October 24th, 2011 by Hafiz Noor Shams
As sovereign insolvency hogs headlines around the world, so heightens the popularity of deficit-reduction agenda. No more only wonks make the noise. Some men in the streets are echoing the slogan of economic conservatism as well, filling the lonely space sitting not quite centered in the Malaysian political spectrum.
One ratio has been brandied around whenever there is a discussion on fiscal deficit: deficit-to-GDP.
In the first reading of the federal budget as well as in the Economic Report published on the same day, the government highlighted the ratio to show that the government is pushing the deficit down earnestly. I myself used the ratio to suggest that the government could have a lower deficit if it was not for the slew of dishonest populism the government is engaging in.
The ratio can be misleading if you are unfamiliar with it. It is a simple ratio, yes, but it is deceivingly so because of its denominator.
Assuming the projection of lower ratio for next year will be achieved, the absolute deficit will not actually fall as dramatically as the ratio suggests. In 2010, 2011 and 2012, the actual and the projected absolute deficit are RM43.3 billion, RM45.5 billion and RM43.0 billion respectively. In terms of deficit/GDP, -5.6%, -5.4% and -4.7%. You can immediately see the relationship between absolute deficit and the ratio is not one of straight line. From 2010 to 2011, the absolute deficit is expected to increase but the ratio is expected to fall. From 2011 to 2012, the absolute deficit is projected to fall modestly. Modest is not an adjective to use to describe the ratio in the same period however.
What reduces the ratio is not so much the reduction in absolute deficit but the increase in GDP. When the increase in GDP overwhelms the increase in deficit, then the ratio will go down.
For this reason, I prefer a more down-to-earth ratio as typically used in business. I prefer the deficit-to-revenue ratio to deficit/GDP. (In fact, if small government is a concern, the absolute deficit figure is a better measure although here, one has to be careful of the context. Absolute figures are important but there are limits.)
In business parlance, it is the net loss margin, if I am not mistaken. This ratio provides a clearer picture of any deficit-reduction effort and the state of government finance than the deficit/GDP ratio, which is meant to be more macro in nature by too much.
One may protest in defense of deficit/GDP, stating that higher GDP translates into greater revenue to the government. That protest will not go far because the positive correlation between GDP and revenue is imperfect. In the case of public finance, GDP is only a proxy to revenue. Why use the proxy when we can use the actual thing the proxy tries to track?
Deficit/GDP has its uses and those uses are mightily useful. I am not going to elaborate that. But if you want to actually reduce debt, then deficit/revenue is the proper metric to use. Deficit/revenue delivers the message of deficit-reduction and its progress—or lack of it—more effectively than the other ratio.