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The Financial Express

Fiscal policy options: Crowding in or crowding out

Muhammad Mahmood | Published: April 29, 2017 19:54:03 | Updated: October 22, 2017 22:16:26


Fiscal policy options: Crowding in or crowding out

"Central problem of depression prevention has been solved'' - Nobel Laureate Robert Lucas
That's what Professor Robert Lucas said in his presidential address at the 2003 American Economic Association's annual conference held in Washington D.C. The economic climate marked by sustained growth with low inflation at that period added credence to such an assertion. It is generally argued following the neo-classical economic logic that that the economy in the long run is always self-stabilising along the satisfactory equilibrium path and no disequilibrium dynamics is taken into consideration. Under those circumstances there is no need for stabilisation policy, let alone fiscal policy. But Keynes pointed out quite some time ago "this long run is a misleading guide to current affairs".
It is not surprising that the use of fiscal policy instruments to stabilise the economy has mostly disappeared for a considerable period of time only to be brought back in the wake of the global financial crisis (GFC) of 2007-08, but even then monetary policy was given the primacy over the fiscal policy and that still remains the case.  However, the public debt to gross domestic product (GDP) ratio has risen sharply in many countries because of the effects of contracting GDP and tax revenues as well as the fiscal response to the crisis. Support and guarantees to financial sector further added to this problem.  But  very soon fiscal approach to the crisis was abandoned and  the accepted wisdom ( influenced by the neo-liberal school)  has become  that fiscal policy should be based on levying taxes efficiently and achieving long run fiscal balance ( i.e. balancing the budget) and  leaving  monetary policy as the only counter cyclical policy tool.  
The ability of fiscal policy to mitigate macroeconomic consequences resulting from such a crisis, it is argued, is conditional upon the size of the public debt. Public debt is the debt owed by a government and it can be categorised as domestic debt (held by lenders within the country) and foreign debt (held by foreign lenders).  Public borrowing is largely undertaken to finance a series of budget deficits.  Most European countries, Japan and the USA have   a very high public debt/GDP ratio. Sustainable fiscal policy presupposes that public debt relative to GDP does not rise in the long run. And that policy stance prevented countries with high public debt/GDP ratio to vigorously pursue the fiscal policy option of fiscal stimulus. Even the International Monetary Fund (IMF) also warned that fiscal stimulus should not have permanent effect on deficits and structural reforms should be implemented to address the current problem.
Nevertheless, a few years after the crisis the advanced industrial economies in response to rising public debt turned again to balanced budget and fiscal austerity to demonstrate their fiscal prudence to maintain their appropriate levels of credit rating. Fiscal austerity often also called fiscal consolidations which have had negative impact on growth resulting in even higher public debt/GDP ratio.
It is argued that public debt should be written off or be kept to a reduced level because it is a burden to the economy.  But only that part of public debt that is held overseas is a burden in real sense, since the interest payments and repayments of overseas debt represent a resource outflow. This will mean the debtor country must generate sufficient exportable surplus to pay for it by reducing domestic consumption. Domestically held public debt is not a burden on the country in a real sense because the interest payments represent a transfer from tax payers to debt holders.   However, to the extent debt holders are not tax payers, the issue of income redistribution arises.
Moreover, the financial institutions hold a very large proportion of public debt.  Any significant reduction of this debt while beneficial to taxpayers will create difficulties for the conduct of monetary policy which is very dependent on the existence of a large body of marketable debt. Furthermore, it can help monetary policy to be more effective by increasing the supply of bonds and raising the equilibrium real interest rate. Also reductions in the debt will put money into the pockets of general public which will then find its way into the banking system creating inflationary pressure and that can be a problem when the economy starts to expand. 
A well-crafted expansionary fiscal policy can yield better economic outcomes if the economy operates below its potent level. Therefore,  prolonged lower interest rates and economies operating below potential level suggest that fiscal expansion is possible.  It will boost potential growth through public investment causing employment growth. As a consequence it will help reduce income inequality which has become not only an economic issue but also an issue of social justice.
Ina country like Bangladesh which experiences persistent budget deficits need to bridge the gap by borrowing from domestic and external sources.  In Bangladesh  domestic public debt is held mostly in commercial banks' holdings of treasury bonds and non-bank holdings in the form of long term interest bearing securities such as national savings certificates.  But it also includes net credit by Bangladesh Bank and outstanding liabilities of state owned enterprises to the banking system. The domestic debt to GDP ratio stood at 20 per cent in the fiscal year (FY), 2014-15. During the same year the same ratio with respect to external debt was 13 per cent. Bangladesh owes about 75 per cent of its external debt to two institutions -- The World Bank and the Asian Development Bank.
The government borrows from the public largely to meet budget deficits and also to finance development activity under the Five Year Plans and other projects and on occasions to meet extraordinary situations like natural disasters. As a consequence the level of public debt has been rising. The level of outstanding domestic debt is indicating an increasing trend, rising from Tk 1168.24 billion, or 116823.84 crore to be more exact, in 2009-10 to Tk 2031.63 billion, or 203163.48 crore to be more exact, in FY 2013-14. A similar trend is also observable for external debt which rose from US$16.17 billion 2002 to US$25.96billion in 2016. Despite rising levels of public debt, the ratio of public debt to GDP declined from 38.6 per cent in 2006 to 27.2 per cent in 2016 indicating that the economy is growing at a much faster rate than the rate of public borrowing.
Overall the level of debt in Bangladesh has been rising over time. But the ratio of external debt to GDP is on the decline while the ratio of domestic debt to GDP is rising. Increasing share of domestically held public debt enables the country to use domestic resources to service it; in fact domestic payment of debt involves only a transfer of income from Bangladeshi taxpayers to Bangladeshi bond holders. However, if tax payers and bond holders are different people that will lead to income redistribution, causing income inequality. But servicing external debt will require sacrificing resources in the form of reduced consumption.
The current economic environment in developed economies is marked by sluggish demand, extremely low inflation with near zero to negative real interest rates. The current debate is primarily on fiscal stimulus. There is now a degree of consensus emerging that fiscal stimulus is required to stimulate private investment (crowding in) through stronger growth which will raise inflation expectation, thus lowering the real interest rate and the cost of capital.  
But most developing countries, especially in South and East Asia are performing reasonably well and that includes Bangladesh. This country is on a steady growth path, fiscal stimulus through domestic borrowing will shift capital from private sector to public sector via ''crowding out'. Persistent budget deficits (and also rising) in Bangladesh is symptomatic of fundamental imbalance in revenue receipts (which can be thought to be proportional to GDP) and government expenditures (structural deficit) as opposed to occasional cyclical factors. The fundamental problem with a structural deficit is, it will continue regardless of the strength of the economy. Therefore, it is important that the government must get close to balancing the structural deficit by overhauling the taxation system by moving more towards income-based taxation and curtailing the whole range of tax concessions and subsidies to businesses, on the one hand and reining in government expenditures, on the other. Failure to do so can lead to a serious crisis of confidence.
muhammad.mahmood47@gmail.com

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