Fiscal Futures

Greg Mankiw’s name needs no introduction. Principles of Economics, Mankiw’s famous introductory text, remains one of my favorite books. Written in simple language, it opened up the world of economics to me.

Not only economists but public policy experts are also familiar with his work on nominal rigidity or “sticky prices.” Mankiw’s landmark contribution is in developing the “sticky-information” model that explains rigid prices arising out of slow information diffusion, as firms do not continuously update their information sets. Given such an impressive body of work, Mankiw will likely win the Nobel Prize in Economics in the near future.

Recently, while delivering the Annual Feldstein Lecture, Mankiw laid out a grim economic forecast for the US economy. Historically, the US debt-to-GDP would spike during crises like major wars but always decline afterwards through a combination of economic growth and fiscal prudence.

However, now the US economy is on an unsustainable fiscal path with no signs of any reduction in the debt-to-GDP ratio for the next 30 years. On top of all this, President Trump’s “Big Beautiful Bill” will end up adding trillions to the debt.

According to the Congressional Budget Office, the US debt-to-GDP ratio will rise from 100 percent at the end of this fiscal year to 156 percent by 2055.

The usual strategy of dealing with high debt has focused on policies like increasing GDP to shrink the debt-to-GDP ratio, curtailing spending or raising revenue through taxes to narrow the fiscal deficit.

Mankiw argues that none of the usual tools are going to come in handy. Despite many economists’ pinning their hopes on it, AI is unlikely to bring about path-breaking economic growth as AI won’t replace past-productivity booms. Spending cuts are extremely difficult, since entitlements–Social Security, Medicare–and defense dominate the budget, and any plan to cut these would face a fierce political backlash.

Tax hikes remain the most likely but politically fraught solution as neither party supports broad tax increases. Consequently, it appears that US policymakers will struggle to close the fiscal gap that will remain at around 4 percent of GDP for the next three decades.

While the fiscal future of the US appears challenging, Pakistan’s government remains under tremendous pressure to put its fiscal house in order.

- Dr. Aqdas Afzal

This inability to close the fiscal gap will also push inflation upwards according to John Cochrane, an American economist. In The Fiscal Theory of the Price Level, Cochrane argues that the real value of government debt must equal to the present value of expected future real budget surpluses. Whenever an imbalance arises, the price level adjusts to restore equilibrium.

Suppose the government increases bond issuance, but the people do not expect higher taxes in the future to pay off this new debt. As a result, the real value of the bonds will decrease through higher inflation until balance is restored in the valuation equation. 

While the fiscal future of the US appears challenging, Pakistan’s government remains under tremendous pressure to put its fiscal house in order. On June 10, the federal government unveiled a budget with a 7 percent spending cut from the current year. Nearly half— Rs8.21 trillion ($29 billion)— will go to debt servicing, straining Pakistan’s finances. Defense spending also rose over 20 percent to Rs2.55 trillion ($9.04 billion) after May’s major clash with India.The government also aims to reduce the fiscal deficit to 3.9 percent of GDP. Not surprisingly, the FBR, Pakistan’s federal tax authority, has been tasked with collecting Rs14.1 trillion, a 19 percent year-on-year increase.

Just like in the US, trying to curtail discretionary spending in Pakistan will result in a fierce political and social backlash. However, Pakistan’s policymakers need to look toward the GCC and Jamaica in order to find innovative instances of reining in the fiscal spending.

In spite of earning billions from exporting hydrocarbons, GCC nations exercise prudence in fiscal expenditure. Some GCC nations have even put financial rules in place that tie spending to the historical average of real revenue from exports, thereby de-linking the economy from volatility in international hydrocarbon prices.

After suffering from years of economic turmoil, Jamaica finally notified an Independent Fiscal Commission this year for monitoring the country’s adherence to fiscal responsibility laws. The Commission is expected to carry out independent assessments of budget outcomes, perform independent fiscal analysis and inform the public.

In the case of the US, Mankiw is correct in highlighting a fiscal future fraught with uncertainty. Pakistan, too, faces a challenging fiscal future. Pakistan’s government is certainly making all the right noises, but it will take a lot of out-of-the-box thinking, political will, hard work and sheer good luck to cross the finish line.

- The writer completed his doctorate in economics on a Fulbright scholarship. X: @AqdasAfzal