Politicians Need Sound Judgment to Back COVID-19-Driven Government Spending Expansion

Excessive government debt could become the trigger for a prolonged recession and financial crisis…

As the COVID-19-induced economic downturn unfolded, governments around the world rushed in unison toward increased public spending. The United States raised the ratio of government spending to GDP by 8.1 percentage points, while Japan expanded it by 9.2 percentage points. Within the EU, there was conflict over the “COVID-19 Economic Recovery Fund,” but fiscal support is being planned, led by Germany and France. As a result, the average fiscal balance of 35 OECD countries relative to GDP deteriorated sharply from -3.3% to -11.1%.

The Korean government also chose an expansionary fiscal policy. Through three supplementary budgets, the government secured a budget totaling about 60 trillion won. This was because government spending rose sharply due to emergency disaster relief payments provided to all citizens and unemployment benefits, among other measures. Combined with tax-cut policies, central government debt surpassed 760 trillion won. This represents the largest deficit ever, showing a serious imbalance between government revenue and expenditure. In particular, Korea is among the countries where government debt is increasing at a very rapid pace.

Fiscal deficits accumulated over a long period can become the trigger for recession. If government spending expands without support from monetary policy, a “crowding-out effect” occurs, slowing economic growth in the private sector. Furthermore, fiscal imbalances and expanding government debt can lead to a decline in sovereign creditworthiness and a sharp rise in bond yields, tightening financial markets. Japan’s prolonged economic stagnation was the result of lax fiscal management and paternalistic support. More recently, Greece’s sovereign default crisis also showed that government debt can create even greater problems.

If government debt is transmitted into private debt, the risks are doubled. In this COVID-19 crisis, the Korean government supplied liquidity to the private sector through policy finance. Expanding private lending through government spending may help ease a short-term credit crunch, but indiscriminate support distorts the market. Policies that keep even structurally insolvent firms alive can proliferate “zombie firms,” causing a prolonged slump through falling total factor productivity. If excessively expanded household lending turns sour, it could become the trigger for a financial crisis.

Just as the 2008 global financial crisis stemmed from reckless lending driven by government pressure on financial markets, unmanaged private debt is a latent risk factor. Therefore, when providing liquidity support to firms, it is necessary to distinguish between temporary distress and structural insolvency. Likewise, when supporting households, the government must carefully consider their repayment capacity so as to prevent moral hazard. Only prudent fiscal management can provide a solution to the COVID-19 crisis.

Government spending certainly helps economic recovery in a temporary crisis. However, if expanded government spending becomes permanent, it will ultimately place a massive tax burden on the shoulders of the public. It may also leave insufficient fiscal capacity available for use in an actual crisis, greatly weakening the effectiveness of fiscal policy. Therefore, we must be on guard against COVID-19 leading to a chronic expansion of government spending.

Democratic governments always have a desire to expand public finances. This is because, in pursuit of the short-term goal of retaining power, they tend to disregard “debt” that must be repaid in the future. By the time the swelling debt becomes visible, it is often already too late to do anything about it. Therefore, to overcome the current crisis and promote constructive growth, political leadership guided by prudence must provide the necessary support.

Sung-no Choi, President of the Center for Free Enterprise (CFE)

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Original title: 코로나19발 정부 지출 확대, 분별력 갖춘 정치적 역량 뒷받침 돼야

Author: Sung-no Choi

Date: 2020-07-08

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=20&idx=22909