Discuss for and against reducing national budget deficit


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Various governments around the world have responded to the 2008 global financial crisis by engaging in fiscal stimulus packages and spending money on 'bailing out' some of their commercial banks. Discuss the case for and against reducing the size of the resulting national budget deficit as quickly as possible as a means of demonstrating good macroeconomic management.

"Under those assumptions, CBO anticipates that the current recession, which started in December 2007, will last until the second half of 2009, making it the longest recession since World War II ... It could also be the deepest recession during the postwar period in terms of the difference between actual and potential output. By CBO's estimates, economic output over the next two years will average 6.8 percent below its potential. The unemployment rate will increase to 9.2 percent by early 2010, up from a low of 4.4 percent at the end of 2006. The peak figure would still be below the 10.8 percent unemployment rate seen near the end of the 1981-1982 recession, because the unemployment rate was much lower at the start of this recession than it was before the downturn in the early 1980s. According to CBO's forecast, real gross domestic product (GDP) in 2009 will average 2.2 percent below its level in 2008 and in 2010 will average only 1.5 percent above the 2009 level" (Congressional Budget Office, 2009).

The short fall rooted in the banking system of the Unites States of America had enormous repercussions around the world. Large Financial institutions collapsed, numerous governments throughout the world bailed out banks and the world's stock markets too faced the most severe downturns between what became known as the 'financial crisis of 2007-2010'. Most importantly, housing markets also suffered in the wake of the crisis in the form of prolonged vacancies, foreclosures and evictions (Global Issues, 2010). On account of the few repercussions mentioned above, economist all over the World termed the 'Financial Crisis of 2007-2010' as the most severe financial crisis since the Great Depression of the 1930s. On the other hand, the crisis helped create an environment of learning and experimentation and governments all over the world started formulating their own individual, innovative and substantive plans in a hope to adopt to the situation and more importantly, forward change towards prosperity. In 2008, President Obama, just a few weeks after his triumphant election, declared, "[y]ou never want a serious crisis to go to waste . . . [because it] provides the opportunity for us to do things that you could not do before" (The wall Street Journal, 2009).

One of the measures to rectify or at the least dampen the widespread repercussions of the crisis, adopted by various governments throughout the world was the formulation and implementation of individualized fiscal stimulus packages. It is reported that precisely 43 counties in total involved in fiscal stimulus packages aggregating to a total of US$ 2.18 trillion or 3.5% of the World's GDP (United Nations Development Programme, 2010). Most of these fiscal stimulus packages targeted to stimulate firms, consumers and public investment in infrastructure. Initially, interest rates were decreased and banks rescued under bailouts. It is reported that $3 trillion was spent on bailouts of US banks alone over a period of two years ending 2008 (Global Issues, 2010).

After the initial inadequacy of bailouts and interest rate adjustments was witnessed and critiqued, governments all over the world than deployed fiscal stimulus plans. Among the most prominent adoptees were United States, Canada, Australia, UK, Spain, Saudi Arabia, Germany and China. Evidence suggests that the amount per country varies from US$ 1 billion (Sweden, Vietnam) to more than US$ 100 billion (Germany, Japan, Saudi Arabia, Spain) (Network Ideas, n.d.). The two largest players here were China with a fiscal stimulus plan of US$ 586 billion and the United States with a stimulus plan of US$ 787 billion (Network Ideas, 2009).

According to Keynesian theory, the lack of aggregate demand initiates recessions and a possible remedy for the outbreak of recession is through stimulating demand. The government can either stimulate its own demand by increased expenditure. For instance, it can spend large sums on money buying military aircrafts or increase expenditure on research and development. Moreover, it can also increase its demand for goods and services by investing on large capital projects like building new highways. Similarly, the government can also increase the demand of consumers and firms through tax cuts and/or increased transfers (Harvard Journal of Law and Public Policy, 2010).

Under the fiscal packages offered to firms, countries focused on their own strategic industry. For instance, while Canada and Germany focused on construction industry, Russia and Vietnam found it more feasible to stimulate the agricultural sector. Likewise, Brazil, France, Spain and Hungary choose to encourage the auto industry. The patterns in fiscal stimulus given to customers are also similar. While most countries, including Canada, Chile, France, UK, US and Germany choose to reduce personal income taxes, others, however, announced reductions in income taxes (for example India) and still others preferred subsidising basic goods ( for example Indonesia, Malaysia and Mexico) (Network Ideas, 2009). Spending on infrastructural projects has also been included as one of the major ingredients of the fiscal stimulus plans by virtually all countries. For instance, France has planned to spend €11.1 billion on direct state investment, including large state-run companies to improve rail and energy infrastructures and the postal service, higher education, research and improvement of state-owned properties (Total, 2009).

Naturally, the fiscal stimulus plans had both strengths and weaknesses, but, the case against the plans is argued to be stronger. Most evidently, a global crisis can and should only be adequately dealt with through a global response instead of a country approach. Moreover, the inadequacy and failure of the current system raises doubt about the successful implementation of the newly designed fiscal stimulus plans, the right mix of fiscal elements to be employed is difficult to determine and if it is assumed, for arguments sake, that a perfect policy is designed and implemented, the effects will only occur after a considerable amount of time and the changes today will also pose negative impact on the future in terms of policy making as well as welfare. Lastly, the developing countries, which are most severely affected, will not be able to meet the crisis effectively without any foreign aid.

