Budget 2009: Let’s Assume We Have a Can Opener

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I first heard the best joke about eco­nom­ics in 1975. The teller was the nuclear physi­cist (and nuclear pow­er advo­cate) Sir Phillip Bax­ter, and he told it in answer to a ques­tion I had asked at a pub­lic forum.

The joke is:

A physi­cist, a chemist and an econ­o­mist are ship­wrecked on a desert isle, along with a con­tain­er full of cans of baked beans.

The chemist says that if they can start a fire, he can cal­cu­late the tem­per­a­ture at which a can will explode.

The physi­cist says that she can work out the tra­jec­to­ry of the baked beans after the explo­sion, so that they can gath­er the baked beans and eat them.

The econ­o­mist looks at them in dis­dain, and final­ly says Guys, you’re going about it the hard way. Let’s assume we have a can open­er.

The can open­er that was the cen­tre­piece of today’s bud­get was the assump­tion that the Down Under ver­sion of the Glob­al Finan­cial Cri­sis will end in 2011-12, and that after it, the econ­o­my will expe­ri­ence above-trend growth of 4.5 per­cent a year for at least two years. Armed with this can open­er, The Trea­sury can eas­i­ly get out of the deficit jam it is now in: cor­po­rate tax rev­enues will grow by a quar­ter, unem­ploy­ment will fall 1% a year from its 8.5% peak, and the bud­get can eke its way back to sur­plus by 2016.

This is a mod­i­fied ver­sion of the can open­er that Trea­sury has been using for the last decade, where its fore­casts for the future were based sim­ply on the assump­tion that the econ­o­my will always return to 3 per­cent growth after any short term dis­tur­bance. Nor­mal­ly they assume that the short term dis­tur­bance only lasts for the cur­rent year, and that the long run trend will reassert itself the fol­low­ing year.

The Trea­sury’s one con­ces­sion to real­i­ty in this Bud­get was to add an addi­tion­al year where growth was expect­ed to be below average–so rather than fore­cast­ing 3% growth in 2010-11 as it would nor­mal­ly do, it assumed growth of 2.5% for that year. But it then assumed growth of 4.5% for the next two years.

Over­all, Trea­sury is assum­ing that the deep­est glob­al reces­sion since the Great Depres­sion (its words) will reduce growth over a 4 year peri­od by a mere 0.25 per­cent per annum.

Isn’t it mar­vel­lous what you can do with a can open­er?

Real­i­ty is rather hard­er to cope with. Though I’ve had many years to get used to this, I still find it bizarre to read state­ments like the worst glob­al reces­sion since the Great Depres­sion and see this jux­ta­posed with expec­ta­tions of a short­er, shal­low­er reces­sion than that of the 1990s.

At least there’s a sense of give us a break, what else could we do? to the way Trea­sury attempts to jus­ti­fy its assump­tions in this doc­u­ment:

The approach is also in line with that tak­en in bud­gets in the ear­ly 1990s when above-trend rates of growth were assumed as the econ­o­my recov­ered from reces­sion.

Oth­er coun­tries are also assum­ing above trend growth in their for­ward esti­mates as their economies are expect­ed to recov­er. The US, UK, New Zealand and Swe­den are all adopt­ing such an approach. (Bud­get Overview page 29)

That’s cold com­fort to the rest of us however–all it real­ly means is that most OECD Trea­suries are hop­ing that the cri­sis just blows over, just as are our alleged eco­nom­ic man­agers.

And we are asked to trust a pro­jec­tion based on the expe­ri­ence of the 1990s, when this is the worst glob­al reces­sion since the Great Depres­sion? Would­n’t that mean that recent expe­ri­ence should be a mis­lead­ing guide as to what to expect? Why not instead show us what hap­pened back then?:

Oops. 4 years of falling out­put with the econ­o­my shrink­ing by 10 per­cent in 1930 alone? Even 1990 does­n’t look quite as good in the data as the Trea­sury describes it:

Then out­put fell by more than 1 per­cent in 1992, and though growth returned to trend lev­els after 3 years of below trend growth, it cer­tain­ly did­n’t bound up to 1.5 times the pre-reces­sion aver­age.

The Trea­sury, like the RBA, did­n’t see this cri­sis coming–have a quick read of the 2008 Bud­get Overview and look for the word cri­sis; you’ll find it once in rela­tion to hous­ing. The Trea­sury’s prog­noses on how long this reces­sion might last, and how deep it will be, are no more than wish­ful think­ing.

Unfor­tu­nate­ly, guid­ed by neo­clas­si­cal eco­nom­ics, there’s lit­tle else that The Trea­sury can do: accord­ing to stan­dard neo­clas­si­cal the­o­ry, this cri­sis should­n’t be hap­pen­ing. Only when they throw away the text­books will they have any hope of under­stand­ing how the econ­o­my actu­al­ly works.

Until that day, make sure your own can open­er is working–and maybe even set aside a stock of baked beans.

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