3  Policy neutrality

Economic objective

The economic objective assumed in this section is to maximise the potential for the gross size and composition of the Crown balance sheet to be neutral for economic welfare.

Two sets of motivations are available in support of this objective. First, if Ricardian equivalence held:

• citizens would achieve their desired wealth portfolio irrespective of the size and structure of the Crown balance sheet; and
• the government could focus on operating policies without having to take into account balance sheet considerations.

Second, two further motivations are available on the basis that Ricardian equivalence is unlikely to hold perfectly:

• since any policy setting inevitably has potential of being in error, the more closely that policy neutrality holds the less detriment to economic welfare arising from errors in Crown financial policy; and
• proposed policies to improve economic welfare may be rejected on the basis of comparative institutional analysis. In this case, Crown financial policy should promote conditions consistent with minimising the adverse real impacts of policy on economic welfare.

Key insights for policy

Ricardian equivalence implies that Crown financial policy is indeterminate in the sense that all policy options achieve the same optimum level of economic welfare. Citizens would rearrange their personal portfolios to undo any changes in the stochastic properties of their exposure to the Crown portfolio. Economic efficiency would require only that citizens’ personal portfolios be on the Capital Market Line (CML), as illustrated below.[7] Notably, however, citizens’ sub-portfolios such as the Crown balance sheet do not need to lie on the CML.

Nevertheless, Ricardian equivalence would not imply that Crown financial policy should be left undetermined. To construct optimal personal portfolios, citizens would need to know the stochastic properties of their exposure to the Crown. This suggests that an objective for Crown financial policy could be to minimise the risk that citizens misperceive the Crown’s policy settings, particularly its risk/return targets. On this basis, the government’s policy settings should be explicit, transparent (hence, easily communicated) and signalled prior to implementation. This could suggest extra Crown reporting requirements, possibly involving changes to the Fiscal Responsibility Act 1994.

Figure 1 below illustrates the situation in risk/return space. The figure shows the Crown portfolio lying inside the efficient frontier at an announced risk/return point. Under the Ricardian assumptions, citizens’ total wealth portfolios would lie on the CML at points reflecting each individual’s level of risk aversion.

Figure 1 – Example of Crown portfolio inside efficient frontier

Summary on policy neutrality

Economic objective

Maximise the potential for gross size and composition of the Crown balance sheet to be neutral for economic welfare

CFP objectives

Minimise the risk that citizens misperceive policy settings (especially risk/return targets)

Targets

No specific targets identified as optimal. For purposes of transparency, the government should announce a risk/return target but otherwise may allow the Crown balance sheet to evolve as residual of government operating policies.

Instruments

Legislative provisions that ensure risk/return and other policies are explicit and transparent, and that changes are signalled in advance of implementation, e.g. Fiscal Responsibility Act 1994