite happily do so – as long as the debt is growing roughly in proportion with the economy, then everything is stable and safe.
The second key difference is regarding size. The Australian Federal Government is around 25% of the economy. The states make the total size of the Government sector larger again. For an entity this size, reducing a deficit is a tricky problem of inter-related movements.
A single family trying to save money should seek extra income and reduce expenditure. These actions have a first-round effect of improving the budget for the family in question. That’s largely the end of the story. There are some very small second round effects, and it is conceivable that some local businesses notice the spending habits of the family changing, but it is very unlikely to be material for any other entities.
For the Government, however, a material pullback in expenditure and increases in revenue have massive implications for the rest of society. Government deficits are often measured in percent of GDP. The May 2024 budget suggested that the 2024-25 Federal Deficit would be 1.0% of GDP. That means 1% of every dollar in the Australian economy that is spent is the government borrowing the dollar and spending it. To push that back to a surplus would take 1% of the economy ceasing to exist, either from increased taxation or reduced government consumption. And while 1% might not sound that large, perhaps think of the impact of the unemployment rate rising from 4.1% to 5.1% because 1% of the jobs suddenly ceased to exist. (The link between 1% of GDP and 1% of labour is a little more complicated, but it helps to illuminate the scales we are talking here.)
Finally, there’s the unenviable observation that, even if the government managed to offload that amount of spending to bring the budget back to surplus, it would have material second round effects. All of those unemployed people would stop paying income tax and start claiming unemployment benefits for a start. With Government revenues and expenses both sitting at a little more than 25% of the Australian economy, the Government is not able to materially lower expenditure or raise revenue without considerable second round impacts.
Having just explained how large the Federal Budget position is, we should point out that despite some drops from the tax cuts, the federal debt is still looking to be in a very manageable position. There’s a small deficit but nothing too worrisome and, with the recent boom in nominal GDP, there’s been a deflating away of the debt. So much so, that the Federal debt now is actually not much more than it was pre-COVID. It’s still higher than it was before the pandemic and notably higher than it was for most of the past 40 years, but on a world scale it’s relatively under control.
The state governments, however, are under a little more pressure. The total borrowing sitting in the states is projected to rise from the current 11.1% of GDP to 14.9% of GDP – and that’s assuming the budget forecasts are correct! You will likely have heard that S&P changed the NSW Government to Negative outlook last week, but they are not the only one feeling the same pressure. Many states have spent huge amounts on infrastructure and now must choose between seeing the projects through to conclusion or scaling back the expenditure.
The September quarter GDP is going to be released shortly after I finish writing this article, but we don’t need to see the exact numbers to understand the contours – many of the “ingredient” data series for GDP have already been released. The private sector in Australia is suffering from weak growth – and indeed negative growth on many measures. Australian GDP is being propped up by the spending of the Government sector – both Federal and State.
The Federal Government is going to go through an election next year and policy is difficult to predict, but the various state governments might plausibly cut spending. In previous times, that is precisely what would have happened, but the political landscape is changing.
The success of Trump has altered the centre-right globally and fiscal discipline is no longer the mantra it used to be. If the various Australian state governments begin to slow spending because of the financial pressures, then the slowdown we expect in 2025 will very likely eventuate – in fact it’s one of the reasons we have pencilled in that slowdown. However, there is just a chance that the spending restraint doesn’t come or comes a little later than we expect.
The truth of the matter is that even if the governments in Australia and around the world do not voluntarily pull back on spending, they will face consequences in the form of ratings downgrades. That might not matter for an entity as large as the US, but the Australian states have typically relied heavily on solid ratings.
We’ll see what the coming Budget season brings. But one thing we know is coming is a material drop in CPI globally. Strangely enough, that’s actually one of the reasons that so many governments are facing difficulty right now. The GDP data is, of course, measured in nominal dollars. When inflation is high, nominal GDP grows very quickly (allowing it to keep pace with the volume of debt). Now that nominal GDP growth rates are falling (because inflation is falling), the pressure to keep the deficits low (so the total stock of debt doesn’t rise faster than nominal GDP) becomes more pressing. In recent weeks, we’ve seen both France and NSW have small issues on this front. We expect the issue to be more at the forefront globally in 2025. CPI is falling but many governments are still running deficits and have a large stock of debt from the pandemic era.
Governments that can’t keep debt under control will face, eventually, a ruction in bond markets and see yields move higher. The other option is austerity – which tends to lower growth and yields move lower. What governments choose to do around debt matters for interest rates in the entire economy.