by Nemat Shafik
As the world economy continues to struggle, people are taking to the streets by the thousands to protest painful cuts in public spending designed to reduce government debt and deficits. This fiscal fury is understandable.
People want to regain the confidence they once had about the future when the economy was booming and more of us had jobs.
But after a protracted economic crisis, this will take planning, fair burden-sharing, and time itself.
If history is any guide, there is no silver bullet to debt reduction. Experience shows that it takes time to reduce government debt and deficits. Sustained efforts over many years will ultimately lead to success.
Most countries have made significant headway in rolling back fiscal deficits. By the end of next year in more than half of the world’s advanced economies, and about the same share of emerging markets, we expect deficits —adjusted for the economic cycle—to be at the same level or lower than before the global economic crisis hit in 2008.
But with a sluggish recovery, efforts at controlling debt stocks are taking longer to yield results, particularly in advanced economies. Gross public debt is nearing 80 percent of GDP on average for advanced economies—over 100 percent in several of them—and we do not expect it to stabilize before 2014-15.
So what can governments do to ease the pain and pave the way for successful debt reduction?
I would highlight two key premises that governments must meet for fiscal consolidation to succeed.
- First, governments need to put together a credible medium-term plan and stick to it. This plan should be based on structural (not nominal) targets to allow flexibility in response to the economic cycle. Such plans are a vital ingredient when it comes to restoring confidence. For most countries, this means tackling the thorny issue of entitlement reform.
- Second, governments need to ensure that fiscal adjustment is fair and carried out in a transparent manner. Spending cuts and tax raises that people perceive as unfair are unlikely to be sustainable.
Let me elaborate on both.
Adjustment to restore fiscal sustainability in high-debt countries will need to be gradual and steady. The pace of consolidation should reflect the size of adjustment needs, the state of the economy, and financing constraints. As a general rule, adjustment of about 1 percentage point of GDP per year seems an appropriate pace for advanced economies over the medium term.
Large advanced economies should take the lead in providing certainty. The United States should define a reasonable plan to reduce government debt and deficits to avoid the “fiscal cliff.”
Japan needs to proceed with a decisive debt reduction plan that includes both revenue and entitlement reform. The recently enacted consumption tax hike will slow debt accumulation, but not arrest it.
In the euro area, determined steps to implement a robust fiscal governance framework that limits moral hazard remains of the essence. A credible roadmap toward a banking union and fiscal integration will enhance necessary crisis actions.
Both advanced and emerging economies need to tackle entitlement reform. Pension and health spending is projected to increase by over 4 percentage points of GDP in advanced economies by 2030, and by 3 percentage points in emerging markets. Pension reforms have been widespread in the last few years, but health care reform has been more timid, and in many countries remains the key long-term challenge for public finances.
I personally worry most about getting health care spending under control—reforming health care in countries with rapidly aging populations is a complex undertaking. In contrast, pension reform, while politically difficult, is fairly straightforward—governments can address costs by increasing the retirement age and looking at contribution and benefit rates.
A fair plan
Income inequality tends to rise when governments need to cut debt and deficits, but this does not have to be the case. Countries should limit the painful social effects of debt reduction and build their plans to last. This means they need to tailor policies to support social equity and long-term employment.
In practical terms, this means a degree of progressivity in taxation and access to social benefits. An enhancement of social safety nets should be supported by greater means-testing and monitoring. Policymakers can improve equity by fighting tax evasion, and—particularly in low-income and emerging economies—subsidy reform.
In many advanced economies, including in the euro area, reviving long-term growth and boosting competitiveness will require tackling policies that have been on the books for years but don’t necessarily work for a modern economy.
Countries often also need to strengthen their fiscal institutions and governance to enhance the credibility of medium-term fiscal plans.
In it for the long haul
The results of the changes taking place now will take time to bear fruit.
This is a frustrating truth for all those people who don’t have the luxury of time. That’s why it is so important for governments to make the case for reforms and to be as transparent and open as possible about their impact on the different segments of the population.
Young people in particular need to be involved and their voices heard loud and clear.
They, after all, are the ones who will bear much of the burden of repaying the consequences of past financial excesses.