Defence, the budget deficit and the age of low economic growth

One of the risks of working up a new plan to drive a whole new generation of new military capability acquisitions distilled from the conclusion of a brand-new Defence White Paper is the burning issue of how the new investment program will be paid for.

This was not a problem for former Prime Minister John Howard, as he spent his way through the mining boom, but really is a problem for Malcolm Turnbull now that the boom is over and the nation is carrying a substantive deficit. Having let Defence free in the new capability lolly shop subsequent to sterner words about a declining regional security environment and new threats to Australia’s long-term strategic interests, the Prime Minister proclaimed last March that $195 billion would be spent over the next decade to give effect to the new Defence Integrated Investment Program (IIP).

A reasonable start was nevertheless made in the 2016/17 federal budget to the task of mapping out a credible trajectory for elevating Defence expenditures to achieve the nominated two per cent of gross domestic product (GDP) by 2020/21. The current financial year effort is shaping up to around 1.88 per cent, depending on whether the economy can deliver on the government’s growth forecasts laid out in last May’s federal budget. If it doesn’t, the percentage figure will rise, but in reality, Defence will not get any extra money.

The May 2016 budget estimated that Defence would spend $7.1 billion over 2016/17 on its Top 30 approved new military capability acquisition projects, albeit with an allowance of $884 million for slippage. Added to this was a further $921 million for projects announced on (or after) budget night, but yet to be allocated to capability managers. This produced a grand total of $7.125 billion in funds available for capital expenditure over 2016/17. Sustainment spending across the 30 largest areas of outlays (along with other approved sustainment product estimates) in turn amounted to $5.24 billion, with an additional $202 million for support to operations.

The ability to meet year-on-year GDP growth forecasts is critical to the question of whether the government has any chance of delivering on the quantum of projects outlined in the IIP over the coming decade. The inability of the Gillard-Rudd governments to do this in similarly challenging economic times remains ingrained in the risk meters of many local defence-industry managers. So there is more than a keen interest in the number for Defence in each subsequent budget.

In framing up the 2016/17 budget, Treasurer Scott Morrison had little choice but to adopt the up-beat set of growth estimates provided by Treasury. To do otherwise would had fed community perceptions that economic forecasts would not be realised, and clearly, there is never any political benefit in following such a course. After all, it is political tradition in Australia that oppositions talk down the economy, not the government.

Budget Strategy and Outlook Paper No.1 argued last May that the Australian economy was entering its 26th year of economic expansion. The real (adjusted for inflation) GDP forecast was set at 2.5 per cent per annum in both 2015/16 and 2016/17, before adopting a more robust three per cent increase in 2017/18 and subsequent financial years.

Were these forecasts reasonable or optimistic? The Mid-Year Economic and Financial Outlook (MYEFO) published in December 2016 came down firmly on the side of the latter. MYEFO’s pessimism was not new, as the year before, flagging a similar scaling down of growth forecasts from the 2.75 per cent optimistically presented by Morrison’s predecessor as treasurer, the now ambassador to the United States.

The continuing reliance by government on Treasury estimates that are habitually unrealistic introduces an unwelcome instability in terms of the government’s financial arrangements, especially when defence-industry is again being asked to tool-up to deliver the new IIP. Scott Morrison adopted in May 2016 a three per cent growth forecast, despite continuing evidence of the slow transition of the Australian economy from the mining investment boom to broader-based growth.

Economists are also debating the proposition that, post the mining boom, Australia’s sustainable long-term growth rate has dropped to a new benchmark of 2.75 per cent. MYEFO has now settled this debate, at least until we see how the economy performs over the balance of 2017 and into the first quarter of calendar 2018.

In short, MYEFO downgraded the financial year GDP forecast for 2016/17 from the 2.5 per cent adopted last May to two per cent; while also reducing the 2017/18 forecast to 2.75 per cent from the three per cent previously adopted. Lest the government be seen to have completely given up on its quest to return to budget surplus in 2020/21, the GDP growth projections for 2018/19 and 2019/20 remain at the more robust three per cent.

