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Revisiting the balance of payments and the fiscal deficit

Countries left-and-right are battling fiscal crises. Have we been too stringent, or not enough? This last blog in a series thinks about how fiscal policy might look different in unorthodox times.

A prudent fiscal stance and a healthy balance of payments have been standard prescriptions for emerging economies.  Manageable debts and a slim deficit keep macroeconomic crises at bay, bringing stability to the economy. Low debt levels help to lower borrowing costs which encourages new investment. On the contrary, having a large foreign debt is dangerous because international financing can dry up and increase the chances of default. A gradual tightening in interest rates in the United States is adding pressure onto capital outflows. Countries facing a balance-of-payments crisis hit a ‘sudden stop’ and may resort to imposing capital controls, souring their reputation among international investors. Once a country is perceived to be a bad borrower the market latches on extra premiums to compensate for greater risk. Investors might even choose not to do business with the country at all, weakening its access to trade and capital markets. Profligacy therefore has real economic consequences. Better to stay the dour course and be prudent.

The above argument assumes that functioning markets will remain as they are in the future. If, however, these markets break down, perhaps due to greater economic isolationism or conflict, then the consequences of being shunned in global markets are smaller. This has even more relevance to countries that have struggled to develop their export sectors. With a lower expected cost of default, the argument for immediate consolidation becomes weaker, especially for countries that are not at risk of a balance-of-payments crisis in the near term (assuming governments recognise this before financiers do). On the margin, countries may therefore be motivated to be less cautious in their borrowing and be slower in reducing their deficits.

A temporary de-emphasis of consolidation creates new opportunities. Instead of tight purse strings, it might be more attractive to finance a larger deficit with foreign borrowing to pursue more expansionary fiscal policies. Importantly, these policies should be geared towards productive investments which promote growth and resilience. Investments into infrastructure, education, health, and technology will improve the productivity of all factors of production. In the face of several significant long-term trends, such as automation and climate change, spending resources to bolster productivity is the surest path to sustained growth.

This blog series has looked at how unorthodox times should force us to rethink our reliance on standard models of development. Whether it is due to fewer opportunities for manufacturing or a tense international system, the future growth path of today’s emerging countries will look different. A repeat South Korean or Chinese growth experience is unlikely. Instead, we are better placed to focus efforts on fundamental reforms which improve the efficient use and allocation of productive resources in a country. The rewards will be gradual, bearing fruit not over years but over decades (Rodrik, 2013). While unorthodox times might alter policy decisions on the margin, none of this reduces the argument that productivity growth remains essential to thrive in an age of change.

Editor’s Note: This blog is part of a 5-part series on unorthodox policies for unorthodox times

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