Fiscal Monitor Series: Navigating the Fiscal Challenges

The International Monetary Fund (IMF) released a report on the global fiscal situation entitled "Navigating the Fiscal Challenges Ahead," the second in the Fiscal Monitor series which began in 2008. It examines cross-country fiscal trends resulting from, and leading up to, the global financial crisis. While countries continue to recover from the crisis, the international fiscal outlook has not substantially improved (refer to Figure 1). The report's analysis of global fiscal trends-historical and current, in both developing and advanced countries-emphasizes the need to act quickly and dramatically in order to avoid long-term damage to the world's growth prospects.

According to the IMF report:

• The global fiscal situation has sharply deteriorated as a result of the economic crisis, and it is only going to get worse in the next five years, barring dramatic action. Debt, as a percent of global economies, is rising quickly, on both state and national levels. Part of this is due to the recent economic crisis, but there are structural fiscal policies that must also be addressed.
• High debt levels have been historically correlated with an array of negative economic indicators-higher interest rates, higher solvency risk, lower GDP growth, lower labor productivity, lower levels of national investment, and, occasionally, greater macroeconomic volatility. It will take large, and "sometimes unprecedented," efforts to establish and enforce fiscal prudence in many countries, but it is not impossible.
• The passage of fiscal rules is becoming common-especially in the countries whose economies have seen the most dramatic changes over the past few years (like Greece, Spain and Portugal), and who face the highest levels of debt as a percentage of their economies. The inability or unwillingness to pass and enforce strong fiscal rules and deficit reduction plans can lead directly to a sharp fall of investor confidence-often exacerbating what are already challenging situations.

The global fiscal situation has sharply deteriorated as a result of the economic crisis, and is only projected to get worse.

On average, advanced economies have accumulated 20 percent GDP in gross debt above pre-crisis levels, and are on a path to accumulate an additional 20 percent GDP in debt, leading to an average total of 110 percent of GDP by 2015 (refer to Figure 2). Deficits everywhere are high; the global average is 3 percentage points higher this year than it was in 2007, only a minority of which is a result of stimulus measures. Much of the immediate rise in debt among advanced countries is due to lower revenue levels over the past few years, but structural policy realities persist, and demographic and health care cost increases would have created fiscal problems for most countries even without the recent financial crisis. Emerging countries have faced some increases in debt during the crisis, but the effects have been much smaller. The impacts in advanced countries could have a trickle-down effect, however, on the financial conditions of emerging and low-income economies by creating higher global interest rates and lower growth rates. In addition, advanced economies will be less capable of providing donor support to low income economies.

In addition, compounding the national fiscal woes is the increased likelihood that state and local governments will accumulate their own debt (as has happened in both the U.S. and Germany).

Large debt-to-GDP ratios have adverse effects on national economies.

Growth in debt has many implications and risks. Immediately, it has the potential to lead to a rise in interest rates. In countries with a majority of debt held in shorter-term maturities, as investor confidence and available capital decrease, rollover risk increases dramatically. In Japan, for example, they have debt maturing this year at the value of 54.2 percent of GDP; in the U.S. and Italy it is around 20 percent of GDP, and in Germany and the U.K. around 10 percent of GDP (refer to Figure 3). High debt also limits the ability of a government to respond to a crisis like that of 2008-2009 with countercyclical fiscal policies (i.e., increasing stimulus spending and decreasing taxes).

In the medium and longer-term, debt growth is also associated with lower subsequent economic growth.

"This issue of the Monitor presents new evidence on the links between debt and growth: it suggests that based on current projections, if public debt is not lowered to precrisis levels, potential growth in advanced economies could decline by over ½ percent annually, a very sizable effect when cumulated over several years."

The report presented an array of newly available econometric evidence on the historic risks of high debt, based on analysis of both advanced and emerging economies over almost four decades. A rise of 10 percent of GDP above initial debt levels has historically correlated with several different economic trends. Over the subsequent 5-year period, countries see average annual declines in real per capita GDP growth of 0.2 percent per year, in productivity of 0.2 percent per year, in total factor productivity (TFP) growth of 0.1 percent per year, and in investment of 0.4 percent of GDP per year.

Many countries either have passed or are in the process of passing fiscal rules to get their budgets back in balance.

The report uses a debt target of 6 percent of GDP (the pre-crisis median of advanced economies), which would require an average cyclically adjusted primary balance improvement of 8.7 percent of GDP. Alternately, the improvement would need to be 6.5 percent of GDP in order simply to stabilize the debt ratio at post-crisis levels.

These improvements could come from spending reductions or revenue reforms, and the paper outlines many different paths, each of which could be adjusted to accommodate the specific country. A reversal of stimulus efforts (on both the spending and revenue sides) at both the national and the state and local levels will be a necessary next step in addressing long-term debt issues. For countries like the U.S. who are in the midst of demographic changes that will result in higher social insurance and health costs, reforms of the pension and health care systems will be important to consider as soon as possible. It will have fewer short-term effects, but will instill confidence in, and lay the groundwork for, long-term fiscal sustainability.

Some countries, like France and Germany, are using the deficit goal of 3 percent of GDP (the Maastricht target) as a measure of reform. France looks to achieve this goal through a mixture of revenue changes on entitlements and reversing a few recently introduced tax cuts, and reducing public spending growth to less than 1 percent per year through 2012. Germany looks to achieve this goal mostly through spending reforms, balancing state and local structural budgets, and limiting the federal structural budget to 0.35 percent of GDP. Other methods of achieving fiscal reform include, on the spending side, freezes on non-entitlement spending (which could save up to 3 percent of GDP over the next ten years). One the revenue side, there is the option of the introduction (in the U.S.) or increase (in most other advanced economies) of a value-added tax (VAT). Other revenue options include increasing alcohol and tobacco excises, carbon taxes and property taxes, and working to decrease levels of tax evasion.

The enactment of policies like these, along with policy-based fiscal goals (like deficit and debt limits), is going to be important in terms of establishing the global path to fiscal solvency.

The time to act is now.

It will be a challenge just to stabilize debt growth at the elevated post-crisis levels. It will be an even greater challenge to bring ratios back down to their pre-crisis levels. On top of these challenges, too, are the added global trends of aging populations and steadily increasing health care spending. The creation, however, of medium-term fiscal objectives (be they spending freezes, entitlement reform, or revenue increases), to which policy makers both current and future can be held, can offer a real path out of the fiscal challenges we face globally.

In 1990, the paper noted, there were only 7 countries with fiscal rules, but by 2009, there were 80. As stated in preface to the report, reducing debt levels will be key in righting the global economy: "One of the key messages in this issue is that fiscal strategies should aim at gradually-but steadily and significantly-reducing public debt ratios, rather than just stabilizing them at their elevated postcrisis levels. Failing to do so would ultimately weaken the world's long-term growth prospects." It will be difficult road, but not an impossible one.

[1] The IMF defines general government gross debt as all liabilities that require payments of interest and/or principal by the debtor to the creditor at a date in the future. Included in general government gross debt is central, state and local debt.

[2] Fiscal balances are in percent of PPP-weighted GDP