When fiscal stimulus becomes a debt burden

Highlights:

• Keynesian stimulus is becoming harder as public debt levels rise
• High debt can weaken growth and limit fiscal stimulus
• Advanced economies face rising borrowing costs and debt-service pressures
• Bangladesh's domestic borrowing costs are currently providing some relief
• Rising external debt repayments pose growing risks for Bangladesh
• Bangladesh must prioritise productive borrowing to avoid future debt crises

Keynesian economics emerged as an emergency response to the Great Depression of the 1930s and has remained a dominant policy tool through major financial crises and shocks, including the Covid-19 pandemic and the Russia-Ukraine war.

It prescribes that governments should spend more to cushion shocks, sustain demand, and encourage households and businesses to spend and invest. For much of the past century, this approach has helped economies avoid deeper downturns.

But the policy has also left a growing burden: public debt.

As debt piles up, governments are finding that the fiscal space that once allowed them to spend their way out of crises is narrowing. Debt-servicing costs are rising even in advanced economies, raising a difficult question: how much longer can governments rely on fiscal stimulus when the stimulus itself is adding to an already heavy debt burden?

Andy Haldane, former chief economist at the Bank of England, has posed an even more fundamental question: is Keynes's theory now dead, or at least becoming ineffective in high-debt countries such as the US, Japan and the UK?

He explains how fiscal multipliers affect household and business spending, influence borrowing costs, and increase the likelihood of governments defaulting on their debts in the future. The impact of fiscal stimulus also depends on central banks' policies – whether monetary policies are accommodative or tightening. Citing evidence from a study of 44 countries, he warned that public stimulus could depress growth in countries where public debt exceeds 60% of GDP – a threshold that G7 countries have already crossed.

Advanced economies face a debt squeeze

US national debt has reached $40 trillion, more than double its level a decade ago, reflecting heavy public spending and higher interest payments. Long-term bond yields have surged to 20-year highs, meaning the federal government has to pay more to raise funds from investors to cover budget deficits.

As a result, consumers are facing higher interest rates and inflation, a situation further aggravated by rising oil prices following the US-Iran war.

Bond yields have risen across major advanced economies, weighing on growth and fuelling inflation. The UK is grappling with weak growth, mounting social and defence spending needs and historically high taxes.

Ahead of the autumn budget in October, Chancellor of the British Exchequer John Healey has promised "a bit of breathing-space for those families and businesses that feel so squeezed".

For decades, Japan kept its borrowing costs near zero. Now, with public debt exceeding 200% of GDP – roughly double the G7 average – its interest rates have risen, gradually making its debt more expensive to service.

While expectations of higher future taxes are already dampening household and business spending in advanced economies such as the US, Japan and the UK, central banks are raising interest rates and moving towards quantitative tightening after missing their inflation targets for years following the Covid pandemic and the Russia-Ukraine war.

With another war now raging in the Middle East and rattling global oil and gas markets, with damaging effects far beyond the conflict zone, advanced economies are struggling to escape the public debt trap while facing growing pressure to increase defence spending. Concerns over debt sustainability are mounting as higher bond yields drive up debt-servicing costs, forcing governments to raise taxes or cut spending – potentially weakening growth further.

Bangladesh faces a different equation

Despite pressure from higher energy subsidy costs following the surge in global oil and gas prices, as well as a sharp increase in the government staff salary bill effective from July, Bangladesh is currently seeing a decline in Treasury bill and bond yields amid weak credit demand from businesses.

The Bangladesh Bank has also begun moving away from the tight monetary stance maintained for roughly two years, lowering its policy rate to reduce the cost of funds for businesses. Inflation, although still elevated, has eased for two consecutive months.

Bangladesh's overall public debt remains well below the levels seen in countries such as Japan, the US and the UK. A decline in domestic borrowing costs, therefore, offers some comfort to the government at a time when it faces higher spending requirements.

But the comfort is limited.

The rising cost of servicing foreign debt is becoming a more serious concern as interest rates on external borrowing increase and concessional sources of foreign financing continue to shrink.

With grace periods on loans for mega projects expiring, Bangladesh is beginning to feel the pressure of external debt repayment. The country will need to service nearly $26 billion in external debt between the current fiscal year and FY30, according to an Economic Relations Division (ERD) report.

The pressure was already evident in July, the first month of the current fiscal year, when Bangladesh repaid 2.5 times the amount it received in foreign loans. Meanwhile, commitments from development partners fell 83% from the amount pledged in the same month last year. ERD officials attributed the decline to the government's cautious and selective approach to foreign-funded projects, with priority now being given to projects expected to offer higher value for money.

Economists have long urged such selectivity as the cost of external borrowing rises.

Mustafa K Mujeri, an economist and former director general of the Bangladesh Institute of Development Studies (BIDS), said repayment pressures are set to increase as interest rates on foreign loans rise and maturity periods shorten. This makes careful selection of externally financed projects increasingly important, he said, warning that otherwise debt management could emerge as a major economic challenge in the coming years.

Bangladesh's total public debt, including domestic and external debt, was estimated at 42.1% of GDP in the last fiscal year. Global lenders are projecting a gradual shift from a relatively comfortable debt position towards greater risk.

The challenge, however, is not simply to contain the growth of debt. More importantly, foreign borrowing needs to be channelled into productive sectors that generate sufficient economic returns to service the debt and avoid the risk of a debt trap in the future, Mujeri said.

Analyses by the World Bank and the IMF indicate that Bangladesh's shift from a "low" to "moderate" debt-risk category is being driven less by its debt-to-GDP ratio than by worsening debt-to-revenue and debt-to-export ratios.

The ERD is also concerned. Although Bangladesh's debt-to-GDP ratio remains low by global standards, it is gradually rising. Without stronger revenue growth, the country could lose its current "comfortable position" in servicing external debt, the ERD said in its latest report, Flow of External Resources into Bangladesh.

For Bangladesh, therefore, the lesson from the current debate over Keynesianism is not that fiscal stimulus has become irrelevant. The real question is no longer whether the government should borrow more to spend more, but how much debt it can afford to manage before it spirals into a future crisis.