Explain briefly the risks of high fiscal deficit?
Answers
There are several risks with high fiscal deficits. These are:
i. Fiscal deficits, spilled over, could lead to macro-economic instability particularly if the government resorts to deficit financing (i.e. borrowing beyond a limit and the printing of new currency);
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ii. High fiscal deficits imperil national saving rates, thereby reducing overall aggregate investment. This further jeopardises the sustainability of growth. Low levels of public -investment renders poor physical infrastructure incompatible with a large increase in the national domestic product.
iii. The continuing large fiscal deficits, even if they do not spill over, lead to macro-economic instability in the short run, requiring higher taxes to cover the burden of internal debt. High tax rates will place the country at a significant disadvantage relative to other fast-growing countries by reducing the competitive strength of the domestic producers;
iv. Larger fiscal deficits have adverse effects on balance of payment (BoP) too. Aggregate excess demand representing a shortage of domestic supplies spills over as current account deficit (CAD). External loans raised to finance the CAD, ultimately leads to a BoP crisis; and
v. With large fiscal deficits, even an independent monetary management cannot sustain a low interest rate regime. This, therefore, impinges on a necessary condition for macro-economic stability that ‘real interest rate must be lower than the GDP growth rate’.
Fiscal deficits occur when governments are spending money they do not have.
Fiscal deficits cause certain risks to an economy.
1. Reduce money supply in an economy. To finance the deficit,the government goes on a borrowing spree. This leads to people and financial institutions buying up government bonds thus reducing the money in supply. Financial institutions also have less money to lend to businesses and individuals as they have already lent to the government.
2. Crowding out of the private sector.This means that private business and individuals cannot get loans favorably. Government loans are considered stable, while lending to private sector is considered risky. Banks therefore set a much higher interest rate on these loans to private sector.
3. External debt leads to outflows from the local economy.When a government resorts to external debt to finance their deficits, they will have to pay interest on these loans which will lead to cash outflows from the local economy leading to inflation and other macro and micro economic issues.