As a contribution to the debate about economic policy making after the Covid shock, ERSA will be presenting a series of conversations about how we think about the economy and the role of fiscal policy. After the initial shock and the short-term welfare response from the state, what is the role of the state and fiscal policy in supporting an economic recovery?
Once the dust starts to settle, we will be faced with a poorer economy, significantly higher debt and interest costs, and legitimate spending pressures. These will mix with a structural deficit that both fails to adequately finance the social and economic needs of the country and stabilize debt. The anatomy of fiscal collapse is well understood, and the South African path is beginning to look like one that has been trodden by other countries such as Argentina, Venezuela, and Zimbabwe. In this four-part series, experts will present their views and discuss amongst themselves how to best manage the contribution of fiscal policy to development after the Covid shock.
At the most basic level, debt sustainability is equivalent to government solvency. Technically, it is often defined by the intertemporal solvency condition – debt is sustainable if the expected present value of future primary balances covers the existing stock of debt. This is fine, except that very few people can understand what that means, and its not always useful due to the difficulties in knowing the future.
From a policy perspective, the public finances are considered sustainable if a government is credibly able to maintain its expenditure policies without defaulting on its debt – a government is expected to be able to pay its way without high risk of fiscal collapse. Functionally, persistently increasing debt to GDP without a credible expectation that it will stabilize or decrease can be considered an unsustainable fiscal stance. Essentially, losing fiscal sustainability means that the social and economic programs of government are unaffordable, and the benefits of the budget enjoyed today will not all be available in the future. The costs of unsustainability are a budget adjustment to stabilize debt. If left unresolved, unsustainability will inevitably be accompanied by severe economic effects that significantly reduce incomes, employment and investment, alongside rising interest rates and inflation, and a depreciating currency.
The Keynesian perspective emphasizes the role of government in addressing short-term cyclical shifts in demand, but subject to the long-term solvency of fiscal policy.
Most macroeconomic analysis of fiscal sustainability abstracts away from politics. However, fiscal policy is a fundamentally political affair. As such, fiscal policy decisions are taken in order to meet political objectives on top of economic ones. That is part of the reason real world debt outcomes often deviate from what optimal debt theories predict. Politically, the time inconsistency caused by the prospect of future regime change and term limits is one source of suboptimality when it comes debt sustainability. Short-term expedience dominates long-term priorities – the costs of fiscal restraint in the short term are more present and real than the future costs of fiscal correction. This leads to deficit bias and the persistent increase in debt to GDP, generally above what is optimal and sometimes beyond what can be sustained.
South Africa has seen its debt to GDP ratio more than double since the onset of the financial crisis in 2008, reaching 64 percent of GDP at the end of last fiscal year. The growth in non-interest expenditure since 2009 has far outpaced revenue – largely as a result of economic forecasts that have failed to materialize, but also due to above inflation wage increases and now deteriorating SOE balance sheets. As a result, a pattern of large and increasing deficit bias has emerged as a characteristic of fiscal policy. On top of this, the COVID-19 crisis is going to cause debt to GDP to jump to around 82 percent this year with baseline scenarios showing a continuous increase in the foreseeable future. As a result, debt service costs have increased significantly (claiming nearly a quarter or budget revenue this year) and continue to accelerate under the baseline scenario. If we accept that a fiscal position cannot be sustainable if it generates a continuous increase in debt to GDP, this is a clearly unsustainable fiscal stance.
In response to the rising debt path, the Treasury has put forward a plan to stabilize debt at 87.4 percent of GDP in 2023/24.The consolidation is to be achieved mainly through expenditure cuts, with the government proposing that a zero based approach to the budget will allow it to make those cuts without significantly undermining the developmental and social impact of the budget. The Treasury’s position is countered by calls for the government to not be too quick to reverse countercyclical fiscal policy until growth returns. The argument emphasizes that debt stabilization should not be the overriding concern as long as the cost of borrowing for South Africa remains relatively low.
All of this is taking place while the productivity of the economy (and government) declines; regulated prices increase the costs of living, business and work; economic regulation remains inefficient; and the balance sheet of state-owned enterprises deteriorates. Structural reforms to enable private sector investment and growth remain absent. Political conditions make it difficult to accept “losers” in the political economy and as a result budgets continue to be thinly spread across many priorities instead of where development opportunities are the greatest. Challenges in streamlining and aligning the wage bill with service delivery, and the deterioration of SOE balance sheets are not likely to significantly resolve. The capacity of the state (outside of a shrinking set of dedicated agencies) to implement large, complex and catalytic infrastructure or development orientated programmes appears to be continuing to decline. Governance, wastefulness and corruption remain significant constraints – possibly continuing to deteriorate.
How do we define fiscal sustainability in South Africa?
Is fiscal sustainability an inviolable priority for fiscal policy?
If fiscal sustainability is inviolable, how do we reconcile it with the short and medium-term demands of the economic collapse?
If fiscal policy is violable, how do we avoid fiscal and economic collapse over the medium to longer-term?
How does one achieve fiscal sustainability in this political economy environment?
In this session, Matthew will delve into what financing the budget deficit in the post-Corona world means. Unprecedented deficits and debt levels are both the result of structural and COVID crisis related factors. Financing the budget deficit over the next few years poses a challenge that we have not faced in the democratic era, and raises a number of questions and concerns about sustainability and macroeconomic impacts:
- Are the public finances facing a financing crunch?
- How can the financing requirement be met?
- What are the opportunities and limits of QE by the SARB?
- Will we need more funding from the IMF?
- What will the role of QE in advanced countries be?
South Africa has a comparably large government sector, and the choices made about revenue, expenditure, the deficit and how money is spent will play a defining role in shaping how incomes and employment will grow. These fiscal-macro issues collide with micro-level issues such as implementation capacity, failing economic regulation, corruption, high costs of economic activity, and 13 years of load-shedding. All of this gets “baked” in a deeply political environment, where “winners” and “losers” trade behind often closed doors; and costs and benefits are often differently and opaquely defined. Key questions that will shape the session discussion include:
- Is it a demand problem or a supply problem? Does it matter?
- Why have large deficits and rising spending (real and as percent of GDP) not generated economic growth?
- How should we balance consolidation against stimulus?
- With so many opportunities for positive reform and so many decent contributions to what needs to be done, why is nothing happening?
Drawing on the discussions in the previous 3 sessions, session 4 will look at how all of this comes together. Guided by the objectives of growing national income and employment, the panel will discuss the shape of a fiscal policy that is credible, sustainable and supportive of economic recovery.