A lesson from US debt ceiling fight: Don’t leave budgets adrift in the sea of democratic politics

Written by Dr Carmelo Ferlito

First published in Focus Malaysia on 29 May 2023

US PRESIDENT Joe Biden and his Republican opponents have announced they have agreed in principle to raise the US debt ceiling and avert a default. Is this good news? Yes and no.

Obviously, the agreement will avoid the spreading of a global financial crisis; however, the agreement also reveals the contradiction of having a limit by law (the debt ceiling) which lawmakers can change at their discretion.

This makes the ceiling a weak tool in the fight against irresponsible deficit spending; as usual, normal people are those paying the consequences of such irresponsibility in terms of inflation and unemployment.

The issuing of additional debt usually pushes up the interest rate (because of the higher demand for loanable funds). This has two consequences: on the one hand, the supply of loanable funds rises (savings are attracted by higher interest rates).

On the other hand, as demand for investments in the private sector decreases because of increased interest rate, utilisation of savings by the government to finance its deficit will crowd out utilisation of savings for private investment thus generating slower economic growth.

Furthermore, governments often resort to increasing the quantity of money in order to finance their deficits. The increase in the quantity of money allows politicians to support spending policies without imposing new taxes and this is the actual cause of inflation.

Fiscal policies financed by deficit spending and the printing of money not only produce inflation but also fail to produce persistent employment because the modification of the structure of relative prices generated by inflation will make unemployment worse.

Although short term injections of money may help maintain jobs temporarily at a higher level than would be possible otherwise, the employment level resulting from these policies is destined to fall in the long term.

Malaysia’s government debt ballooned from RM687 bil in 2017 to RM1.12 tril in 1Q 2023, making it increasingly difficult for the government to serve its debt and compromising the nation’s future in terms of less opportunities for growth and potentially higher inflation.

What can Malaysia learn from these numbers and the situation in the US? We need first and foremost to reaffirm the superiority and importance of balanced budgets. To quote James Buchanan (Nobel Laureate in Economics 1986) and Richard Wagner (theorist of political economy and social philosophy):

“Budgets cannot be left adrift in the sea of democratic politics. They must be constructed within constraints that impose external form and coherence on the particular decisions about size and distribution which an annual budget reflects.

“The elected politicians who must be responsive to their constituents, the governmental bureaucracy as well as the electorate need something by way of an external and ‘superior’ rule that will allow them to forestall the persistent demands for an increased flow of public-spending benefits along with reduced levels of taxation.”

Therefore, deficit spending should be subject to an external rule that could not simply be modified by lawmakers. Such a rule needs to be simple and straight-forward and it must offer clear criteria for adherence and for violation.

Moreover, such a rule should incorporate an automatic adjustment mechanism in the case of budgeted outlays that are projected to exceed tax receipts.

For example, if the projected balanced budget proves in error and a budget deficit beyond specified limits occurs, federal outlays shall be automatically adjusted downward to restore projected balance within a period of three months.

Eventual surpluses, instead, should be used to retire existing debt. In conclusion, the dangers of government debt are:

  • Rising interest rates and slower economic growth;
  • Inflation; and
  • Inflation-induced unemployment.

At the light of this analysis, the recent US crisis over debt ceiling and the ballooning Malaysian government debt suggest that Malaysia should introduce an automatic debt control mechanism which would escape direct control from policymakers.

Such a mechanism should force the government to reduce spending when deficits occur and indicate that surplus should be used to retire existing debt.