Financial Crisis – A Route to Deficit Crisis

The current financial crisis should be credited for one remarkable job: it brought  Keynesian economics back with a bang and with dangerous consequences. Keynesian economics – named after the economist Maynard Keynes – is a solution for countries facing recession to spur economic growth through increase in government spending and lowering taxes.  Yet, would Keynes have advised to rescue the heavily indebted financial system today?

The answer is difficult particularly when the options themselves pose bitter realities. One one hand, not opting to rescue would have created global chaos as the very nerve of the economy – the financial system would have collapsed. On the other hand, the rescue option meant swallowing the bitter pill of heavy debts for the future.  The governments opted for the latter. They saved the system, only, to jeopardize the economy with a debt crisis.

As the world recovers from the financial mess, another potential crisis awaits that could alter the very course of economic growth. This is the deficit crisis.

Developed vs Developing Countries

The budget as we know is a balance sheet of an economy whereby spending and revenue are matched. It includes elements like government spending, duties from trade, imports payments, export earnings and others forms of earnings. Budget deficit occurs when  the government spending exceeds the government revenue and creates a gap between the two.

The developed countries are facing an immense deficit on their accounts as their debt to GDP ratio is at higher levels than ever before, courtesy of the financial meltdown. Currently, US, Britain, Japan and France have the highest debt to GDP ratio. In Europe, Spain, Greece, Italy and Britain are facing a similar situation. On the other hand, countries like China, Indonesia, South Africa and Brazil have sound debt to GDP ratio. Ironically, these are the developing countries.

The above observation clearly indicates that the trend of high deficits has reversed. Today, the developed countries face higher deficits.  The financial crisis has exacerbated the gap between spending and receipt and it holds critical outcomes for the economies.

Why Deficit is a Crucial Matter?

Deficit (or debt)  is a critical issue, simply because of the levels that it has attained, especially in the developed world. According to Fareed Zakaria – foreign affairs analyst and host of CNN’s ‘Fareed Zakaria GPS’ – the debt is worrisome as now ‘the bill is beginning to come due’

Budget deficit is an important element of economy, one that can turn the course of future growth. Government spending is necessary in an economy for it provides various services that beyond the scope of the public for a variety of reasons. Healthcare, education, military, institutions, law and infrastructure are main government spending areas.

It is not the spending part that is hard but the maintaining part that is difficult to control. A high deficit can cause problems in the future especially if unsustainable levels are reached. This combined with the present scenario of globalization has made the matter difficult to rein in as diverse dynamic mechanisms are involved. Economies have integrated through various liberalization tools and foreign policies making it dynamic and at the same time, vulnerable. Any policies that try to rein in the deficit will have effects through various channels on different sectors and on other countries.

The current crisis plunged the global economy into recession leading to unemployment and inflation.  Many firms went bankrupt – General Motors (GM) being the biggest casualty. International trade went down. Consumption decreased which in turn had effects on production of products, revenue, costs and profits. The effects continued to multiply both within and outside the economy creating other rippling effects. This coupled with sliding dollar also had its impact in various ways. The heavily indebted financial system further added to the woes and the deficit exploded  as it was bailed out.

Under recession, lowering taxes, increasing government spending and using other economic tools to spur consumption is recommended in order to spur economic activity.  Here lies a dilemma for the developed countries.

The government spending in developed countries is far greater than its revenue. The scenario exists for several reasons. Firstly, there is a trend that government should spend more and charge lower taxes. This creates a gap between the two as lower taxes means lower generation of revenue. The result resembles a cone shape – where the base is small (that is the revenue is small) and the top is larger (the spending is greater). This coupled with burden such as pensions, state employees salaries and others places the pressure on the structure.

Secondly and most interestingly, there is tax evasion in the developed countries by the wealthier class – a phenomenon attributed to the developing countries. Greece is all set to crack down on tax evasion and is implementing policy where the high income earners will have to pay higher taxes. Thirdly, the crisis exposed a variety of structural weaknesses which led to further damages. Spain is one case where the burst in the housing bubble exposed weak spots in finance and other sectors indicating the inefficiency of the state’s resources.

Then there is uncertainty regarding the level at which the deficit becomes unsustainable for a country. This is due to the differences in the structural and market characteristics of an economy.  Greece ran 14.4% of current account deficit in 2007 and today it nearly came to the brink of bankruptcy due to unemployment and weak tourism sector. On the other side, Britain’s deficit is merely at 2.7% and it can be brought down as strong structural characteristics exist to spur the growth and narrow the gap. The two examples indicate how differences in economic characteristics make it difficult to predict the  unsustainable level of deficit for any country.

In a nutshell, the fundamentals that the developing countries keep getting wrong are exactly the ones that the developed world is getting wrong. That too on a grand scale. This has placed a great pressure on the present and future generation as they will be the ones bearing the debts and paying them off.

The current financial crisis will leave a mark on economic growth and both present and future generation must be prepared for outcomes that the high debt will bring. For now, one can only wait and see whether the crisis will send another shock wave to the global economy through a deficit crisis or will the economies emerge just in time to tackle the debt before it sinks the economies.