Economic risks of the rise in budget deficits

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Analyse the economic impact and the economic risks of the rapid rise both in budget deficits and national debt for countries within the Eurozone.

What is budget deficit and national debt?

Budget Deficit is when government's expenditure is larger than its revenue. This extra cash injected through deficit financing in the economy is raised by issuing bonds or treasury bills and sold to the general public or financial intermediaries. With the funds raised, governments may improve the country's infrastructure, invests in education, environment and incentivise research and development. Such long term investment improves the competitiveness of a country. Deficit financing can be employed when resources in the economy underutilised and the national government aims to stimulate economic growth through its spending. Government spending is an investment in the economy and therefore directly and indirectly creates more jobs. The government is basically giving the economy a kick start. But this needs to be regarded as a short-term solution as to avoid ballooning national debts and increases burden over the tax payer (i.e. debt servicing costs). The national debt is the stock of outstanding government debt. High national debt increases the burden of interest payments which have to be paid by the public, and therefore keeps taxes high.

According to the Eurostat statistics, the Eurozone has an aggregate deficit of 6.3% of the GDP (Eurostat, 2010). Way above the 3% threshold defined in the Maastricht criteria. The recent financial crisis and the global recession have severely affected all Eurozone states and many of them are struggling for recovery. But some countries are jeopardising the economic stability of the other Eurozone members. Countries like Ireland, Greece and Spain have their budget deficits over 10% of GDP (Eurostat, 2010). These are alarming statistics which hamper the credibility of the single currency.

As for the national debt, statistics show a similar picture with the aggregate gross national debt for the Eurozone countries reaching 78.7% of GDP (Eurostat, 2010). The agreed acceptable level for national debt is not more than 60%. Greece's and Italy's gross national debt has reached over 100% of GDP.

Fiscal Policy:

The current levels of budget deficit and national debt for many Eurozone countries has left a direct impact on their potential lending capacity. The majority of Eurozone countries have already ballooning national debt. Can they continue borrowing money at this pace? Financing of debt has become increasingly burdensome for these countries. In a report issued in April 2010, the Bank for International Settlements concluded that "Drastic austerity measures will be needed to head off a compound interest spiral, if it is not already too late for some" (Ambrose, 2010). These austerity measures are part of intense fiscal consolidation programmes taken on by Eurozone governments. With fiscal consolidation, governments try to maximise income through taxation and reduce dramatically their costs. Countries like Spain, Greece, Germany and even the UK have announced severe costs cuts.

Fiscal consolidation is very much in vogue in the Eurozone. But governments need to be extremely cautious. Excessive costs cuts may hamper economic growth. Eurozone governments are major players in the Eurozone economy. During the financial crisis, governments took a major role in stabilising the economy and helping industries by cushioning the bumps of the crisis. Governments had the important role to reinstate confidence in the banking system through bank nationalisation process (example: ABN Amro nationalisation). Bank bailouts and other incentives hit hard public finances. In 2009, government expenditure in the Eurozone area amounted to 50.7% of GDP, an increase of 3.7% from 2008 - see table below (Eurostat, 2010). Through fiscal consolidation, governments will need to rethink their budgets and maximise their income. The risk is that governments will shift too quickly from heavy spenders to savers jeopardising the road to recovery for the Eurozone economy. A similar scenario is seen in the UK, where government expenditure reached 51.5% of GDP from 47.4% recorded in 2008. Government intervention in the economy was a hot debate in this year's general election. David Cameron's Conservative Party campaigned that the UK needed immediate cuts in government expenditure to control budget deficit. Whilst the Labour Party insisted that more gradual cuts in expenditure are needed to avoid shocks in the economy. Such diverse views in the UK political spectrum resulted in a hung parliament, where the Conservatives agreed terms with the Liberal Democrats to form a coalition government; the first coalition government since 1945. Rapid rise in budget deficits and national debt could cause political instability as seen in the UK, with consequences on the economic stability of the country. Currently, the UK coalition government is working on its spending review.

During fiscal consolidation, countries start scrutinising their welfare state. Social benefits and pension systems have been major expenses in the Eurozone. According to Eurostat, Eurozone's social protection expenditure amounts to 27% of GDP, and over 45% of that is expenditure on pensions. All European countries are facing similar challenges such aging population, increase in inequalities and exclusion, a changing labour market etc... Alan Greenspan has warned the US government that "deficit spending and the effects that the aging of the baby boomers will have on Social Security funding levels require the government to take action as soon as possible" (Bell, 2004). This can be applied for Eurozone countries as well. But the current state of public finances has urged governments to take immediate action. Salary cuts (or freeze), decrease in social benefits and increase taxes are all solutions to contain costs and decrease the burden on public finances. But cutting social benefits / salaries is not an easy task especially in heavily unionised countries like Portugal and Greece. The risk is that such measures may result in social unrest, protests and violence (similar to those witnessed in Greece in May 2010). Greenspan also warns that an increase in tax rates may pose significant risks to economic growth.

