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Financing by deficit or inflation: Who pays the price?

Feb 07,2021 - Last updated at Feb 07,2021

Practical experiences have shown that a stagnant economy will not automatically return to a normal state of equilibrium after a period of recession, because once the economic downturn begins, the fear and depression that it generates among companies and investors will lead to a long period of low economic activity and high unemployment rates. Here comes the importance of adopting a counter-cyclical fiscal policy, as the government must, during periods of economic hardship, ensure deficit spending to compensate for the decline in investment and boost consumption spending in order to stabilise aggregate demand. Certainly, such a fiscal policy has some immediate and short-term consequences, and these consequences depend on the nature of the fiscal deficit.

If the deficit arises due to the government's involvement in infrastructure spending projects and providing support to some sectors, then those sectors chosen to receive the funds may receive a short-term boost of stimulus in their operations and profitability. If the deficit arises due to lower government revenues resulting from lower tax rates, tax exemptions, or a decrease in commercial activity, then such stimulus will not occur. Whether stimulus spending is desirable is also a matter of debate, but there can be no doubt that some sectors will benefit from it in the short term. In any case, the deficit must be financed. How is this done?

This is done by either obtaining free grants and this is an age that has passed except for purely political purposes and usually has a high price, or through government borrowing by selling treasury bills and bonds in local or foreign currencies. The obvious initial effect of local government borrowing is that it reduces the money available in the economy that can be lent or invested in other businesses. This is called crowding out effect; the government is competing with the private sector over the money available in the market. 

Moreover, selling government securities to finance the deficit has a direct effect on interest rates. Government bonds are very safe investments, so the interest rate paid on loans to the government is a risk-free investment that almost all other financial instruments must compete for. Other types of financial assets must pay a price high enough to induce investors to turn away from investing in government bonds. This negatively affects the demand for credit in the market, and thus frustrates economic activity again. Usually, the central bank intervenes through open market operations to influence interest rates and correct them, but within the limits of monetary policy operations. Thus, all deficits have the effect of reducing the potential stock of capital in the economy.

But if the Central Bank prints money for the purposes of repaying government debt, which is something directly prohibited by law in Jordan, the risk would be high inflation and not a reduction in the amount of capital available in the economy.

In light of the negative effects of the above options, there are two solutions available to decision makers: The first is available for the Parliament; to open for discussion and amendment the Public Debt Law of 2001, and to work on activating Articles 22 and 23 and abolishing Article 24 of the law. The other option is to revitalize the domestic and foreign private sector and to further transfer the burden of economic development to them. Otherwise, worsening government debt has real and negative long-term consequences for the economy and people to pay for.

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