Undertaking a sizable fiscal adjustment is a lot like driving up a tall mountain: it’s hard work, it can take a long time, and you don’t want to run out of fuel partway up the incline. Countries are starting the climb, cutting back government deficits and debt levels, but according to our analysis often current plans aren’t enough to get countries where they need and want to go.
The plans in place are large by historical standards, which brings with it difficult choices, and particular risks and uncertainties. Let me fill you in on what these are.
The starting line
Advanced country government budget deficits edged down in 2010, but mostly as a result of improved economic conditions and lower support to the financial sector in the United States. The problem is government debt kept rising, and fast. By the end of 2010, government debt was as much as 25-30 percentage points of GDP above the pre-crisis (2007) level for several countries.
The crisis has been much more contained for emerging economies. Already in 2010, debt ratios had stabilized and started declining, although performance was relatively weaker in some areas like emerging Europe.
How bad was the fiscal situation at end 2010?
One way to look at this is to gauge the improvement needed to stabilize the government’s debt to GDP ratio—what we regard as the minimum goal of any sustainable policy. I expanded on this issue in my press conference remarks, but here are the bare bones of it.
- With only two exceptions, no advanced economy had in 2010 a sufficiently strong cyclically-adjusted primary budget balance—total budget balance excluding the effects of the business cycle and interest payments—to keep its debt ratio from continuing to rise.
- The situation is completely different for emerging economies because their primary balances are not as weak and most have had a favorable differential between interest rate and growth—a key driver of the debt ratio—for many decades.
However, stabilizing debt at post-crisis levels would not be a good outcome in the longer run. High debt is likely to be associated with higher real interest rates, lower growth, and higher exposure to shocks. It also leaves less space to respond when new shocks come in the future.
For almost all advanced countries, with the notable exception of United States and Japan, deficits are expected to decline in 2011; major adjustment efforts are on tap for 2012 in almost all, based on the medium term adjustment plans that most countries have now produced. But, even then most countries will still be far away from the long term adjustment target.
There are three major sources of uncertainty regarding the fiscal outlook:
First, there is the risk of financial sector shocks that could require additional support for the financial sector. At this point, this risk seems to be limited to some specific countries, in the absence of additional shocks, but it could trigger more general adverse market reactions.
Second, there could be fiscal policy implementation shocks. Problems may arise in some countries because of the political cycle. The adjustment envisaged in 2012 is particularly daunting, one of the largest on record, particularly in the US. Over the medium-term, the adjustment is further complicated by having to take place at a time when spending for pension and health care will be tending to increase.
Third, interest rate shocks could materialize. Here, the focus is the differential between the interest rate and growth. The assumptions underlying the baseline are fairly benign, especially for advanced countries, where the differential is projected to be negative during 2011-15. This could happen given cyclical conditions, but there are major risks in the presence of a rising debt stock.
This is a risk for emerging economies too, where we also project the interest rate-growth differential to remain negative. Here things are more complicated, though.
- For emerging economies, the largely negative interest rate-growth differential in the decades before the crisis allowed them to run primary deficits, while maintaining a stable debt ratio. Indeed, in most emerging economies, the average real interest rate on public debt was negative. We suspect this reflects financial market underdevelopment and financial repression—through, for example, but not exclusively, liquidity constraints or interest rate ceilings.
- This means that, as these countries liberalize their financial markets, interest rates on public debt will rise, requiring adjustments in their primary balances. How fast this will happen is hard to say, but it casts a shadow on the fiscal baseline for these economies. In this respect, it is also important to stress that the baseline for emerging economies also reflects other favorable conditions, including high commodity prices, strong capital inflows and asset prices, and, in general, strong growth.
The road ahead
The fiscal outlook is clearly more challenging for advanced economies, but there are also risks for emerging markets.
It is difficult to assess the likelihood that the weak state of public finances would lead to major disturbances in some sovereign debt markets, particularly the largest ones. The largest advanced countries have a lot of credibility. The risk that sovereign debt problems arise in these markets is a “tail”—or extreme—event, but one that would have major consequences for them and also for the rest of the world.
Even if these tail risks do not materialize, there is the risk that, over the medium term, fiscal adjustment in advanced economies will run out of gas midway up the mountain, leaving public debt stable in relation to GDP, but at very high levels. This would be detrimental for real interest rates and growth over the medium term.