Calamities, debt crisis, growth: prospects – I

Natural disasters such as floods can have detrimental effects on growth as they depress both supply and demand, and require substantial resources to mitigate the negative consequences for economic activity.

The immediate challenge for Pakistan now is an emerging food crisis, with millions of acres of farmland destroyed. Many hundreds of thousands of people are at risk of growing hungry with food shortages expected to rise. The recent flooding shall therefore play a role in aggravating food price inflation, which already remains high due to demand outstripping and fixed supply.

Over the medium to long run spending on rehabilitation and reconstruction could cost about billions of dollars but it remains to be seen to what percent would the government provide financial support for construction efforts.

We may however be certain of one thing increased expenditure will further exacerbate the fiscal deficit and debt of the government with the shortfall likely to be bridged by higher levels of borrowing. Pakistan may have to take even more debt to fund relief and construction efforts brought upon by the recent floods.

According to the World Bank estimates, public debt on average grew 2.3 to 3.6 percentage points higher during the three years after a natural disaster struck compared to unaffected economies.

A threshold between 75 and 100 percent government-debt-to-GDP ratio has been shown repeatedly in many studies from leading research institutions and academics to have a negative or significant (or both) effects on the growth rate of an economy.

The outlook for Pakistan is already a cause for concern as its government-debt-to-GDP ratio reached 75 percent at the start of FY23 well before the flood calamity. Moreover, the higher levels of Pakistan’s debt is not simply accrued by higher borrowing but also due to currency depreciation which upon revaluation increases external debt to be paid.

But when is debt a burden for the economy and why? Aside from the threshold question, the empirical evidence overwhelmingly supports the view that large government debt has a negative impact on the growth potential of a debt-burdened economy. In many cases, this impact gets stronger as debt increases. Moreover, even in countries that are seen as having too much debt, adjustment costs can vary significantly in the form of two types of distortions that are created in the economy at large.

Rising debt can distort the economy directly by creating suboptimal transfers:

Government spending by debt accumulation automatically increases the purchasing power of some sector of the economy, in effect increasing demand. The problem is more concerning when debt rises faster than the country’s real debt-servicing capacity. This occurs when debt boosts the demand for goods and services without directly or indirectly causing an equivalent rise in the production of goods and services.

This can happen for a variety of reasons. For example, rising government debt in an economy without excess labor and capacity may fund additional consumption through welfare payments such as Benazir Income Support Program, or towards purchase of goods and services to support and provide flood victims with relief, or towards building infrastructure damaged from the flood such as houses and bridges.

But any government spending that increases demand without directly or indirectly increasing supply by the same amount creates an imbalance in ex ante supply and ex ante demand, an imbalance that must be resolved by implicit or explicit transfers.

For example merely providing welfare payments to people to buy food does not solve the problem that less agricultural output is available as a result of the flood to begin with and therefore higher demand with limited supply is likely to increase food prices.

These transfers must therefore reduce the purchasing power of one or more sectors of the economy by enough so that the ex ante gap between demand and supply is reduced to zero. This transfer mechanism can itself distort the economy. The manner that excessive debt becomes a problem is when these transfers adversely affect the economy.

For example, if the transfers take the form of high levels of inflation or financial repression, they can raise business uncertainty and otherwise distort economic activity. If they take the form of higher taxes, they can undermine what economist John Meynard Keynes called “animal spirits” and reduce investment in risky but productive sectors of the economy. Or if they result in trade deficits, they can force up wage suppression and so on.

Rising debt can distort the economy indirectly by setting off financial distress costs:

Rising government debt can also indirectly undermine economic growth. When there is enough uncertainty about how real debt-servicing costs will be allocated through the explicit or implicit transfers described above, the debt can cause various sectors of the economy to change their behaviour in ways that protect themselves from being forced to absorb the real cost of the debt. These behavioural changes either undermine growth, increase financial fragility, or both.

What is more, this behaviour tends to be highly self-reinforcing. Economic agents aren’t stupid or incapable of learning. As uncertainty rises about how real debt-servicing costs are to be allocated, there is also increasing uncertainty about which sector will be forced to absorb the cost and how; so economic agents are likely to alter their behaviour in ways that protect themselves.

(To be continued)

Copyright Business Recorder, 2022