Last month, an internal speech by Treasury secretary Ken Henry was leaked to the media and the results were explosive. Apart from the revelation that the Prime Minister did not consult with treasury to create his water policy, some of the harshest statements were directly related to fiscal policy.

“In an economy operating at, or close to, full employment…expansionary fiscal policy tends to ‘crowd out’ private activity: it puts upward pressure on prices which …puts upward pressure on interest rates.”

“… in a full employment economy it will almost always be the case that government activity that doesn’t expand the economy’s aggregate supply potential will … reallocate resources from higher to lower productive areas, and in doing so reduce aggregate output – by definition.”

The real question is whether the budget does enough to expand aggregate supply to offset the extra aggregate demand caused by the tax cuts. Of course, pushing extra spending further into the future minimises the risk of being inflationary, but it also decreases the political benefits of such spending. The reactions of the commentariat to this budget in coming weeks will be interesting.

One of Henry’s (Ken, not Thornton) presuppositions is that the economy is running at full employment, as official statistics indicate. As Henry (Thornton, not Ken) has argued, the amount of un- and under-employed is significantly underestimated. The Roy Morgan Unemployment Estimate, which gives an unemployment rate of 7.2%, gives a better indication of the amount of unemployed, but this is still below Henry’s estimate of underutilised labour.

Regardless of whether Australia is currently running at full employment, the trend is certainly down, indicating that the labour market is getting tighter. Today’s Manpower — Melbourne Institute Employment Report suggests that employment growth is predicted to reach 2.6% in April, followed by 2.3% and 2.0%, respectively, in May and June — obviously demand is still strong in the labour market. The Olivier Internet Job Index and the ANZ Job Ads Index, both released on Monday, also highlight this.

The March Quarter Wage Price Index, to be released next Wednesday, will prove to be all-important. As Henry has highlighted, WorkChoices has added downward pressure to wage-price inflation, but the Reserve Bank will still be very interested in this data.

Another indication of the strength of aggregate demand at present is continually growing house prices. Although the heat has come out of the housing market in Perth, the overall Australian House Price Index, released today by the ABS, is still running hot. Over the twelve months to March quarter 2007, established house prices rose by 8.6%, from an upwardly revised 8.8% in the December quarter. Combines with this week’s sluggish housing approvals data, this is an area of concern.

Read more at Henry Thornton.