The Malta Independent 16 May 2021, Sunday

After the largesse, expect taxes to balance debt

George M Mangion Tuesday, 27 April 2021, 09:46 Last update: about 19 days ago

It comes as no surprise that various governments have dug deep in their pockets (and borrowed hard) to help economies during this pandemic. Is this government's intervention, aimed to give a stimulus to certain sectors, a sign of rampant protectionism?

Economics lecturers remind us of John Maynard Keynes who advocated heavy government intervention (particularly in extreme cases such as the Great Depression of the 1930s).  Keynes promoted a demand side theory calling for an expansionary fiscal policy to stimulate aggregate demand and hence pull the global economy out of the depression.


More specifically, Keynes argued that in order for an economy to improve its conditions, greater government expenditure (injections to the economy) is required while simultaneously reducing the leakages within the economy by reducing taxes. Does this seem similar to what President Joe Biden managed to fight for, a $1.9 trillion treasure chest?

The policy includes a cash donation of $1,400 to every US citizen, assist mass inoculation and help fund start-up companies. Ex-US president Donald Trump had intentionally lowered corporate taxes (from 35% to 21%) and allocated a high government expenditure to rebuild ailing infrastructure.

Back to the Keynesian model, the understanding is that as the money in circulation increases, households and firms are able to spend and invest more money, hence stimulate aggregate demand. Consequently, this higher spending generates higher levels of economic activity leading to more output to meet a higher demand.

As can be expected, demand for sustainable employment increases. In Europe, currently there is talk about fixing a universal basic income (UBI) that can guarantee all workers a decent living threshold. The UBI theory goes on to argue that as employment levels improve, people's disposable income increases, which can be used to further increase consumption and hence further stimulate economic activity.

In short, Keynes proposed that government intervention is essential especially during times of crisis, such as the pandemic which forced countries to order lockdowns and curfews, because through expansionary fiscal policy government can stimulate aggregate demand and hence stabilise the economy.

Economists argue that Keynes' economic reasoning contradicts that proposed by Adam Smith and other classical economists. The latter contend that economic cycles and fluctuations in employment and output would be modest and render themselves self-adjusting via market mechanisms. But this theory did not function well during the recent financial crash of 2007/8. Many observed that this self-regulating mechanism would not be enough to stimulate economic recovery and even stated that the rigidities and characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.

In fact, during the past decade the global economy (barring China) faced sluggish growth and relatively low interest rates commingled with low inflation (under 2%). Here, one may reflect that the Keynesian theory did not prove to be 100% correct, even though it dominated the first half of the 20th century. The winner of the coveted trophy for a practical economic model was Milton Friedman.

Friedman developed his theory, entitled Monetarism, which unlike Keynes' theory emphasised the importance of monetary policy and free-market regimes over fiscal policy to stabilise the economy. Friedman argued that Keynesian economics focuses on short-term implications rather than on the long-term inferences of such policy actions. Closer to home, higher government spending will lead to higher taxation even though such a policy will not be ushered in at a time so close to a general election.

The NSO said public finances last year registered an unprecedented deficit of 10.1% as government expenditure shot up to cushion the impact of the coronavirus pandemic. This resulted in an additional daily expenditure of €5m pushing the forecast for this year's deficit to 12% (the budget forecast stood at 5.9%).  

This emerges because it is common during an election year that one expects government to inject more capital in upgrading infrastructure. As can be expected, some economists fear that inflation will return once the pandemic is over. As inflation increases, the European Central Bank intervenes to bring the inflation rate back to its intended target by increasing the policy interest rate and hence discourage investment and interest rate sensitive consumption.

Back to the discussion on economic theory, the monetarism creed worked well for the latter part of the 20th century (except for stagnant growth in Japan) but not for the global economy which suffered an unprecedented financial loss during the last recession of 2007/8. Simply put, Friedman argued for free trade, smaller governments and a slow increase in money supply. On the contrary, the 2007/8 global financial crisis contradicted the rationale discussed in the aforementioned paragraphs. The 2007/9 crisis was preceded by long periods of rapid credit growth, low risk premia, abundant liquidity, strong leverage and build-ups of asset price bubbles.

All these factors rendered financial markets and institutions vulnerable to even marginal fluctuations and when the asset price bubble burst in 2007 sub-prime lenders started to default on their loan obligations within a few months and the US financial markets collapsed (remember Lehman Brothers). Due to the high degree of interrelatedness of banks and other financial institutions, this situation quickly spread throughout the global financial markets, leading to the worse crisis the world had ever experienced since the Great Depression of the 1930s.

To this end, during the last decade, central banks turned to unconventional monetary policy tools, namely the Asset Purchasing Programme (APP), better known as Quantitative Easing (QE). This technique was mainly adopted by the Fed., the ECB and the Bank of Japan. The medicine did not work and consequently this year global interest rates remain at their all-time lows, with some countries even registering negative rates.

In conclusion, last year most governments joined in a race to the bottom by borrowing to the hilt. Debt was used to finance jobs with a wage supplement under a nationwide furlough scheme. Such plans did not come a moment too soon and one hopes that normality returns at large once 70% of the global population is inoculated. Hopefully, demand picks up and firms start looking for new export orders. Closer to home - can Dr Owen Bonnici, the minister for post-Covid recovery come up with a concrete revival plan? Surely this calls for a disruptive yet effective way, culminating in a post-Covid-19 Renaissance; one that unlocks creativity while building a supply side revival.


George M. Mangion is a partner in PKFMalta, an audit and business advisory firm


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