Budgets caught in deficit trap

The Keynesian theory of deficit financing advocating injection of money into the economy to ensure full employment has widely been accepted by many developed and developing countries in their fiscal policies. Deficit financing in a national budget usually happens as a result of mismatch between revenue mobilisation and expenditure. The deficit is financed either through borrowings-domestically or foreign-or through use of foreign reserves. Borrowing means the government has to agree on the terms of payments which usually are attached with bizarre regulations. Hence it creates a deficit as the government needs to spend more money on debt servicing leading to more expenditure and deficit.
William Shakespeare was neither an economist nor a politician. But he wisely says:
Neither a borrower nor a lender be,
For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.
When a national budget is declared in any country, it is expected that the budget will come with big "fiscal deficits" and the end-users of the budget, the general people, will have to bear the costs of the deficits for the ongoing year and the years to come.
From polls conducted by various organisations, it is evident that people and even the politicians do not like fiscal deficits. President Obama and the Republican leadership in the House of Congress in the United States are found to be critical about the fiscal deficits and both the parties want to reduce the deficits-the national debt burden-as best as possible. Some economists express their concern about the fiscal deficits and say that fiscal deficits not only put the present people in the trap of debt but also keep the future generations ensnared in debt.
Governments in developing countries face serious constraints in raising revenues as the set of policy instruments available is limited, given the rigid structure of expenditures and the low level of income. With globalisation, developing countries lost a historically reliable source of income from tariffs due to trade liberalisation, but failed to recover the lost revenue by introducing tax reform in the form of Value-Added Tax (VAT), increasing tax rates and widening the tax net. The access to international credit markets' finance is also limited for most developing countries compared to developed ones. So, the restricted sources of finance faced by governments in developing countries lead them to borrow more from the domestic market and this borrowing has increased dramatically from the late 1990s.
Unwarranted and prolonged deficit financing through the creation of high-powered money may deny the attainment of macro-economic stability, which may, in turn, affect the level of desired investment in an economy and thereby its growth. The major determinant that directly affects the macro-economic policy is investment, both public and private. Such macro-economic policies involve deliberate manipulation of policy instruments, such as monetary policy, government fiscal operations, exchange rate and trade policies, pricing and environmental policies for the purpose of achieving broad macro-economic gains like relative price stability, high level of employment, economic growth, equitable distribution of the national income and the balance of payment equilibrium. These are significant macro-economic indicators, upon which investors' confidence, expectation and decisions on whether to invest or not hinge.
High leeway debt stocks and debt-weight are also shown to have a stifling effect on investment, mainly through the debt overhang effect, the crowding out effect and credit rationing. The overhang effect discourages investments in the private sector. A highly indebted country is likely to face credit constriction in the international capital market and this leads to stiff reduction of investment.
Poland has so far avoided austerity policies comparable to those conducted in Southern Europe and some Eastern European EU-member states. The country has been the only EU member not to have undergone a recession since the outbreak of the financial crisis. The raising of government spending-particularly through increased public investment-has meant that Polish society has been sheltered from some of the worst effects of the crisis. Public debt has risen steadily over the past few years but its current level is still well below the EU average. The country still has considerable room for further fiscal expansion. As the Polish banking system did not undergo a crisis like others, the government was not required to divert large sums of money to bail out its banking and financial sectors. The government is increasingly working in line with the accepted economic wisdom in Europe that seeks deficit reduction through cutting public spending.
Egypt, Turkey, Nigeria, Brazil and some other developing economies have had the shocks and aftermaths created from prolonged fiscal deficits. All these countries are struggling to come out of the trap of deficit financing and undertaken various programmes to reduce fiscal deficits. The reason behind the high budget deficit in Pakistan is the hyper increase in its dependence on external resources like loans and other forms of aid. These loans are sought from donors in order to service debts, which ultimately further enhance the budget deficit and hence the deficit goes up year after year.
It is often alleged that in developing countries, the major causes of fiscal deficits on the expenditure side are the expenditure on non-development or unproductive items like subsidies, defence and administration. On the revenue side, the main problem is relatively small taxes and small tax net and thus relative stagnation in the share of direct taxes as a source of revenue. Almost 9.0 per cent of the GDP (Gross Domestic Product) of Pakistan was allocated for the debt servicing each year during a whole decade.
Deficit financing seems to present a negative impact on investment in the economy of Nigeria. When there is a budget deficit, the government finds ways of financing deficit through borrowing from commercial banks or from non-banking sources and through issuance of short-term bonds and monetary instruments. The use of these forms of deficit financing for the pursuit of fiscal policies often leads to crowding out of private investment, inflation and any future debt crisis.
Bangladesh's fiscal budgets have been trapped in deficit financing over the last few years. Instead of reduction, the fiscal deficits are increasing incessantly. The country's fiscal budget for the fiscal year (FY) 2015-16 is likely to be higher by 26.74 per cent than the budget for the FY 2014-15. If the political unrest escalates, that will severely deter investments and widen the fiscal deficit as has been observed by Finance Division officials.  The government plans that over 75 per cent of that deficit will be met with borrowings from banks and savings instruments, as there could be a lack of external funds. Interest payment in the next July-June fiscal year will also increase to Tk 350 billion (35,000 crore) from the current fiscal's Tk 310.43 billion. The deficit in this fiscal is Tk 613.46 billion and in the next fiscal it would be Tk777.50 billion. Recently the Finance Division officials discussed the structure of the next budget with the visiting IMF mission.
The 75 per cent of deficit financing with borrowings from banks and savings instruments will constrain private investments in the productive sector. The current year has had the worse effects of excessive borrowings from banks and savings instruments. The deficit has two clear costs for the economy. First, higher government borrowing from domestic sources has crowded out the private sector investment. Second, policy costs are included in the deficit. The cost of borrowing, viz., interest payable for banks and for savings instruments, will increase abnormally and time will come when paying borrowing costs would be a very difficult task. According to economists, if the borrowed fund under fiscal deficit is not used properly in the productive sector, the country will be left in a cycle of long-term debts and economic achievement will be a nightmare. Fiscal deficits have direct links with inflation and fiscal deficit-prone countries have high inflation rates.
Many countries in Asia, the EU and Africa are suffering from the aftermaths of continuous fiscal deficits. Some countries used such funds for unproductive purposes, paying benefits to retired staff, subsidies on commodities, etc.,  instead of investment in productive sectors. Greece, Spain and Italy have had the adverse effects of long-term fiscal deficits. Greece has been maintaining the high-deficit financing policy for many years and ended up with economic and financial crises. It was temporarily bailed out by the EU and the IMF. Foreign debts of Serbia with a growing budget deficit and balance of payments have stood as a big obstacle to its economic recovery and development. A highly deficit budget is not suitable from the economic point of view, as it relieves the short-term pain of a nation only to make it endure it for a long term.
The writer is CFO of a private group of companies.
[email protected]