How to cut the fiscal deficit

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How to cut the fiscal deficit

Lee Jong-wha
The author is a professor of economics at Korea University.

Governments around the world have stretched debt-financed spending to cope with the worst economic slowdown since World War II. In a report in June, the International Monetary Fund (IMF) projected that the share of government debt against the gross domestic product (GDP) would increase 19 percentage points on average to exceed 100 percent. The IMF expected U.S. federal debt to hit 140 percent of GDP this year.

Korea is in a lesser danger. Its debt-to-GDP ratio will increase eight percentage points to near 50 percent this year, according to the IMF. The ratio may not raise an immediate danger, yet it poses a significant burden to fiscal integrity in the mid- to long-term. The Korean economy’s growth potential has been watered down by the world’s lowest birth rate and fastest aging.

The demographic factors cause fast increases in welfare spending and government debt. In its latest public finance outlook, the Ministry of Strategy and Finance projected the government’s debt-to-GDP ratio to reach 100 percent in 2045. Moreover, the deficits in four public pensions (for the people, government employees, teachers and soldiers) are rising fast.

The ballooning public sector debt should be borne by people in their 10s and 20s. The interest on government bonds may not burden the government for the time being as a result of low rates, but the financing cost will rise if investors become doubtful on Korea’s sovereign credibility and shun investment. If the government has trouble repaying the debt by issuing more bonds, it could face a default crisis. Latin American economies scared the world with several fiscal crises as they could not meet debt obligations due to high borrowing cost. Korea is not immune to such a danger.

It is still debatable what level of government debt to GDP causes danger. Some studies put 90 percent as a threshold, but that should apply differently to different countries at different times. Even an economy with a high debt-to-GDP ratio can fare well if nominal GDP grows at a robust pace. U.S. federal debt hit 119 percent of GDP after the Second World War, but with fast economic growth since, the ratio came down to 40 percent in the early 1960s. But the pace of recovery is uncertain now. Even if the world overcomes the coronavirus pandemic, most developed economies won’t be able to shake off their slowed growth and low inflation.

Some scholars and politicians argue that government debt-to-GDP ratios will stay manageable if their central banks continue to buy the debt. For instance, the Bank of Japan has kept up smooth operations and supported government spending by absorbing government debt over the last 25 years. Under recession and deflation, a central bank’s bond-purchase program would not cause a problem. But the debt can stoke inflationary pressure and create asset bubbles. If the value of the currency falls, the country could face a financial crisis. Venezuela experienced hyperinflation of 930,000 percent in 2018 after it recklessly printed notes to make up for the fiscal deficit, sending its citizens fleeing the country after fighting for daily food and necessities.

To lessen the debt burden on future generations, the government must stimulate the economy and private activities through productive spending.

The Moon Jae-in administration has drawn up four supplementary budgets this year and announced a 160 trillion won ($131 billion) spending plan over the next five years for its New Deal projects. The money should be spent wisely so as not to cause waste. Public-sector spending must serve as priming water for private investments. Government support also must go to education, training, child care and housing for younger people who would be burdened with today’s debt.

Feasibility of large government projects should be carefully studied. In a recent report, the IMF pointed out that a third of global public infrastructure spending had been wasteful due to bad planning and political collusion. The report cited Korea as a country that spends efficiently, but pointed out growing political influence in recent large infrastructure projects.

To sustain mid- to long-term fiscal integrity, governance over economic policy and execution is important. The Korean government and central bank must run fiscal and monetary policies with a long-term vision. Politics must not interfere. Politicians chase unproductive policies for their political interests. Populist governments often wrecked their economies with reckless fiscal and monetary stimuli. Most governments keep the cap on fiscal deficit and debt and ensure sovereignty of the central bank. Korea lacks fiscal guidelines on deficit management. It also often pressures the central bank to increase debt purchases to back its spending.

The pandemic crisis weighs on not just the contemporary but the future generations. Fiscal and monetary stimuli actions are necessary to fight the crisis. But governance over economic policies should be strengthened to raise efficiency and mid- to long-term fiscal integrity.
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