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Why Hong Kong needs a fiscal deficit

Updated: Oct 21, 2021

Ernest Lau is a guest writer for the Warwick Economics Summit Blog. He is studying Philosophy, Politics, and Economics at Hatfield College, Durham University

In the 2020-21 Budget Speech delivered by Financial Secretary Paul Chan, it was predicted that the Hong Kong SAR Government would run its first fiscal deficit in 15 years, at HKD$139.1 billion. The epidemic had a detrimental effect on Hong Kong’s economy, as it forced stores (especially restaurants) to close early and blocked tourists from visiting the city, leading to a sharp drop in the demand side of the economy. Therefore, the HKSAR government rolled out the Anti-epidemic Fund (AEF) which cost just under HKD$200 billion, hence the actual prevailing deficit is set to be higher than the predicted one. Despite the spike in government expenditure caused by the epidemic, Chief Executive Carrie Lam is still determined to push forward her ‘Lantau Tomorrow Vision’ initiative that was first proposed in her 2018 policy address. It was met with fierce opposition from the pro-democracy camp and the ecologists, citing detrimental effects to marine life, as well as depleting fiscal reserves of the government. I will not discuss whether this initiative would be damaging to the environment, or if it is a gift that enables land developers to make gigantic profits. I will only focus on rebuking the argument that the project should not be pursued because it would cost nearly half of the city’s fiscal reserves, leading to an unsustainable budget.

In the aftermath of the 2007-8 financial crisis, many governments introduced austerity programmes. The UK’s austerity programme, led by Cameron and Osborne, saw more than £30 billion being cut in welfare expenditure. Greece went even further and was forced by the IMF, ECB, and the EU to introduce a range of austerity packages in 2010, 2012, and 2015, as they faced a sovereign default. These policies could be explained by the Swabian housewife metaphor put forward by German Chancellor Angela Merkel -- You need to put your house in order by paying off your debt and therefore you now must tighten your belt to repay the debt you accumulated yourself and eventually run a primary surplus in the long run. However, is this the right mentality for a government?

Although it is appealing to say that each and every government should not spend more than they earn, it is important to remember that the household budget is very different from the government one. A government can take a substantial amount of debt for a prolonged period without fear of default. The obvious example is that it can print legal tender, which a household can’t do. Therefore, a fresh approach should be taken to walk out of an economic crisis, to prevent the world following Greece’s footsteps after the 2008 crisis, which saw their GDP drop by nearly 50% largely due to the austerity policies, as argued by former Greek Finance Minister Yanis Varofakis.

The situation faced by worldwide governments can be illustrated in the diagram above, which was put forward by Paul Krugman in his 2009 blog and later refined by Matteo Iannizotto. It takes the sectoral balance approach and the closed economy accounting identity of ‘Private Domestic Balance (Savings [S(y)] - Investment [I]) = Fiscal Deficit (Government Expenditure [G] - Taxation Revenue [T(y)])’, and hence the Private and Fiscal Balance curves. Although it is annotated on the graph that the vertical axis measures the level of fiscal deficit (or surplus), it also measures the level of private deficit (or surplus), which in the closed economy case mirrors the level of fiscal deficit (or surplus). The dark blue line denotes the original position, where there is neither a fiscal deficit nor a surplus. When there is a drop in investment, as empirically seen by companies (especially the commodities and consumer goods sectors) taking a more conservative expansion approach recently, the Private Balance curve moves up, bringing us to Point B, where there is a fiscal deficit and a drop in output. Intuitively explained, this is because a drop in investment will lead to a drop in tax revenue from sources such as stamp duty and corporate tax, leading to the government expenditure (which is somewhat unchanged) now being higher than the government revenue, and ultimately resulting in a fiscal deficit. Krugman argues that the Government has two options, the deficit hawks approach and the deficit doves approach.

The deficit hawks approach (denoted in red) was the response widely taken by worldwide governments in the aftermath of the 2007-8 financial crisis. Although the budget was balanced, it led to a massive decrease in output, leading to a prolonged recession, or as Krugman puts it, a ‘Great Depression’. A comparatively novel response would be the deficit doves approach, which aims to recover output at the expense of the fiscal balance. This will lead to an alternative Point C denoted in green, where there is a further increase in fiscal deficit but with a much lower overall drop in output. To do this, an increase in government expenditure is required to kickstart the economy -- and the Lantau Tomorrow Vision is exactly an initiative which would do this trick. Building infrastructure, or in this case, a massive development project, is an investment, not consumption. It brings jobs and opportunities to the area and would create an economic boom as seen by the Government Expenditure multiplier proved by Keynes. However, Lantau Tomorrow Vision is not necessarily the only lifesaver of Hong Kong’s economy. Any viable investments by the government would do -- including developing brownfield sites and peripheries of the country parks. But that is another debate.


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