In the midst of jittery financial markets, and global economic doom and gloom, it’s easy to become pessimistic. Perhaps too much so; amid what seems like a steady drum beat of bad news, one can lose sight of what has been achieved over the last couple of years.
Public debt and fiscal deficits in many advanced economies remain very high. Nevertheless, important progress has been made in fiscal adjustment in many advanced economies. For most countries, government deficits have fallen substantially—by 2¼ percentage points of GDP on average compared to two years ago.
The fiscal outlook in most countries is stronger than we expected two years ago. Let’s take the five largest European countries. The chart below shows, in gray, the increase in the public debt to GDP ratio that we were projecting two years ago for the period 2012 through 2014. It also shows in blue the increase in debt over that same period that we are projecting today. As you can see, debt ratios are now projected to go up by less than we previously expected. In some cases, they are even expected to fall. This reflects the commitment that these countries have made to reduce their deficits over an extended period.
Despite this progress, Europe’s financial markets don’t appear to think the region is doing enough on the fiscal front. What accounts for this gap between market perceptions and reality?
Communications may be part of the problem. There is a cacophony of voices in the Euro zone, where 17 policymakers express their views, each with their own nuances. This creates a sort of uncertainty, where what financial markets want is a clear voice and message. Also, this summer’s agreement by European leaders gives them more flexibility to address problems before they turn into full blown crises, but it still needs to be implemented. Doing so without further delay will send a clear political signal that Euro area members will continue to do whatever it takes to preserve confidence.
So to the pessimists I say don’t lose sight of what’s been achieved.
To the optimists (if there are any) I say don’t underestimate what still needs to be done.
The task that fiscal policymakers face is complicated. They need to ensure the public sector is not a source of instability by committing to a plan that will stabilize and then bring down public debt. At the same time, they need to make sure that the fiscal tightening associated with this objective does not itself become a source of instability by undermining the economic recovery, which is at a delicate moment.
Some countries will have no choice but to tighten significantly in the short term, because of market conditions, while trying to minimize the growth fallout. Others facing easier financing conditions may have scope for a more moderate pace of short-term adjustment, especially if their medium-term commitment is seen as being highly credible. The right mix of short- and long-term adjustment for each country will depend on its particular circumstances.
For the United States, for example, commitment to a credible program to reduce debt and deficits over the medium term could free up space for a short-term stance that is more attuned to the economic cycle. From this perspective, the American Jobs Act proposed by President Obama can play an important role in supporting growth and employment, if it is embedded in an appropriate medium-term framework to bring down the public debt.
Given the size of the adjustment needed in the United States, this framework will need to involve an increase in tax revenues, and it will be important to ensure that the burden of this is distributed equitably across society. Reform of entitlements—both health care and social security—to contain the growth of spending on these items is also needed. However, it is critical that any debt reduction package be the product of a broad political consensus to give financial markets confidence that it will be adhered to over the long haul.
To use an old cliché, markets seem to be focusing on the fact that the glass is half empty, and ignoring the fact that it is also half full. Perhaps the pessimists would be wise to pause, take a sip, and reflect on where we have come from before turning to face the admittedly very difficult challenges that remain ahead of us.