Salary cuts may decrease government expenditure, but will also negatively affect consumption. Decrease in consumption will negatively affect the private sector. The risk is that a decrease in consumption may well lead to more unemployment and put the country in recession. Increase in unemployment means reduction in tax income and increase in social benefits for unemployed.

With the current levels of national debt and deficit in many of the Eurozone countries, the markets have raised eyebrows about the ability of countries like Greece or Portugal to repay their debt. In fact, in April, Greece did not manage to sell enough of its bonds to repay its immediate obligations. Eurozone countries bailed out Greece by issuing a loan of over €130bn. This inability for Greece to service its debt sparked a sovereign debt crisis. Eurozone countries were facing difficulties in raising funds on the market to service their debt because the markets were sceptic about the ability of other euro-med countries to meet their obligations - Contagion Risk. Market players believed that what happened to Greece could happen elsewhere (mainly Spain and Portugal). Spreads with the Bund for Greek, Spanish, Irish and Portuguese bonds have widened dramatically resulting in higher cost of funding due to the higher risk premium (see table below). Spreads between 10 year Greek bonds and 10 year Bunds exceeded 800 basis points (the Bund is defined as benchmark for euro sovereign debt). The Bank for International Settlements has warned Eurozone countries and other Western countries (including the UK) of an "abrupt rise in government bond yields" brought by the post-financial crisis fiscal problems in industrial economies (Ambrose, 2010).

The sovereign debt crisis has had repercussions on Eurozone stability, both financially and politically. From a political perspective, the EU was not swift enough to tackle this crisis effectively showing lack of leadership and unity. Greek Prime Minister George Papandreou have publicly criticised the European Union that it "has been slow to realise that the attack of speculators against Greece was the last stage of an attack against other countries and threatened stability in the euro area" (EUbusiness, 2010). At the start of the sovereign debt crisis, European leaders were reluctant to help Greece and carry the burden of Greece's jeopardised finances. EU citizens were finding it very hard to understand (and accept) why their money should finance Greece's mismanaged finances. German Chancellor Angela Merkel suffered a heavy defeat in May's regional elections, days after the Bundestag approved a payment of € 22bn circa in aid to Greece. Merkel's pre-election foreign affairs policy proved to be a catastrophe for both for her domestic political career and for the EU. She attempted to delay decision on Greece aid until after Germany's regional election in attempt to salvage votes of CDU supporters in North Rhine-Westphalia. In March Merkel had halted France's plans of an EU mechanism to help Greece (Abadi C. 2010). This has proved disastrous for Greece and the Eurozone, which later on entered into a sovereign debt crisis. Merkel was heavily criticised by former chancellors and opposition parties that she is putting Germany's EU leadership in jeopardy.

The rapid rise both in budget deficits and national debt may well mean the end of fiscal policy independence for Eurozone countries. Countries of the monetary union cannot afford to face another "Greek" crisis. In February 2010, EU president Herman Van Rompuy has called for an economic government that would have quantitative targets to be translated into individual national programmes (EUbusiness, 2010). This will result in better governance of public finances of member states. On the other hand, an economic government may prevent European citizens from choosing the best policies that affect them.

Monetary Policy effectiveness:

During the post-financial crisis recession, the ECB decided to cut rates up to 1% to help economic recovery. Businesses and individuals will borrow money at a cheaper price and spend it in the economy; increasing consumption to stimulate economic growth. As national debt balloons, debt financing becomes more expensive due to an increased risk premium. The higher the risk, the higher is the price for sovereign bonds to guarantee decent market participation. Sovereign bonds are in competition with bonds issued by the private sector. The price level of sovereign bonds is an important factor for the price setting of private sector bonds. Therefore, the higher the price of sovereign bonds, the higher the price of the private sector bond. The private sector will incur extra cost to fund its investment making it less attractive and viable. The risk is that these extra costs will deter the private sector from undertaking new investment and create new employment opportunities, thus cancelling out the positive effects of the ECB's loose monetary policy stance.

