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Should government cut spending?

13th August 2010

By: Seeraj Mohamed

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The next phase, or second dip, of the global financial crisis may well be due to the impact of the sovereign-debt problems in Europe and elsewhere.

The response of many countries has been to reduce government spending. Should South Africa reduce government spending as well? I believe that we should not reduce government spending, provided we spend money on the correct things. In other words, we have to ensure that government spending is an investment in future economic produc- tivity and is also aimed at building skills and reducing poverty and unemployment.

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It is worth remembering that those countries with sovereign-debt problems are in these situations because they used easily obtained foreign loans wastefully, and not to improving the future competitiveness of their economies. Further, some of their debt problems resulted from nationalising private debt when their banks and financial institutions had to be bailed out. The South African government has not used cheap foreign loans for wasteful expenditure or to bail out our banks. We do not have serious foreign-debt problems.

Reductions in government spending will not quickly solve the problems of countries with high levels of sovereign debt. In fact, reductions in government spending will have a negative impact on economic performance. Firstly, lower government spending will exert downward pressure on economic growth and may lead to recessions in many of the countries with high levels of sovereign debt. Secondly, reduced government spending will lead to reduced levels of investment and higher levels of unemployment. In many countries, unemployment and cuts in government social and welfare spending could trigger protests and even political instability.

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The decision to cut government spending is usually taken by desperate governments. An important reason for drastic government spending cuts is to send signals to global financial markets and credit rating agen- cies that a country’s determination to tackle its debt problems is credible. Desperate governments hope that financiers and credit ratings agencies will not discourage investment and make their borrowing more expensive. These attempts to appease financial markets and rating agencies may be effec- tive only in the short term. Financiers and credit ratings agencies will quickly realise that government expenditure cuts will cause lower economic growth, unemployment and, possibly, social unrest. Further, cuts affect the upkeep of public infrastructure and systems that support private businesses. The rating agencies will report these findings to their customers and adjust their ratings downward to take account of the negative impacts of governments’ budget cuts.

The solution for many countries facing sovereign-debt problems is to stop wasteful expenditure and to keep spending on infrastructure and other areas that support indus- try and employment. I would give South African economic policymakers the same advice. Government support to business through improving infrastructure will boost economic growth. Government sup- port to poor households will support economic growth in areas of the economy that require stimulus, such as labour-intensive manufacturing sectors and low-income residential construction.

If government spending leads to economic growth in the correct sectors, it will help the economy, even an economy with a big debt, because one has to consider the level of debt that is sustainable for government, not just the size of the debt. If a country has higher economic growth because of government spending, the debt level will be more sustainable. In other words, the debt to gross domestic product (GDP) ratio and interest payments to GDP ratio will be lower when government spending stimulates GDP growth.

Further, many people worry about inflation increases when government spending increases. I do not believe that inflation will pose a problem if government spending stimulates growth in the correct sectors. Growth in economic output will mean more supply to meet demand and less upward pressure on prices. In fact, inflationary pressures may be higher when government spends less because government spending cuts usually result in economic output shrinking. Less supply of outputs to meet demand in the economy will lead to inflation.

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