Balancing act of economic growth and Public debt : A fiscal policy conundrum

The covid 19 pandemic has forced governments around the world to borrow and spend at an enormous and unprecedented rate, between April & June 2020 America alone had borrowed more than 3 trillion dollars, the largest amount borrowed in a single course since records began.

The rise in public debt has been unlike anything we have seen in recent history, in past, the communists had warned of high levels of borrowing, however, a new theory has come up that tells that high levels of debt might be sustainable. The fact that there has been such a dramatic change in consensus, makes some people nervous. How much cause of concern should the world rising public debt be?

The government has borrowed to finance their spending for 100s of years, at the end of the napoleon’s War, Britain’s debt was 164% of GDP, and after the second world war, it was 259% of GDP.

Historically, governments have borrowed for two reasons, the biggest reason was to fight a war, like the war bonds issued during the world war ( this also led to the creation of the Fiat currencies, which were earlier pegged to gold but later de-pegged) and other has been in past few years to keep economy on track.

To raise money government issue bonds, they are” I Owe you”  with interest that depends on the length of the bond( called the duration ), How desirable these bonds are to investors, depends on the country’s credit worthiness.

Gov bonds are bought by pension funds, hedge funds, banks, and even by the country’s central bank. The foreign government also buys bonds, The biggest foreign holders of American bonds are China and Japan.

The government’s willingness to issue debt has changed over time, after the sky-high debt of the world war, many gov were warry to keep going into the red, and in the 1970s, ( borrowing ) was blamed for high inflation. In the RICH world, the financial crisis of 2007 pushed the public debt to 74% to 105% of GDP in a decade, and in the emerging economies, it was raised from 25 % to 47 % of GDP.

This ballooning debt caused political panic, with the government starting practicing austerity to bring the deficit down, like in Greece and other parts of Europe in 2008 -10. The problems of austerity led to new thinking though.

IMF chief, 2010, said that governments can borrow far more as long as the nominal growth of GDP is more than the interest rates of G Secs. , as long as GDP is growing faster than the interest rate, the nation can grow as no fiscal cost will be there.

In 2020, the Coronavirus emerged in China, and the greatest exercise for generations began. However, Not every country can borrow easily, the difference is that poor countries get a higher interest rate, borrowing on this scale is not without risk, as there is always the threat that interest rate can rise again,

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In general , on mortgage and gov bonds , interest rates on savings accounts are driven by demand, if the desire to save is high, the bank rates will be low.

The interest rates can be down, if the ageing population is there for one reason, as people tend to save for retirement etc ( like what’s happening in Japan, inflation is still under control there ), fear of global financial instability can also force people to save more or invest in G secs. These have been the reasons for low interest rates and therefore more government borrowings . Despite these risks, the governments will keep borrowing, to cut the deficit spending. But how much can countries continue to borrow is unclear.

What can the governments do?

To begin with, the governments have to spend more on infra to increase tax avenues and bring down revenue expenditure in the long run, because if the government doesn’t increase its revenue receipts, the fiscal deficit will rise further and the cost of borrowing will rise even further. This will lead to more revenue spent on debt servicing instead of the growth of the respective states and countries.

Many governments are into subsidising utilities and other offerings, this could be done for a short period but in the long term these measures will first eat up tax revenues, secondly it will not give any incentives for the respective industries to become self-sufficient. Governments have to strike a balance between debt and economic growth, else we could see government across the world getting stuck in a vicious cycle of low growth and high deficit .

Written By: Ankur Kushwaha, Consultant, Invest Punjab | Govt of Punjab

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