What is a sustainable surplus?

Chair of the National Commission of Audit, Tony Shepherd, laments the widespread criticism of the Federal Budget. He says:

I wish people could... stand back, look at the overall picture of the Commonwealth budget and rather than say 'don't touch me', say 'what can be our contribution to a sustainable surplus'.

The terms of reference for Shepherd's Commission of Audit included that it 'make recommendations to achieve savings sufficient to deliver a surplus of 1 per cent of GDP prior to 2023-24.'

So what is a sustainable surplus?

There's probably no such thing, at least for the Australian economy. Government deficits are more sustainable than surpluses.

First, let's get clear on what a surplus is, and what a deficit is. Each refers to the government's net income over a period (a year). If the Australian Government's income (primarily taxes) is more than its spending, the Government is in surplus; and if its spending is more than its income, it is in deficit.

Of course, one person's spending is another person's income, so if the Australian Government is in surplus, everything that's not the Australian Government (households, firms, other governments) must, by identity, be in deficit.

(This means, incidentally, that rather than saying a government 'delivers' a surplus, it is better to say that it 'takes' or 'extracts' a surplus.)

We can narrow down that broad non-government sector by distinguishing an external sector (ie foreign households, firms and governments) from the Australian private sector.

For any given period, one (or two) of the three sectors can be in surplus – and two (or one) in deficit. Not all of them can be in surplus, or in deficit, at once. Their total surpluses and deficits for the period must net to zero.

In the case of Australia, what we pay to the external sector is nearly always more the income we receive from it (we have a current account deficit). With that in mind, when the Australian Government takes a surplus, the Australian private sector must be in deficit – paying out more than it receives in income.

The Australian private sector can do this by running down stocks of money accumulated in previous periods of Australian private sector surplus (that is to say, periods of Australian Government deficits).

This cannot be sustained for long. Theoretically, if the Government persisted bloodymindedly in taking surpluses year after year, the private sector would end depleting all its net financial assets, then start offering up real assets (houses, cars, the shirt off your back) to the voracious Government. More realistically, financially constrained households and firms would try to shore themselves up individually by spending less and saving more, thus reducing overall income and economic activity.

By contrast, when the Australian Government is in deficit, its spending is not financially constrained, because it issues the currency. With an Australian private sector that is inclined to save Australian dollars and other net financial assets, and an external sector of trading partners pleased to accumulate Australian net financial assets, an Australian Government deficit is the sustainable and appropriate way to promote economic activity.