Standard Life Investments

Published Article

The CA Magazine - Defusing the fiscal time-bomb


The global financial crisis and its aftermath have led to a massive deterioration in public sector balance sheets across the developed world. Large cyclical and structural budget deficits arose as economic activity dropped, unemployment surged, public sector saving was forced down to absorb the surge in private sector savings and governments took policy steps to boost growth and directly capitalise failing financial institutions to prevent a large collapse in output.

As a consequence, the ratio of gross public debt to GDP rose in almost all of the larger developed economies, with the median country experiencing an increase of 21.5 ppts and only five countries – Belgium, Canada, Denmark, Sweden and Switzerland – have a lower debt ratio now than they did in 1997. The IMF generally anticipates that fiscal positions will improve modestly through the rest of the decade with the median country reducing its structural budget deficit from 1.5% of GDP to 0.1%, and lowering its gross debt ratio by 4.5 ppts. Does that mean that all is well on the fiscal sustainability front? Not at all; even by 2019 only six countries are expected to have a lower debt ratio than in 1997. More importantly, the IMF’s projections could turn out to be too optimistic. Although its assessment of potential growth is fair for most countries, the IMF’s projections assume that there are no severe global or even country-specific economic shocks over the forecast horizon. Yet by the end of 2019, the US economy will have been expanding for 126 months, twice as long as the average business cycle expansion since 1945 and even longer than the 1990s boom.

To simulate how developed country public balance sheets might be affected by a recession within the IMF’s 5-year forecast horizon, we introduce a symmetric 2ppt decline in real GDP in each country in 2017. With regard to fiscal policy we assume that the downturn does not have a permanent effect on output and governments do not pursue structural easing policies. That means that countries’ primary budget balances are only affected by the cyclical decline in government revenues and rise in social spending. Finally, we assume that interest rates fall during the downturn, but only on new government borrowing.

A global recession in 2017 would punch another hole in public finance positions in the developed world. The median increase in debt to GDP levels is just a shade over 10 ppts between 2017 and 2020, with indebtedness increasing in all countries. Compared to the IMF forecasts, debt ratios are some 17% higher at the end of 2020 with the shock derailing consolidation efforts. Our analysis suggests that such a recession would leave the median debt to GDP ratios a full 35ppts higher than in 2007.

What can be done to support public finances in order to make them robust and drive a reduction in overall debt positions? Improving the nominal growth outlook provides the best policy option. Some economies, particularly those in the Eurozone, require greater monetary stimulus alongside a temporary, targeted loosening of fiscal policy. More generally, countries should look to improve their long-term growth rates through accelerating productivity enhancing structural reforms and raising public infrastructure spending. Improving fiscal planning is also important. Countries should design credible and transparent fiscal rules, publish the details of their longer-term consolidation plans, and set up independent bodies to monitor adherence to these rules and plans.

If policymakers do not take aggressive action to raise near-term and long-term nominal growth, as well as enhance their long-term consolidation plans, more painful and damaging policies might be required to deal with excessive public debt burdens. These could include financial repression, the monetisation of deficits and even debt write-downs. The clock is ticking on the next global downturn. Policymakers should act with the upmost haste.

Jeremy Lawson, Chief Economist, Standard Life Investments

First published in The CA Magazine – January 2015