One obvious fallout of the global financial crisis is a huge deterioration in fiscal conditions, particularly in advanced countries. The numbers are nothing short of staggering. Gross general government debt in the G-20 advanced economies is projected to approach 120 percent of GDP by 2014, up from about 80 percent in 2007, and this is even assuming no renewal of fiscal stimulus beyond 2010.
Some might think that this comes from an “exotic” form of fiscal policy whereby governments opened their coffers to prop up financial institutions. But only a small part of this debt spike is matched by a rise in financial assets. It really boils down to “plain vanilla” deficits—revenue losses from the recession, fiscal stimulus, and some underlying spending increases that would have occurred even without a recession.
A first step
Pretty much everybody agrees that something has to be done about this, and that fiscal policy needs to be tightened once the economic recovery has firmly established. The first step is to stabilize the debt-to-GDP ratio.
Even this will not be easy, given trend increases in pension and health spending, often reflecting population aging. But is stabilizing debt ratios at their post-crisis level enough?
The temptation will be strong. Just look at the numbers.
Let’s assume that advanced countries want to reduce gross debt to 60 percent of GDP (the median pre-crisis level) by 2030. To do this, they will need to improve their structural primary balance by 8 percentage points of GDP over the next decade, and keep it there for another decade. Obviously, this is a tall order. Simply stabilizing debt at its post-crisis level means half the work—an adjustment of 4½ percent. This is still ambitious, but much more manageable.
Easy path not the best
Still, taking the easy path is not the best idea. Governments need to do whatever they can to lower debt ratios, for at least three reasons.
- First, they need space for fiscal responses to possible future crises. If you start with high debt, it’s really hard to let fiscal policy cushion the shock—just look at Italy.
- Second, high debt pushes up real interest rates, with pressure on a limited pool of private savings. We have computed that raising government debt ratios by 40 percentage points (exactly what is projected to happen on current trends) would increase real interest rates by a sizable 2 percentage points. This may even be an underestimation as it is based on backward-looking estimates from a world where only a few countries were running high debt ratios, which could partly be financed abroad. With so many large economies borrowing at the same time, the effect on interest rates may be larger.
- Third, high-debt countries tend to grow more slowly—just look at Japan and Italy. While other factors were certainly at play, the experience of several emerging market countries confirms the existence of debt overhang effects.
Altogether, I believe that living with 100 percent government debt ratios is not a good idea. Fiscal exit strategies in advanced countries should target a reduction of government debt to prudent levels.
If a debt ratio not exceeding 60 percent—as noted, the pre-crisis median level—was regarded by many countries as an appropriate norm before the crisis, it should continue to appear so after the crisis. And while it is too early to tighten fiscal policy today, the plans should certainly be put in motion.