With the budget surplus for the Hong Kong government forecast to exceed HK$70 billion, there is strong demand from the public to increase government expenditure next year.

Politicians from a few different political parties are campaigning to augment government transfer payments so as to "fight inflation" and reduce inequality. Furthermore, the pressure for higher tax rebates and various dole payouts is growing. The Hong Kong General Chamber of Commerce has proposed to cut the corporate profits tax rate to 15 percent from 16.5 percent currently.

You see, everybody loves a free lunch. Children love chocolate, but feeding chocolate to an overweight child is simply harmful. All the aforementioned policy proposals demonstrate a fundamental lack of understanding about the role macroeconomic policies are playing.

Since Hong Kong has adopted a currency board system, its interest rate has to follow that of the US. In other words, monetary policies cannot work independently. However, what is honey for the US economy may be toxic for Hong Kong. With the unemployment rate sticking at above 9 percent for a prolonged period of time, interest rates in the US needs to be low. However, with the GDP growth rate approaching 7 percent, and unemployment below 4 percent, a near zero interest rate and an ultra loose monetary policy are overly stimulative for the Hong Kong economy. They are also causing asset bubbles and firing up inflation expectations.

Given that Hong Kong has no monetary policy, the only way for the goverment to control the economy is through fiscal policy. Going back to basic economics, GDP is equal to the sum of consumption, investment, government expenditure and net exports. But if GDP is growing fast already, increasing government expenditure will likely send up the growth rate to an unsustainable level. This is like flooring the accelerator pedal when you are already driving above the speed limit. It can get you to your destination faster, but you may crash on the way.

A prudent policy would be to reduce the government expenditure while simultaneously raising the tax rate - i.e. running a larger government surplus - to cool down an overheating economy with high inflation.

Yet, although it is theoretically workable, the idea is almost politically infeasible given the lack of understanding among the general public and also some local politicians of basic economic principles. Still, the government should at least hold out against calls to further stimulate the economy.

Stoked by rising rents and food prices, Hong Kong's inflation accelerated to 3.1 percent in December. However, increasing government expenditure will not "fight inflation" as suggested by local politicians. In fact, it will be adding fuel to the fire.

Since rent represents a significant part of the cost of living, the main cause of increased inflation is the misdirected policy of restricting land supply in the past few years.

Increasing land supply to force down rental prices will not only counter the pressure from rising commodity prices but will also help boost the competitiveness of Hong Kong business. This will be a much better policy than cutting the corporate profits tax rate. More importantly, high inflation can simply be engendered by rising inflation expectations.

Therefore, the government needs to adopt a firm policy of boosting land supply to change the entrenched expectation of forever rising rental and property prices. Otherwise, we may again experience the horrible consequences of asset deflation from 1998 to 2003 after several years of high inflation in the 1990s.

Long-term structural problems such as inequality and lack of class mobility cannot be solved by one-off measures such as increasing transfer payments for the current fiscal year. To improve the living standard of the lower income class, the Hong Kong government should step up public housing construction, and re-introduce the Home Ownership Scheme, as well as other measures to reduce rental costs.

Given the openness of Hong Kong's economy, it can be severely affected by external shocks. Therefore, we need much larger government reserves to cope with potential problems in the future. With the US economy still on shaky ground and a crisis looming over EU countries, having enough reserves so that we can run multiple years of deficit to handle a large macroeconomic crisis is important.

Speeding and spending is always fun while careful driving and saving tends to be hard and uninteresting. However, we should do what is good for us. Hong Kong citizens should press the government to resist the temptation of taking economic growth steroids and regretting it later. If not, wait for the right moment to buy some put options on the market and profit from the inevitable crash.

The author, a former investment banker, is currently the associate director of MBA programs at the Chinese University of Hong Kong. The opinions expressed here are entirely his own.

(HK Edition 02/17/2011 page2)