Can less be more? On budget and deficit

Similar to Latvia, the budget consolidation process is underway in a number of other European countries as well. A group or school of economists maintains that consolidation is unwelcome in a downturn economy and that cutting public spending inevitably decelerates the economic growth. This article is an attempt to find out whether this presumption is true and how past decisions have affected today's budgetary policies.

Tight budget policy can promote economic growth not only over years but also right away

Economists do not argue against a tight budget policy (or commitment to a small budget deficit) as a driving force for economic growth in a longer term. If, instead of borrowing, budget expenditures are covered by budget revenues, funds are not withdrawn from the financial market and more money is available for corporate investment, i.e. economic growth, including the creation of new jobs. By contrast, persistent support to the economy, with the state living with an unbalanced budget (with deficit) on account of ever growing debt, poses risks to the economic outlook.

It has become particularly evident at the current juncture: the borrowing costs have risen considerably in many European countries with lasting budget deficits and high debt levels. Large indebtedness also implies that, in order to meet interest and principal payments, the state needs more and more tax revenues, the collection of which can be increased by raising tax rates, thus hindering the economic growth. A persistent fiscal stimulus is not to the advantage of nation's competitiveness either, as it results, sooner or later, in price and wage rises that push up corporate costs, i.e. companies encounter problems to export or to compete with imports. Competitiveness is subdued also by the above referred tax hikes. A large body of evidence points to the favourable impact of prudent fiscal policies on long-term economic growth. Researchers C. Reinhart and K. Rogoff[1] suggest that high debt levels in countries, both advanced and developing, are associated with notably slower rates of growth.

Can budget consolidation support the economy not only in the long run but also right away?

In accordance with the theory of the well-known British economist J. M. Keynes, cuts to the government spending reduce the overall demand for goods and services, thus making the economy contract in the short run. The response of other economic sectors to the government policy is excluded from this simplified approach. Certainly, the decisions households and the corporate sector make are affected by the actions governments are likely to take. Both latest inferences of the economic theory and the experience of a number of countries suggest that public expenditure cuts may have a positive effect on the economic (GDP) growth also in the short term. These mechanisms are known as non-Keynesian effects.

First empirical evidence about eventual non-Keynesian effects comes from the 1980s when after fiscal consolidation the immediate positive effects on economic growth were observed in Denmark and Ireland. Since then, many economists have found evidence that contradictory to conventional Keynesian theory the budget deficit cuts may have an immediate positive effect on economic growth also in the short term. For instance, A. Rzonca and P. Cizkowicz[2] in their working paper point to the presence of non-Keynesian effects or a positive impact of budget consolidation on the GDP growth for the new EU Member States also in the shorter term.

What mechanisms determine the existence of such non-Keynesian effects?

First, on the basis of anticipated government budget policy impact on population's future income, households can make appropriate spending decisions already today. For instance, a decline in public expenditure today may point to an economy-distorting tax lowering in the future or, at least, does not create expectations of tax increases. Consequently, households feeling more secure about their future income (as it is not expected to shrink on account of higher taxes) can increase their spending. Corporations, in turn, gain motivation to boost investment in production.  

In the same way, creditors to the state closely follow the developments in fiscal policy to decide whether they increase default risks or inflationary pressures and adjust their interest rates accordingly, i.e. when risks intensify, interest rates go up. Consequently, the pursuit of tight fiscal policy (balancing expenditures with revenues) drives interest rates down; this, in turn, enhances investment. The share of private consumption sensitive to interest rate changes (e.g. purchase, often on credit, of durable goods) also increases. It has an immediate positive effect on the economy.

Second, as has been indicated above, higher public expenditure can have an upward pressure on prices and wages, with their rate of growth exceeding that of productivity, which, in turn, would increase corporate costs. In such circumstances, companies lose their competitiveness while bankruptcy risks increase. When government expenditure on remuneration contracts, companies can also lower wages, reduce production costs and more successfully compete with foreign producers. As a result, labour costs reduced thanks to the stringent fiscal policy facilitate the expansion of production, improvement in external competitiveness and exports as well as creation of new jobs. With such developments in place and productivity on the upswing, wages can also be raised accordingly – so less turns out to be more, so to say.

Confidence gains importance in debt crisis

When assessing the fiscal policy's potential effects, the nature of the current crisis should be accounted for. In the classical Keynesian theory, a fiscal stimulus is intended for coping with a temporary economic downturn in order to offset the sluggish economic activity of companies and households. It is obvious today that the fiscal stimulus packages implemented in many advanced economies have not notably improved the situation. Along with slack output and employment, the enormous debt burden is the largest problem which, if not solved, will most likely hold back the revival of economic activity. Economic stimulus from the government, however, means augmenting the budget deficit, which, for its part, implies an even higher debt level. In contrast to cyclical economic downturns which as a rule are overcome in short time (sometimes by supportive fiscal stimuli), the effective resolving of financial crises and deleveraging require more time, with resolute actions of policy makers in balancing the state budget and launching structural reforms in public administration, education, health care, etc. being decisive.

Countries with elevated debt levels are susceptible to eventual interest rate increases that may lead to their inability to service debt and thus become insolvent. In this context, the confidence and behaviour of households and investors become more important than the potential direct effect from the injection of additional (borrowed) budget funds into the economy. Interest rate hikes unsustainable for the state and companies, investor outflows and other developments with unpredictable and sad consequences become possible – so more becomes less, so to say.

According to the Keynesian theory, fiscal policy is implemented in a symmetrical and countercyclical manner, i.e. with a budget in surplus during good years to stimulate the economy during the crisis. Consequently, if countries had implemented tight fiscal policies in the years of prosperity, had not spent more than they earned, and had not borrowed (and there are such countries), today they would have been able to consider bolstering public spending or lowering tax rates at the expense of increasing debt levels. The truth, however, is that many countries incurred fiscal deficits even in the years of prosperity and debt was accrued at enormous levels; at present, there seems to be a need for fiscal stimulus without gain: implementation of fiscal stimulus packages give rise to more pronounced uncertainty, speculations, worries about nation's solvency, and large interest expense. In the meantime, the economy keeps on stagnating.

The loose fiscal policy of previous years is responsible for governments facing a shortage of instruments today. To regain trust, build confidence and find new growth stimuli, governments should demonstrate explicitly their ability to balance expenditure with income, reduce the debt and set on a sustainable financial path. This translates into difficult and often unpopular decisions with regard to budget cuts. Nevertheless, there is good news as well: this will lead to a gradual recovery of investors' confidence and the return of investment flows to viable companies that can attract labour force and give impetus to output growth. Materialisation of this positive scenario also depends on whether budget cuts address the issues of efficiency of public sector institutions, education and other systems and improve the business environment.

[1] Reinhart, C., Rogoff, K., “Growth in a Time of Debt”, NBER Working Paper No. 15639, 2010

[2] Rzonca, A., Cizkowicz, P. “Non-Keynesian Effects of Fiscal Contraction in New Member States”. ECB Working Paper No. 519, 2005


The article was published by Delfi on August 23, 2011.

APA: Kalniņš, G. (2020, 20. sep.). Can less be more? On budget and deficit. Taken from https://www.macroeconomics.lv/node/1822
MLA: Kalniņš, Guntis. "Can less be more? On budget and deficit" www.macroeconomics.lv. Tīmeklis. 20.09.2020. <https://www.macroeconomics.lv/node/1822>.

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