What is Better: Balanced or Deficit Budget?

Few issues are more contentious, in many developed and emerging economies, as a government’s budget. Those who argue in favour of a balanced budget claim growing government debt is harmful to the future. Others say a government budget isn’t like a household budget. Deficits are used to ward off economic impact of pandemics or other extenuating circumstances.

Proponents of balanced budgets also support restricting power and scope of the government. Opponents want the government to have the power to effect wide-ranging changes if needed.

Economists are divided on how important it is to tackle the budget deficit and total outstanding debt. The mainstream view is that debt isn’t a cause for concern, especially for the United States (with USD 23 trillion). Proponents of Modern Monetary Theory (“MMT”) argue that deficits and debts don’t matter because the government, unlike a household, can simply print more money. This assumes inflation is weak or contained. Government borrowing becomes a problem only when it raises aggregate demand to inflationary levels.

Others argue that government debt will become a problem and it is easier to tackle it now. They further argue that ever-rising debt will eventually cause investors to question government’s ability to repay debt, resulting in rising interest rates and quash private-sector investment. And if interest rates rise too quickly then it may be difficult to repay debt or service interest. This may lead to difficult circumstances or higher inflation.

Two American economists Carmen Reinhart and Kenneth Rogoff (Harvard) published a paper, “Growth in Time of Debt” in 2010. This paper argued that when gross external debt reaches 60% of GDP, a country’s annual growth will decline by 2%. And where external debt exceeds 90%, GDP growth will be cut in half. Appearing after the Great Recession (2008), the 90% debt threshold hypothesis provided ammunition for pro-austerity policies.

In 2013, academic critics accused Reinhart and Rogoff (R&R) of employing methodology that had errors, which did not support their conclusions. Further papers by R&R and the IMF did not have similar errors and reached conclusions equivalent to that of the earlier paper. However, impact on GDP growth was deemed lower. A consensus amongst economists on the 90% threshold hypothesis in relation to external debt and economic growth, nevertheless, remains elusive.

What do some observations suggest?

During the Asian Financial Crisis, countries with large external debt were vulnerable to currency “attack”. Indonesia, Thailand and South Korea were notably so, Malaysia imposed capital controls and was shielded from the attack on the ringgit.

In more recent times, Argentina has suffered budget deficits, high external debt and currency depreciation/ collapse. That supports R&R hypothesis. The lesson to be learned is perhaps maintaining a prudent level of external debt, well below the 90% (or 60%) of GDP level.

Should we then balance the budget?

The British government under Cameron and May pursued this balanced budget objective. Austerity policies over 8-9 years caused untold misery and suffering. Now, under the Conservative Party with Boris, it looks more like Labour policies are in place, partly because of Covid-19. There is no inherent need to balance the budget. Keynesian economics will suggest budget deficits are to stimulate a moribund economy. It is when deficits occur every year for long periods of time that GDP growth begins to taper off with debt servicing and inflation rising in prominence.