Perhaps the strongest argument in favour of fiscal stimulation plans is explained by the lessons learnt from the past, more specifically from the Great Depression of the 1930s. In the aftermath of the 1930 crisis, it was established that markets are not self correcting and thus, government intervention or counter-cyclical measures are required to ensure recovery. For instance, in order to stabilize the economy during the 1930, the government introduced context-specific policy frameworks and provided automatic stabilizers to help increase aggregate demand, reduce economic instability and promote employment (The United Nations Non-Governmental Liaison Service, n.d.). Moreover, the official IMF position on the issue, after considering the East Asian crisis, is "that coordinated countercyclical policies and large fiscal stimulus packages are the most effective means to compensate for the fall in aggregate demand" (Google Books, 2009). Encouraging results have reported from the adherers of the IMF policy. For instance, Pakistan was able to decrease its fiscal deficit from 7.4 percent in 2008 percent to percent of GDP in 2009 after a successful implementation of a tightened fiscal policy (The United Nations Non-Governmental Liaison Service, n.d.). Based on these evidences, it is reasonably prudent to claim that the use fiscal policy plans for stabilizing the current financial crisis of 2007 - 2010 will help the countries achieve their aims and therefore shall definitely be implemented.

Theoretically, a fiscal stimulus plan necessarily includes lower taxes which help encourage work, savings and investments which ultimately lead to increased productivity and income. Similarly, increased government spending, another vital tools in the fiscal stimulus plans, helps increase aggregate demand directly which also help fill the gap entitled recession. However, it cannot be denied that "the multiplier effects of investments in employment-intensive areas, including infrastructure, is higher than with alternative measures such as tax cuts" (The United Nations Non-Governmental Liaison Service, n.d.). But to the dismay of victims of the financial crisis all over the world, the policies designed and implemented all over the World has little to contribute towards generating employment and ensuring a provision of social protection for all. After carefully reviewing the policies implemented under 40 different stimulus plans, the International Labour Organization (ILO) reported that "on average, direct transfers to low-income households and employment measures constitute the two smallest components - at 9.2 percent and 1.8 percent respectively" (International Labour Organization, 2009). Furthermore, "the analysis (also) found that the greater the employment orientation of the measures, the stronger the stimulus for the real economy" (International Labour Organization, 2009). Therefore, it is important to realize that the theoretical benefits of the fiscal stimulus plans will only be effective if the packages are structured towards creating employment and social protection.

On the other hand, a number of facts are presented against the implementation of the fiscal plans. Perhaps, the strongest argument against the case of using fiscal stimulus plans lies in the fact that a country approach is invariably inadequate to cater for the widespread repercussions of the Financial Crisis of 2007-2010. It is a global crisis and definitely, the solution must be global as well (Network Ideas, 2009). This is because no country was able to isolate its economy and its society from its effects and naturally, it is impossible for a single country to solve the crisis on its own. The need here is to formulate a co-ordinated international action that addresses the global imbalances.

Further, the failure of the current development models in terms of wealth distribution and uneven consumption patterns also provide testimony to the claim that a country approach is inadequate. Large asymmetries mark the consumption patterns in the 21st century. Consumption is concentrated in upper income groups which provide evidence for the current development plan as being unsustainable. Furthermore, inequality has been on a rise among and in between countries. According to the statistics published by the United Nations, up to 85% of the world's assets are owned by roughly 10% of rich adults and the other half of the adults only own a humble 1% of the world's assets (United Nations University, 2007). Therefore, the adequacy and fairness of the current development models can be questioned and the US deficit needs to be addressed alongside reviewing its debt policies under a co-ordinated global expansion plan throughout the globe. According to Isabel Ortiz, Senior Interregional Advisor, UN Department of Economic and Social Affairs, United Nations, New York, "The announced stimulus packages are a first country-based response, but more is needed. Particularly regulating the financial sector, given that the Asian crisis in the late 1990s and the present crisis are a result of an over influential and under regulated financial sector. Policies need to be coordinated, combined with regulatory measures, so stimulus packages are development-oriented and solve fundamental flaws of the system" (Network Ideas, 2009.).

Most importantly, the time lags associated with the approval and implementation of the fiscal stimulus plans also contribute as a discouraging factor because the crisis this huge will only worsen with time, if not catered for immediately. Firstly, because of the recognition time lag, the difficulty of collecting economic data in a timely and accurate fashion, the Business Cycle Dating Committee of the National Bureau of Economic Research announced that the recession was only identified in October 2008 while it had begun in December 2007 (The Saylor Foundation). Moreover, implementation lag, the time spent in putting into effect the proposed changes in government spending and taxation, and impact lag, the time before the policy has its full effect on aggregate demand, also stand as hurdles in the way of policy effectiveness (The Saylor Foundation, 2010). Numerous examples of implementation lag can be quoted as testimony to the aforementioned claims. For instance, John F. Kennedy proposed a tax cut in 1960 which was presented to the congress in 1962 and it was only in 1964 that the tax cut was passed, three years after the recession had already ended (Slate Magazine, 2004). It is for this reason that economists claim the discretionary fiscal policy as an ineffective tool for the purposes of stabilization.

