Why Swan is right to stick to his surplus plan

You wouldn't be Wayne Swan for quids.

Politically, the Treasurer is damned if he doesn't deliver his promised surplus in the budget papers on May 8. But, increasingly, it also appears Australia's most obstinate Treasurer will be damned if he does. Should the economy slow unexpectedly at a time when the government is cutting spending, he's sure to cop some of the blame.

Swan's dogged pursuit of a surplus has already earned him some awkward bedfellows, conservatives who claim he has embraced the idea of small government and paying off debt at any cost.

Meanwhile, his traditional allies - left-wing economists and some private sector economists who praised the government's fiscal stimulus - have turned against him, worried that planned spending cuts or tax rises will send a tepid economy even further off the boil.

So, should we have a budget surplus in 2012-13, or not?

Opponents rightly point out that the impact of past tax and spend decisions means the government is already taking heat out of the economy. By going from a deficit of $40 billion or so in one year, to a slim surplus the next, the budget is already contractionary.

True. But these figures have been around for some time, and Treasury has still been predicting a trend level of growth - around 2.5 per cent a year.

What matters for the economy with this budget is the magnitude of any new cuts.

But, without knowing what the figures are, it seems unlikely cuts will be big enough or ugly enough to derail growth. At least not when the Reserve Bank can also cut interest rates.

To keep his surplus promise, all Swan is concerned with is getting the 2012-13 books into the black. On the last count, he was there by $3 billion, though revenues have slipped since.

Let's assume revenue for that year has collapsed by about $10 billion, while spending is unchanged. That would mean the Treasurer needs to reduce spending or raise taxes by $7 billion to achieve his surplus.

One audacious strategy would be to pull forward spending from 2012-13 into 2011-12. He could, say, pre-pay $3 billion worth in planned carbon tax compensation payments before the end of this financial year. Doing so would, in fact, be both stimulatory in the short term and help achieve the surplus.

That would leave just $4 billion in spending cuts, which out of a $1.3 trillion economy, would reduce growth by only 0.3 percentage points. It's not huge, and could easily be offset by the Reserve Bank reducing interest rates.

Even then, the nature of the budget cuts or tax increases will matter too. For the same reason that lower income earners were the target of budget stimulus - they react more to changes in their income - budget cuts targeted at higher income earners would have less impact on demand.

Tax increases on foreigners earning profits in Australia, say mining companies, would also have less of an impact on domestic demand, as would reduced spending on foreign-produced defence equipment. So it's far from clear that bringing the budget to surplus in 2012-13 will damage the economy.

But will it do any good?

A dubious argument doing the rounds, and coming from the government itself, is that a surplus is needed to give investors confidence in the Australian economy and Australian government bonds. In fact, all the evidence suggests foreign investors are too keen to hold Australian assets. All this demand is actually pushing up the value of the Australian dollar as investors must first buy dollars to purchase Australian assets. Less demand for Australian assets could in fact help bring the dollar down and relieve some pressure on manufacturing, tourism and education services.

A second dodgy argument is that we need a surplus to give the Reserve Bank the space to cut interest rates. It's dodgy, because it is in the clear to cut rates whenever it wants. Fiscal policy, as noted, is already contractionary and with inflation under control and a cash rate at 4.25 per cent - compared to close to zero in other developed nations - the Reserve Bank already has more room than most to cut rates.

But there are better reasons for achieving a surplus.

A change in the ''policy mix'' back towards having monetary policy (interest rates) rather than fiscal policy (government tax and spend policies) as the major tool for stabilising the macro-economy would be good for several reasons.

At a time when the exchange rate is high, in part because interest rates are high, tighter fiscal policy combined with lower interest rates will help to take pressure off some parts of the economy.

After the turmoil of the global financial crisis, it would also mean a return to business as usual. Before the global financial crisis, the consensus was that it was much better to have an independent central bank managing demand through interest rates, not politicians through government spending.

Pollies have sticky fingers, and hate cutting spending or raising taxes. An independent Reserve Bank is more at liberty to change policy settings. It also meets monthly and can change policy settings more quickly than the government, which tends to make decisions only every six months, coinciding with budget updates.

So, on balance, we should have a surplus, if only because it won't hurt too much and it could, at the margin, help shift the responsibility for macro-stability back to where it belongs - the Reserve Bank.

Keynesian demand-management fiscal policy is best kept as a ''break in case of emergency'' tool. It works best when it's clear a downturn is imminent - like the collapse of Lehman Brothers in 2008. In the absence of such signals, it's better for the government to concentrate on balancing its books and to leave day-to-day management of the macro-economy to the independent Reserve Bank.

Jessica Irvine is Economics Writer for The Sydney Morning Herald