Post-MYEFO, the target of returning the budget to surplus in 2020/21 stands – albeit now a few months later than first projected. Yet the roadmap for getting to that point now requires a schedule of much larger interim deficits across the forward estimates. For 2017/18, the deficit estimate is $28.7 billion (MYEFO) compared to $26.1 billion (budget), while the 2018/19 projection is now $19.7 billion (MYEFO), compared to $15.4 billion (budget). The 2019/20 deficit projection has similarly grown to $10.0 billion (MYEFO) compared to $6.0 billion (budget). In all, the net deterioration in the budget deficit over the current financial year and forward estimates totals $10.3 billion.

Political cartoonists have portrayed this as the Treasurer bailing out water ever faster, but with the ship still sinking. For if these amended growth forecasts are not realised, then without major reductions in government expenditures or an equivalent rise in the quantum of taxation paid by Australians, the government’s ability to acquit its 2016 Defence White Paper undertakings will be limited, and perhaps only achieved by resorting to additional borrowing, thus condemning the nation to a virtually unending cycle of deficit financing.

On the taxation/expenditure side, MYEFO says the net impact of decisions taken since the 2016 Pre-Election Financial Outlook (PEFO) is an improvement to the underlying cash balance of $2.5 billion over the forward estimates. The government has also revived an old mechanism to repair the budget through the crafting of omnibus legislation packages which have yielded over $22 billion of savings since the election.

More of the omnibus approach is on the way, given MYEFO’s estimate that the value of the remaining unlegislated repair measures over the forward estimates is another $13.2 billion. Consistent with the government’s fiscal strategy, spending decisions taken since the 2016 PEFO are similarly judged by MYEO as having been more than offset by reductions in spending elsewhere in the budget.

Yet as Treasury officials again sit down to frame up the economic growth forecasts that will underpin the coming 2017/18 federal budget, the real wild card remains the outlook for global growth, which remains uncertain. As a major exporter of commodities, Australia sits at the bottom end of an international feeding chain where the health of the global economy, via demand for especially Chinese-made goods, ends up having a major effect on our own GDP growth forecasts as a sub-set of both the volume we ship, and the price we receive.

It is unfortunately true that since the 2016 PEFO, there have been weaker than expected outcomes in advanced and emerging market economies. MYEFO, in turn, looks to the United States and Australia’s other major trading partners for a lead on growth that is anticipated to end up being stronger than the global economy. Such figures have since been revised downwards through to the end of 2016/17, largely reflecting weaker than expected outcomes in the first half of 2016, including below average growth in the other East Asian economies.

The practical reality is that global economic growth has been below expectations for some time. Low productivity growth and weak trade growth characterise the global economy despite ongoing major infusions of cheap money courtesy of the actions of central banks. While unemployment rates have remained relatively low and inflation has been very subdued, economists increasingly don’t have a feel for where this is going in the medium term, meaning uncertainty remains elevated and business investment remains weak.

And that is before you add into the mix Donald Trump’s ascendancy to the US Presidency, along with growing support for protectionist sentiment on both sides of the Atlantic, that if subsequently translated into anti-free trade measures, would place further pressure on global growth. Hence the difficulty of crafting the growth forecasts underpinning the next Federal budget.

If nominal GDP growth continues to be constrained by weak inflation and wage growth, there will be adverse consequences for government tax receipts. Hence the need for an insurance policy in the form of omnibus legislation that is first headlined by an attractive policy reform – such as that most recently introduced in regard to child care – but at the same time comes with a host of negative welfare payment adjustments (the majority of which have been held up since 2014), to keep the budget surplus target on track should the revenue picture not markedly improve.

To maintain the trajectory towards two per cent of GDP being spent on Defence by 2020/21 and achieve the Defence White Paper’s estimate of $42.4 billion of total Defence funding for that year, the 2017/18 budget needs to contain $11.5 billion to advance the IIP and $8.4 billion to effectively sustain Defence – all within a $35 billion (Serial 4) Defence funding package. In the absence of publication of the Defence Portfolio Additional Estimates papers, there remains roughly two months from commencement of the Avalon International Airshow to Budget night when, hopefully, we will all be better informed.

This editorial was first published in the March-April 2017 issue of Australian Defence Business Review.