Credibility trumps optimism when it comes to growth forecasts

One of the most intriguing aspects of the budget announced last week by Treasurer Joe Hockey is the set of macroeconomic forecasts it is based on. Cherry-picking from the Budget papers, non-mining investment is predicted to more than triple in a couple of year’s time, soaring from its current annual growth rate of 2% to 7.5%.

Real GDP growth is expected to get to 3.75% in 2016‑17, a higher value than the 2.75% predicted in 2015-2016. Household consumption is also expected to improve, moving from the current 2.75% to 3.25% in 2016-17.

When questioned if his growth forecasts were too optimistic, Hockey said no - a claim promptly questioned by economists. As correctly pointed out by Professor Warwick McKibbin, these predictions come in a phase in which global uncertainty is high. Uncertainty is bad for economic growth. Think of investment. Entrepreneurs, in presence of uncertainty, stop investing and prefer to wait until the smoke clears.

The Coalition government has been careful not to return to the “debt deficit disaster” rhetoric which dogged its deeply unpopular first budget and dragged on both consumer and business confidence. But the debt sustainability issue remains.

Although still enjoying one of the lowest debt-over-GDP ratios among industrialised economies, Australia’s public debt has been steadily growing since the onset of the global financial crisis. This calls for medium-to-long run fiscal consolidation plans which point to a reduction in deficit in the next few years and some periods of positive surplus in the medium run.

Now, favourable economic prospects are of help to keep the Australian fiscal train on the right track. But if these forecasts turn out to be indeed too optimistic, fiscal sustainability may be in danger. In this case, Treasury might be forced to redesign its fiscal plans for the years to come by reducing aggregate spending and increasing fiscal revenues. In other words, the government will need to revise its own announcements.

But international academic research suggests such a policy redesign runs the risk of inducing uncertainty in an economic system that can be quantifiable drain on a country’s economic growth.

In their 2013 research, Nicholas Bloom, Scott Baker and Steven Davis found a decline in US GDP of 2.3% in 2007-2009, could be attributed to spikes in uncertainty surrounding tax, spending and healthcare policies from 2006 to 2011.

A 2014 paper I co-published with Giovanni Caggiano and Nicolas Groshenny found that a portion as large as 1.8% (in absolute terms) of the increase in the US unemployment during the last economic recession is attributable to spikes in uncertainty.

So it is imperative for the government to keep the policy-induced uncertainty low, especially when it comes to revising economic forecasts. The key to doing so is one and one only: clear, timely, fully informative communication to the public. If variations to the government’s fiscal plan announced a few days ago are needed, Hockey and Tony Abbott will have to communicate them clearly, and equally clearly explain the economic reasons behind such variations.

The interconnections relating to economic forecasts, policy communication, and debt sustainability have been recently discussed in an Economic Policy Forum (organised by the Melbourne Institute). Two main messages arose.

First, the economy will likely feature some spare capacity in the next few years. Second, in spite of forecasts predicting some weakness from the demand side, fiscal sustainability does not seem to be in danger, but some gradual budget adjustments appear necessary. Also, it appears necessary to clearly communicate in a timely way the rationale of such adjustments.

A clear and convincing policy communication can help financial markets form correct expectations over future fiscal deficits and the evolution of the Australian debt, something markets need to know to assess the sustainability of Australia’s fiscal situation. Clear communication can strengthen policy credibility, lower the risk premia paid by the Australian Government on its bonds, and enhance the country’s ability to repay its debt.

Communication is a tool that policymakers should wisely employ. If our politicians have something to tell us, Australians are ready to listen.

Efrem Castelnuovo does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.