5 minute read 4 Apr 2020

Is Australia's debt level unprecedented?

By Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

5 minute read 4 Apr 2020

Australia is going in to debt to cope with the economic ramifications of the COVID-19 health crisis. It might look like an eyewatering amount, but we've been here before. Sort of. EY Oceania Chief Economist Jo Masters explains.  

Earlier this week, Prime Minister Scott Morrison announced a $130 billion package for eligible employers hit hardest by the impact of the COVID-19 lockdown, to help subsidise their wage bills. Preliminary estimates suggest the government will need to borrow $400 billion to cover these packages, and that doesn’t include what will need to come out of state and territory coffers. 

Australia currently has one of the lowest national debt levels in the world, so we are in a good place to be able to do this. At the moment, net Federal Government debt is just shy of 20 per cent. Once we add the $400bn of debt, it will take debt to about $1 trillion, or around 50 per cent of GDP.

There is no doubt this is a debt burden that our future generations will have to bear. Government spending to support the economy through the GFC was much less and, even with a strong economy, it took a decade to get the budget back to balance. Realistically, this new debt burden could take several decades to pay off.

Arguably, it means higher taxes than there would have been otherwise and an ongoing need for spending restraint from governments to come. It also means there will be less of a fiscal buffer when the next crisis that comes along.  

But, whilst this debt level seems eye-watering and quite confronting, we also want to leave our children with an economy that is functioning and has enough economic fabric for there to be jobs and for economic opportunity for our children. 

Levels of Government debt can be described in two ways:

Net-debt is more commonly reported. It tells us our balance of liabilities minus any government financial assets. We generally use net debt when talking about levels of debt in Australia.

Gross debt is simply a government's financial liabilities. It is more useful than net-debt for making international comparisons as it is ignores international differences in accounting standards. The chart below shows gross debt in Australia relative to the US and the UK, both of whom are significantly more indebted.

So, how does this crisis look against our past crises? 

There is a lot of talk of this current crisis being unprecedented. It’s not comparable because by definition all crises are different, but it’s not true to say we haven’t had this degree of government support before. Even if we do a superficial comparison with the past three big economic crises for Australia, we find the expected debt to GDP ratio is not unprecedented. 

  • The Global Financial Crisis - 2007 to 2008

In 2008 and 2009, government support for the economy was $52 billion, or 4 per cent of GDP. Net Federal government debt went from negative (where the government has more assets than outstanding debt) and kept rising as we funded the persistent budget deficits.  

It took us more than 10 years after the financial crisis to return the annual budget to balance, and the plan was to start paying back that debt from 2020/21.

  • World War II - 1939 to 1945

Australia’s debt to GDP ratio went from 40 per cent in 1939 to 120 per cent in 1945. It took 15 years to reduce that back down to 40 per cent, outstanding debt was still 8 per cent of GDP in 1974.  Debt repayment mostly reflected cuts to government spending and high inflation.

  • The Great Recession - 1930 to 1939

Over a period of three years, Australia’s gross debt doubled and peaked at 215 per cent of GDP, but the policy errors were big. As Dr David Gruen writes in his 2009 Colin Clark memorial lecture, the 1931 ‘Premiers’ Plan’ was agreed with a representative from the Bank of England, Otto Niemeyer. The plan introduced 20 per cent cuts to government spending, and increased federal and state taxes, on Niemeyer’s recommendation to focus on reducing the interest payments Australia owed to the British banks. (In other circumstances it might have actually been John Maynard Keynes who came out to Australia, which would have led to a very different outcome, but more on that later).

“The Premier’s Plan was hailed as a success, but this verdict has not stood the test of time,” Gruen writes. “Viewed from a modern perspective, with recognition of the importance of supporting aggregate demand when private sector spending is in retreat, Australia’s policy responses to the Great Depression appear counterproductive, and certainly not supportive of recovery.”

Today, we are seeing that support for aggregate demand – which is investment and consumption – as well as support for the financial system. 

How do we get out of debt? We have three options

  1. Spend our way out of this

The idea that you can stimulate the economy to the extent that you then can continue to keep “growing away” debt as a percentage of GDP is not sound. When government raises debt, it does so in a market which only has a certain amount of demand for buying debt. So, when Government does that, it crowds out the private sector’s ability to raise debt and this inevitably slows investment in cap ex, infrastructure and R&D. Basically, you’re issuing bonds to cover your debt burden and not getting any investment as a result of it, so that's a bad idea. Working to improve productivity is a good idea, however, and certainly part of the answer. We’ve been having this debate in Australia for some time, around how to make ‘doing business’ more efficient.

    2.   Crunch government spending

We already know this is a bad idea because we did that during the Great Recession, and it didn’t work.

    3.   Raise government revenue (that means tax)         

Nobody likes to hear this but it needs to be on the table. There are a myriad of taxes, of course, and the reality is raising tax revenue does not mean changing one tax rate. But when you look at the three main taxes – income tax, corporate tax and the GST – one stands out. Raising income or corporate tax seems unlikely to be on the table. Earlier this week Treasurer Frydenberg committed to the second and third stages of the income tax cuts. We can’t really raise corporate tax, because our corporate taxes are already globally uncompetitive (a big conversation before this crisis hit).

Economists have been arguing to raise GST for ages, it’s just been politically difficult. The difference now is that we have a new narrative to go with the increase.

So, the next alternative is to raise and broaden GST. Economists have been arguing for this for ages, it’s been politically difficult. Now, it’s not straight forward, and the regressive nature of the tax needs to be addressed but our GST rate and coverage are both low by international standards. It may just be that now we have a new narrative that opens the debate, which is that ‘we have to do this so our children and grandchildren aren’t saddled with paying off the debt from this virus’.

When do we choose which path to take?

You don’t choose now. And you don’t need to do it now. At the moment we haven’t actually increased out debt, but within the next 18 months it will end up at about 50 per cent of GDP and may actually be bigger. One of the risks at the moment is that we are all focused on this six month horizon, but actually we have no idea how long this will last. Much of that depends on the science of the virus, not economics.

So we don’t need to think about how to pay it back until the economy has stabilised, and the health crisis is largely behind us. The Federal Government will be looking at whether the economy is back to close to potential growth, that might be about a two-point-something growth rate, and then you can say, ‘right, now what do we do?’.

The other thing is that almost half of this debt ratio comes from stimulus. The other part comes from the fact that when your economy is weak, your revenue goes down and government spending goes up.  So that means less income tax, less corporate tax, less stamp duty, less mining royalties. That’s the ‘cyclical’ component. At the end of the day it’s still all debt, but you can’t really start repaying it until the cyclical component stabilises.

For now, the RBA has been very clear in saying it is not going to raise rates until unemployment is trending back to full employment (that’s 4.5 per cent); and they are confident inflation will be sustainably within the target of 2 per cent to 3 per cent. That’s probably at least three years away, so that’s a good indicator of when the ‘what next’ question might arise. 

And it's worth noting that the ways to pay off the debt aren’t mutually exclusive. The reality is, you can do a bit of everything. Have a strong, productive economy, keep a close eye on government spending and look to boost the tax base. 

Summary

About this article

By Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

Levels of Government debt can be described in two ways:

Net-debt is more commonly reported, it tells us our balance of liabilities less any government financial assets. We generally use net debt when talking about levels of debt here in Australia. 

Gross debt is simply governments financial liabilities. It is more useful than net-debt for making international comparisons as it is ignores international differences in accounting standards. The chart below shows gross debt in Australia relative to the US and the UK, both of whom are significantly more indebted.