Too much spending or too little tax? Why interest rates are rising

It'll only take a few minutes from Michele Bullock's ascension to the podium at this afternoon's post rate decision press conference for the blame game to begin.

Who is responsible for the inflation outbreak?

She won't answer, at least directly. And she certainly won't deliver the answer required by a baying press pack.

For most of this year the Opposition has cleverly sheeted responsibility home to the federal government with accusations of profligate spending.

It's not just gaining traction, it's become an article of fact.

Shadow Treasurer Tim Wilson is having a field day.

Treasurer Jim Chalmers, it is said, is out control, spending your hard-earned tax dollars like a drunken sailor, pushing up the price of almost everything and forcing the Reserve Bank to counter with rate hikes.

It's simple and it's neat, the kind of messaging that resonates with an electorate tired of being whacked around the ears, first by runaway prices and then by higher mortgage repayments.

There's just one problem. It's hugely misleading on a number of fronts.

Look to deficits, not government spending

For a start, government spending, on its own, doesn't create or mitigate inflation.

It's deficits — the shortfall between tax revenue and spending — that are the culprit. Budget deficits inject a net inflow into the economy, spurring demand. The bigger the deficit, the more stimulus is added.

Surpluses have the opposite effect.

It's true that we are running a deficit now and will be into foreseen future.

The problem is that we have allowed and encouraged our politicians to construct a fiscal system that has created a structural or permanent deficit by permanently cutting off lines of revenue.

That's the long-term story.

The short-term reality, as far as our inflation problem is concerned, is that two massive oil price shocks have lifted the cost of almost everything, eating into Australian living standards.

And if anyone cared to check the official figures, the recent spending boom has come not from government but from the private sector as technology giants have poured billions of dollars into Australia on an unprecedented construction boom to build data centres.

Cutting off your nose

How many times have you heard this phrase: "Government spending is the highest it's ever been outside the pandemic."

In other words, government spending is the highest it's ever been, if you ignore the time it was the highest it's ever been.

True, the pandemic was an emergency, and government spending was required at that point.

Whether the Morrison government's cash flood was appropriate is open to debate.

What can't be disputed is that it was still washing through the economy right when the first oil shock from Russia's Ukraine invasion hit, sending inflation soaring.

But it's a moot point.

A better indicator of our fiscal management is the fact that in the past 20 years, ever since the onset of the Global Financial Crisis, Australia has delivered surpluses on just two occasions.

Given our status as a leading commodity-exporting nation during the biggest mining boom in global history, that truly is a remarkable failure.

And it's not down to excessive spending.

Tax cuts create their own spending problems

There's another element to fiscal management, and that's taxation.

At almost every election, tax cuts almost inevitably are used as a lure to lasso voters.

They're never offset by spending cuts because that is a sure-fire strategy to be booted out at the very next election.

Former Treasurer Joe Hockey tried it in his very first budget back in 2014 and was immediately howled down.

And despite his promise that a Coalition government would deliver a surplus in each and every year it was in power, it didn't manage to deliver any at all.

Instead, the Coalition racked up a decade of deficits.

In one of his first moves, then-newly elected prime minister Tony Abbott made good on his promise to junk the mining tax.

That cost the budget around $69 billion in the decade to 2022, according to Parliamentary Budget Office.

Next came the axing of the carbon tax which raised $15.4 billion during its two years of operation.

The Abbott government replaced that with a spending measure, forking out billions of dollars to companies and individuals to reduce emissions.

Regardless of your philosophical leanings on mining or emissions, from an accounting perspective both decisions were a disaster.

Revenue slashed. Spending maintained or increased.

Out of control (private) spending

In the past two years the economy has experienced a spending spree.

But it's come from the private sector, as this graph from the Australian Bureau of Statistics highlights.

The tan coloured component of each bar represents private spending growth while the dark blue bit is government spending.

Since June last year, and particularly in the March quarter this year, business invested vast amounts of cash in a data centre building boom.

At the same time there has been muted growth in public spending, which tends to undermine the ongoing alarm about federal outlays.

But why let facts get in the way?

In addition to building materials, the boom in data centre building has soaked up construction workers by the score along with vast numbers of skilled electrical and IT specialists.

That's blowing out the cost of construction.

Add the impact of surging fuel prices into the mix and inflation is being fanned by forces well beyond government spending, as the most recent ABS inflation data highlights.

According to the May budget papers, total spending this year is estimated to rise to 26.8 per cent of GDP.

While that's well below the pandemic era's 31.3 per cent, the trend is rising, giving rise to some legitimate concerns on spending growth.

But, importantly, the gap between revenue coming in and spending going out is now just 1 per cent, well below the 2 to 3 per cent gap of a decade ago which drove a massive blow-out in debt.

And remember, it is that gap that determines how much stimulus a deficit will inject into the economy.

Spending pressure to increase

For the past three decades, developed world governments have paid little heed to balancing budgets.

They'd been forced to hand over control of monetary policy to their central banks because politicians facing elections couldn't be trusted to set interest or exchange rates.

But that's now coming to a head.

Slashing taxes, particularly for the wealthy, while raising debt to cover the never-ending round of deficits was fine while inflation was hibernating, as US President Donald Trump is beginning to discover.

The massive cost of servicing that debt is now escalating.

In America's case, the annual interest bill alone has gone beyond $US1 trillion a year, laying the ground for a potential sovereign debt crisis.

Those financing demands are beginning to rattle money market investors, who are pushing interest rates higher across the globe.

Spending demands, meanwhile, are only likely to increase.

In an increasingly divided world, defence spending is escalating. Add in the cost of an epochal shift in energy systems, demands for better education opportunities, soaring health and aged care costs from aging populations and there are very few options available for cost cutting.

At some stage Western governments are going to have to admit to their constituents that there is no magic pudding.

If you want these services you're going to have to pay. And if it is a harmonious society you crave, everyone, including the wealthy, will need to pitch in.