Morning Call about Growth – Economy – Arif Habib Limited

Karachi: The fiscal phobic approach towards growth

Austerity, the talk of the town
Conventional economic wisdom entails that a fiscal austerity is necessary in order to strengthen up a country short-medium term growth.

According to Arif Habib Limited, in a way that, it ensures confidence in the long-term sustainability of government’s budget deficits, which avoids inflation overshoots and thus limits any abrupt discount rate changes. This pretty much has been the order of day for the monetary authorities, where fiscal austerity is considered directly proportional to revival of economic growth. However historical insights suggest that this may not always be the case and sometime this very approach might just back fire.

Correcting a cyclical problem with structural blame
The problem is to identify how and when to tighten up the fiscal belt as it would shore up medium to long-term growth prospects. A normal belief held is that if an economy faces temporary cyclical fluctuation then it would eventually restores to its predetermined long-term productive pattern, where this might not be true in case of permanent cutback in productivity where the economic long-run trend-line has already shifted. However if it is a temporary fluctuation, then it requires highly stimulating policy in order to boost economy back to long-term growth pattern, which thus entails policy reaction.

Growth engine of last resort
Countries with tighter fiscal policies are often led by low investments to GDP growth, stagnant growth and thus reduced tax revenues. However in contrast government expenditure leads towards higher private sector investments. That is to say in times when investor both domestic and external confidence lack, the government acts as a “growth engine of the last resort”. As it has been the case in Pakistan where public led capital formation has eventually uplifted private sector investment capital formation.

The fiscal phobic approach
The recent news headline touts extensively over country’s expansionary fiscal policy, which has restricted monetary authority objective of keeping low interest rates and has in some way de-railed short-term growth. However what must be understood is that Pakistan is currently facing cyclical fluctuation in the face “weakening external capital financing”, which if not accompanied by an expansionary fiscal backing (namely the government expenditure) may produce unintended outcomes, in particularly towards growth. The case of low revenue in the country is indeed not a new thing. Back in 7% GDP growth era (FY04-07) country’s tax-to-GDP was no more different from what it looks today, averaging just above 10.6% of the GDP in the mentioned period. Neither was this growth a follow-up of high taxed economy.

Bottom line
Fiscal expansion can protect against vulnerable external shocks, which the country faces now (capital inflows) and these shocks could have a hard landing on the overall economy during the recent crisis. However fiscal policies can only be used as tool for growth as long as these fiscal deficits represent the best way to stimulate economy that is the quality fiscal deficit which matters.

Leave a Reply