Earlier this year, the ECB took unprecedented action to start buying Eurozone bonds. According to ECB executive board member Gertrude Tumpel-Gugerell, the objective of this programme is 'to address the malfunctioning of securities markets and to ensure the proper transmission of monetary policy impulses to the wider economy' (ECB, 2010). The impact of such decision was a decrease in cost of funding. But such action brought heavy criticisms by analysts and economists questioning the ECB's credibility. Analysts argue the move has compromised the central bank's independence; the bank would effectively be buying government debt, giving governments a freer hand in raising money when it should actually be policing their efforts to do so. Bundesbank president Alex Weber (candidate to succeed Trichet next year), has described the ECB's bond purchase programme as a threat to economic and political stability (Blau, 2010). ECB's President Jean-Claude Trichet dismissed criticism and confirmed price stability as the prime objective for the bank. Regardless of this criticism, markets have reacted well to the ECB's programme and resulted in a breather to many Eurozone countries.

Inflation:

There is no direct correlation between inflation and national debt / budget deficit. But economists still show their concern about the possible correlations between the two because government deficit spending is linked to the quantity of money circulating in the economy.

Through fiscal consolidation, governments increase their revenue through an increase in taxation, E.g. increase in taxation on consumption such as Value Added Tax, or by cutting tax incentives to manufacturing companies. Businesses will experience an increase in costs, which is normally passed on to the customer by increasing prices of their products on offer. Monetary Policy is the main tool to control inflation and analysts predict that the ECB will not tighten monetary policy until Q2 of 2011. If high inflation is experienced during these times of fiscal consolidation, it would be extremely difficult to control it. Price stability is the ECB's main objective. ECB's acceptable level of inflation is around 2%.

Foreign Exchange Rates:

Following the sovereign debt crisis, international markets started to speculate severely on the single currency. From January 2010, the euro declined by more than 15% against the USD. Therefore huge fiscal imbalances put pressure on a country's currency and will experience increased volatility. Following the collapse of Greece, markets started to sell the euro, and therefore declined dramatically. Following this phenomenon, Germany have banned short-selling of the single currency. A decision heavily criticised by market players but at least helped to slow the currency's downfall. Apart from Germany's ban, Eurozone states together with the European Commission and the International Monetary Fund have issued a guarantee of over €700bn to help countries in case of risk of default. This contributed to limit speculation and slow down further the decline of the euro.

The decline of the euro meant that many companies (including financial institutions) which account in euro will experience shrinkage in their balance sheets. Many institutions in the Eurozone have the majority of their assets denominated in euro. If a currency becomes too volatile, it would be extremely difficult for organisations to account for such big shifts in value. High currency volatility will also harm organisations which import goods from outside the Eurozone. Imported goods will become more expensive, the added cost will be passed to the consumer, with the risk of an increase in inflation. The decline in the euro meant that energy prices went up considerably igniting more inflationary pressures.

Foreign Direct Investment and Competitiveness:

Foreign Direct investment is vital for economic growth because it is new liquidity injected into the system. With this new investment, jobs are created and consequently consumption increases. In medium to long term, the government will increase its revenue directly through tax on profits generated by operations of foreign companies operating in the country, and indirectly through increase in consumption (through value added tax).

But as we have seen in countries like Greece and Spain, governments' austerity measures (in a context of a fiscal reform) have created political turbulences and social unrest. This political instability will discourage foreign direct investment. Foreign companies will invest in countries where political and social stability is guaranteed.

Countries with high fiscal imbalances will not be able to offer incentives to foreign organisations to invest in their country. These incentives might include subsidies for the first years of operation, tax incentives, readily available infrastructure to commence operations etc... When experiencing high fiscal imbalances, these incentives may be cut as part of fiscal consolidation efforts.

The elimination of incentives to industries and foreign direct investment means that the country may well lose its competitiveness with other countries, especially with those operating outside the Eurozone with lower labour costs such as China or India. Incentives offered by governments compensated higher labour costs thus protecting existing investment in the country and attracting other foreign direct investment. Cutting incentives means that organisations may shift operations to other countries offering a more viable, stable and profitable environment for its operations.

Reputability

High fiscal imbalance is a result of poor vigilance of public finances and governance, and therefore jeopardising its credibility and reputation with other member states and on international markets. Greece was accused of manipulating statistics to depict a healthier picture of its financial position. These accusations hamper credibility for both Greece and other Eurozone member states.

Following the sovereign debt crisis, reputable credit rating agencies have downgraded Greece and Spain for their precarious public finances. Moody's and other credit rating agencies have now classified Greek bonds as 'Junk'. A rating downgrade has a number of repercussions such as increase in cost of borrowing and increase in country risk premium. Another risk following a rating downgrade is that it may hamper the stability of the financial system. Following downgrades to Greece and Spain, investors in these countries were worried of other possible downgrades. Greece might experience an increase in capital flight and a reduction of liquidity in the financial system, thus affecting banks' credit creation capabilities.

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