Can the Budget look after itself?🍋

The Treasury’s long-term insights briefing

Apr 14, 2025

Last week the Treasury released its latest Long-Term Insights Briefing on the relationship between fiscal policy and economic shocks and the business cycle.

This is an important topic and is something that has been of interest to economists for decades. Indeed, J. M. Keynes famously said in 1933, “look after the unemployment, and the budget will look after itself.”

Keynes argued that during economic downturns, government spending, especially on welfare, would increase while taxes would fall. When the economy improves, welfare spending should decrease, and revenues rise, automatically balancing the budget.

However, as Robert Skidelsky, a biographer of Keynes, noted in 1996, the idea of letting the budget look after itself “would be fine if budget deficits were purely cyclical, as they were in Keynes’ day. But they are now structural products of steady upward pressure on spending, combined with tax resistance.”1

Beware the debt ratchet

The result is that debt can build up during recessions and not be cleared during booms, leading to a debt ratchet. It is, as the Treasury argue, easier to increase spending during downturns than to cut it during upturns, potentially leading to rising debt levels over time.

Lake Rotoiti, Nelson Lakes National Park. *Dave Heatley*

Further, the relationship between fiscal policy and economic shocks and the business cycle does not just go in one direction. Not only do economic conditions affect fiscal policy, but fiscal policy influences these conditions themselves.

With all of this in mind, the Treasury drew several conclusions on the role of fiscal policy. I have summarised some of the highlights below.

While both macroeconomic and fiscal policy should be “on the field” during a crisis, the primary tool for stabilising the economy should be monetary policy run by an independent central bank. Compared to fiscal policy, monetary policy changes can, the Treasury reckon, be deployed more quickly, and are more easily reversed.

Nonetheless, fiscal policy does have a role to play, particularly when monetary policy is constrained, where there is concern for maintaining key government services, or for achieving distributional objectives.

To avoid debt ratcheting up, the Treasury argue that rules for using discretionary fiscal policy need to be set out ahead of time. These rules need to ensure that discretionary policies are timely, temporary, and targeted.

They also identify a menu of options, including policies such as lump-sum transfers to the public, and liquidity support or credit guarantee schemes for businesses. They emphasise that such options should be designed with clear exit strategies to avoid long-term economic inefficiencies.

Good governance plays a role too. The Treasury highlight the importance of transparency and medium-term fiscal sustainability targets. They also canvass the idea of establishing an independent fiscal institution.

As the focus shouldn’t just be on providing a fiscal ambulance at the bottom of the cliff, they highlight the importance of helping build up the resilience of the private sector. This can reduce the need for, and cost of, fiscal responses.

The key here is to maintain features of the economy that keep it flexible and adaptable to change, along with the building of what the Treasury calls “resilience infrastructure,” such as earthquake codes and private insurance markets.

They also reinforce the importance of maintaining prudent debt levels, which give future governments the fiscal headroom to respond to future shocks.

Large shocks occur frequently

This isn’t just a consideration for some distant time in the future. We shouldn’t underestimate the frequency of large economic shocks. Indeed, the Treasury estimate that since the late 1980s the cost of government responses to shocks has averaged about 1% of GDP per year.

Longer-term considerations matter too, and these include interest rate and growth trends, along with long-term fiscal pressures from population ageing and climate change. While not the subject of the briefing released last week, the Treasury will revisit these topics in its Long-Term Fiscal Statement later this year.

In the meantime, the Treasury is encouraging submissions on its Long-Term Insights Briefing, which you can find on their website along with information about making a submission.

These topics are important and seem especially timely given the current international economic environment. A better understanding could help New Zealand navigate future challenges while safeguarding the wellbeing of future generations. I encourage NZAE members and other Asymmetric Information readers to read the briefing and let the Treasury know your thoughts.

By Patrick Nolan