The fiscal dilemma By Shahid Javed Burki

THOSE who remember economic history would recall that the most notable contribution the British economist John Maynard Keynes made was to argue that governments should use their capacity to create money to step up the rate of economic growth.

That should be done when the economy is in serious stress which has resulted in a significant increase in unemployment. His great contribution was to point out that governments can get caught up in a trap if they meet the situation by curtailing expenditure rather than expanding it.

Reducing government expenditure would result in greater unemployment, decline in income, decline in government revenues and fall in government expenditure. This produces the Keynesian vicious cycle. The only way to step out of it is to stimulate the economy. Asked by some of the conventional economists as to what would be the long-term consequences of such an approach, Keynes said famously that in the “long run we are all dead.”

From my brief description of the way Keynes would have seen the revival of stalled growth is to suggest Pakistan’s policymakers are dealing with exactly the kind of situation envisaged by the great economist. The difference is that because of his work we understand what would be the consequences of limiting government expenditure or by curtailing private demand through increased taxation. In both situations, Pakistan will suffer further loss of economic dynamism. Already the rate of growth is not much more than the rate of increase in population.

Since the flow of incremental income is greatly skewed in favour of the rich, a low GDP growth means increase in poverty. This Pakistan cannot afford at such a difficult time in its history. The little bit of recovery that we have seen in the last few months will evaporate if too severe a retrenchment is undertaken on the fiscal side. And yet, Pakistan cannot spend its way out of the economic problems it confronts. This is precisely what the Greeks tried to do and we know the consequences. This is Pakistan’s fiscal dilemma.

A week ago at an Islamabad meeting I made public the main findings of State of the Economy: Pulling Back from the Abyss, the third annual report issued by the Institute of Public Policy, Lahore. The IPP was founded by a number of us – including Sartaj Aziz, Jehangir Karamat, Hafiz Pasha, Shahid Hamid, Shahid Kardar, Pervez Hasan and myself. The tone of each report has become more worried. In the first report issued in 2008 we dealt with the challenges and opportunities the economy faced.

We presented the government with a menu of options from which it could choose to set the economy on a sustainable, reasonably high rate of growth while reducing the incidence of poverty. In the second report published last year we thought the economy might emerge from the crisis it was then dealing with provided some actions were urgently taken by Islamabad.

The set of options were now limited. In this year’s report we are of the view that we stand at the edge of an abyss from which we might pull back, again with appropriate government policies. Each of the three reports was presented before the government announced the budget for the following year, hoping that some of our ideas would be looked at seriously by the policymakers.

For Pakistan, financial year 2007-08 set the stage for what was to happen later. Fiscal deficit as a percentage of GNP increased from a reasonable 4.3 in the previous year to a whopping 7.4 per cent. The main reason was the loosening of the purse strings by the government to prepare for the elections of February 2008. This was compounded by the increase in the price of oil and food which resulted in a sharp decline in the country’s reserves as the import bill mounted. Current account deficit increased from 4.9 per cent to 8.4 per cent. By the time action was taken, a democratically elected government had assumed office which thought that the international community would come to the country’s rescue by providing quick-disbursing assistance to stem the run on the reserves.

After all with Pakistan’s long record of military rule, there was a justifiable assumption that the world would not let the country sink as it was busy establishing a democratic political order. A Friends of Democratic Pakistan group, the FODP, was assembled which promised help on the condition that a programme was first negotiated with the IMF. Pakistan having promised in the closing years of the Musharraf period that it would never return to the Fund had to go back. This it did with what it called a “home grown” policy programme that would provide some support to the poor as the economy slowed down through fiscal retrenchment. In 2008-09 there was an adjustment of 2.2 percentage points in the fiscal deficit which declined from 7.4 to 5.2 per cent. GNP growth also slowed down to 2.5 compared to 6.2 per cent in the previous year.

The about-to-be concluded 2009-10 fiscal year was a better year in the short-term. The rate of growth picked up as industrial activity recovered somewhat. Balance of payments deficit declined as imports plummeted and the price of oil declined. The level of reserves improved, reaching about $15 billion. But in the hope that the money promised by FODP would arrive – an assumption that supported the 2009-10 budget – the government did little to reduce its expenditure, particularly on non-development activities. The level of fiscal deficit once again began to increase.

What is especially worrying is the distribution of the cost of adjustment across the various segments of the population. Our report estimates that even though fiscal deficit declined, overall consumption increased by as much as one per cent. Some classes benefited a great deal. Wheat farmers, for instance, saw large increases in their incomes as the price of procurement was increased by the government to increase the output of this vital crop.

Since national income accounts must balance, fiscal deficit decline accompanied by increase in consumption meant that something else had to give. This was the rate of investment which declined, not a good development for a slow growing economy. Also the increase in consumption was those of the relatively well-off groups, including the wheat framers who had surpluses to sell. Clearly, these trends are unhealthy and need to be checked through the adoption of the right set of policies, particularly on the fiscal side.

It appears to us that when the current programme with the Fund ends this December, another dose of finance will be needed from that institution. The Fund in return will ask for a sharp fiscal adjustment which will once again slow down the rate of economic growth, increase unemployment and add to the number of people living in poverty. Islamabad should resist such an approach. In our report we have developed an alternative model that calls for a less radical fiscal adjustment.

At the same time we have asked for a meaningful response by the citizenry towards taxation. With the tax to GDP ratio as low as it is, the government cannot afford to increase by much the expenditure on such social services as health and education. Without these Pakistan cannot turn its large and young population into an economic asset rather than a growing social and economic burden.

There are clear choices for the government as well as the citizenry. Sacrifices have to be made to pull back the country from the edge of an abyss. But these sacrifices need to be made by all segments of the population. The burden should not fall on those who are politically and economically weak.

Source: http://www.dawn.com/wps/wcm/connect/dawn-content-library/dawn/in-paper-magazine/economic-and-business/the-fiscal-dilemma-760