By Mike Ng

Since the Asian Financial Crisis 1997-98, the Hong Kong economy has experienced two recessions. Unemployment is high and the government has been running serious budget deficits since 1998. Many people are worried that the deficits will damage Hong Kong as an international financial centre. I am very surprised and cannot understand that government officials, the media and even local economists have foolishly believed that the current budget deficit situation of Hong Kong is ‘structural’. Because of this belief, the government has decided to cut spending and plans to increase the tax base. Do they know that cutting spending and/or raising taxes will further depress the economy when it has not fully recovered? (I cannot see that the Hong Kong economy will fully recover before 2006.)

I shall argue against their view and clarify that the present problem is mainly ‘cyclical’ (or temporary); therefore, there is no need to worry about the deficit. The following four points support my argument:

1. In order to understand the structural problem, we need to know what ‘structural unemployment’ is. Structural unemployment exists because economies undergo structural change. Certain industries and certain regions decline, while others expand. The transition between jobs in these circumstances is prolonged because relocation and retraining is involved. For the Hong Kong case, the current problem does not seem structural because the last five years showed that all sectors of the economy suffered.

2. The gross domestic product (GDP) and unemployment figures between 1998 and 2001 did not support the case of structural deficits. For example, when economic growth and unemployment improved in 2000, the deficit was small compared with the other three years. On the other hand, many people expect that the deficit in 2002 will be bigger than the previous four years because the unemployment rate has reached a historically high level (over 7%).

3. If Hong Kong’s budget deficit is structural, this means that the Hong Kong economy is operating at full employment level of output. In other words, the unemployment rate should be between 2.8-3.8% (currently at 7.4% in the third quarter of 2002), i.e. the natural rate of unemployment (UN) or long-term average level of unemployment. It is true to say that any level of unemployment above UN is caused by cyclical downturn, thereby, ‘cyclical unemployment’. Note that there is a huge gap between UN and 7.4% for Hong Kong.

4. The government claims that the Hong Kong economy has been under structural transformation, so unemployment is inevitably high and we all have to suffer. The government is right in some extent but wrong in other extent. Did the structural transformation only happen over the last five years? No! The transformation has begun and will continue since the reform and opening-up of Mainland China in 1978. Hong Kong’s manufacturing operations have been gradually moving back to Mainland China, however, the annual unemployment rate was 3.3% on average before 1997. In comparison, the corresponding figure was 4.6% between 1997-2001.

The above analyses show that Hong Kong’s current budget deficit problem is mainly cyclical. You might ask: in terms of policy implications, does it make any difference whether the deficit is structural or cyclical? Yes, it does indeed! If the deficit is structural, the deficit will exist even if the economy fully recovers. Hence, the government has to raise taxes and/or cut spending. If the deficit is cyclical, the deficit will disappear when the economy fully recovers. Therefore, the government should not care about the deficit and focus on how to get the economy back on track.

After all, my advice for fiscal policy is that the government should balance its budget over the course of the business cycle, and not in every year. Raising taxes and/or cutting spending during economic recessions is never a good thing.