Another major argument against the imposition of fiscal stimulus plans is that the developing countries, the worst sufferers of the crisis, do not have the capacity to engage in countercyclical stimulation without increased aid. In the words of President Obama himself, "leaving governments the responsibility to finance their own stimulus plans implies that 'main street' will bail out 'Wall Street' " (Network Ideas, 2009).

In order to respond to the consequences of the crisis, Countries like Peru and Egypt have to take loans and the overseas development aid (ODA) needs to increase massively (Network Ideas, 2009). Moreover, it is preferable that these ODA are given in the form of grants and on concessional terms. Previously, the conditionalities imposed on borrowing countries have been questioned and criticized. According to the Thai Prime Minister, Mr Abhisit, "When the G20 talks about reform of international financial institutions; it is not just a question of increasing capital, but also of how that capital is used" (Financial Times, 2009).

Most importantly, the stimulus packages announced fail to accommodate three critical factors: (i) Banks will try to improve their balance sheets and avoid interbank lending ;(ii) investments in infrastructure - one of the most ambitious area of planning and implementation under the fiscal stimulus plans - will have impacts only in the long term; (iii) Decreased interest rates will remain ineffective if people persistently fear losing their job, home and pension (Network Ideas, 2009). The fear would encourage them towards save and pay debt rather than increase consumption. The decreased interest rates can be explained in other words as an attempt to encourage borrowing among people who have already borrowed beyond their capacity. Thus, another argument against the fiscal stimulus plans is they being indispensably questionable on the grounds of being adequately planned or well thought.

Policymakers have undeniably failed to account for the depth and breadth of financial crisis in the past and their decisions can be best explained as myopic and expensive quick fixes. Politicians are spending trillions of dollars on bailing out financial institutions and on infrastructure without any concrete evidence that the expenditure will work. A professor at Harvard University explains this situation with the help of an interesting anomaly, "Imagine you are a physician and a patient comes to you with some adverse symptoms. He's in pretty bad shape. You have never treated a condition quite like this before, and the causes of his ailments are not at all clear … What you would prefer to do is run a controlled experiment … But you do not have 100 patients; you have only one. What do you do? Well, you take your best shot. You decide what you believe to be the most likely cause of the patient's trouble and the most likely remedy to improve his health." (Harvard University Department of Economics, 2010).

Academic economists too speak against the fiscal stimulus plans. They argue that monetary policy is better suited for stabilization purposes as it principally acts quickly while the fiscal policy can suffer significant delays in adaptation, implementation and impact (Harvard Journal of Law and Public Policy, 2010). Furthermore, it is difficult, and in the worst case scenario - impossible, for the government to determine the right combination of tax cuts and increase in expenditure. It is also important to consider the fact that even if the current policy is adequate, it will unsurprisingly lead to adverse long-term effects. Current tax cuts would entail higher taxation in the future, assuming that the government aims to balance its budgets on average. Higher taxes would imply distortions and decreased productivity. Moreover, people might also take risky projects when they are expecting government support and thereby generate instability (Harvard Journal of Law and Public Policy, 2010).

A divide can also be seen on the issue among the economists themselves. Some of the economists in opposition of the fiscal stimulus plans have also launched coordinated efforts of opposition against its imposition. In the case of US for example, an ad funded by the Cato Institute and signed by 200 economists stated, "... we the undersigned do not believe that more government spending is a way to improve economic performance. More government spending by Hoover and Roosevelt did not pull the United States economy out of the Great Depression in the 1930s... To improve the economy, policymakers should focus on reforms that remove impediments to work, savings, investment, and production. Lower tax rates and a reduction in the burden of government are the best ways of using fiscal policy to boost growth" (The Cato Institute, 2009). According to their claims, adaptation of a fiscal stimulus plan would only increase debt burden at worst or be ineffective at best.

Lastly, it is also important to recognize that the Stimulus Packages would not address the underlying fundamental causes of the depression. According to some critics, the policies are no more than a temporary band-aid cooped with some long-term infrastructure and social services funding. This further entails that the benefits will only last in the short-run and in the long-run, only inconsequential benefits can be expected. Moreover, the burden of increased debt and government intervention will further worsen long-term conditions.

After analysing the situation and the policies intended to accomplish stability, valid arguments can be presented for both the opposition and the proposition of the fiscal stimulus plans. While some strongly support government intervention to curve the sluggish demand of a deep recession, others however strongly speak in favour for less intervention and the removal of restrictions. It is simply or more crudely, dependent on one's own understanding of the crisis and upon what one believes should be the government's role. It will be only possible in the course of time to conclude which approach o r if a new unforeseen one will prove right.

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