Fiscal Sustainability

The above considerations suggest the following conclusions. To maximize the impact of fiscal stimulus and reap a double dividend, governments should concentrate their spending efforts on infrastructure investment and enhance international cooperation so as to internalize the spillover effects of openness. However, a crucial component in boosting impact is ensuring the credibility of measures to ensure fiscal sustainability over the long term. As Corsetti, Meier, and Mueller (2009) have argued, the stimulus impact of fiscal expansion would be enhanced in the presence of “spending reversals,” that is, the expectation that public spending would be reversed in the future to offset fiscal stimulus today. This would lower long-term interest rates and thus increase private spending, which would replace declining public spending. However such a positive outcome could be less likely in the face of persistent output gaps of the size currently seen. Large and non-declining negative output gaps weaken the expectations of spending reversals as they signal the need for additional stimulus. They also lower the expectations of higher interest rates as an inflation surge becomes more remote.

Crisis driven fiscal stimulus also impacts on debt accumulation: this is on top of commitments that arise from existing obligations, including those related to ageing debts. Further, the fiscal stimulus is only one determinant of crisis-related debt accumulation, the other being measures employed to support the financial system, an issue which I will not consider here. However, as Reinhart and Rogoff (2009) note, historical evidence shows that the huge debt build-up in the aftermath of crises is the consequence of both recession-led falling revenues and the spending increases introduced to counter the recession. This seems to be the case this time too. As Figure 5 [ PDF 21.2KB | 1 page ] shows, the average debt level in OECD countries has risen sharply and significantly since the outbreak of the crisis and is expected to peak at 100% by 2010, with some countries moving well beyond this figure.

Such a steep rise in debt has a significant impact on the size of fiscal adjustment that will be needed to ensure debt sustainability. According to the standard debt dynamics formula, for a given primary balance, the debt to GDP ratio declines as long as nominal GDP growth is higher than the nominal interest rate. Let us considers these three variables separately. For given growth and interest rates, Table 6 [ PDF 13.9KB | 1 page ] shows that the primary surplus needed to stabilize debt rises significantly in almost all countries between 2008 and 2010. Such increases, coupled with the fiscal deficits generated in response to the crisis, significantly increase the fiscal gaps, most notably in the United States and in the United Kingdom.

The projections reported in Table 6 assume unchanged growth and interest rates. What if these assumptions are relaxed? An IMF (2009) simulation looks at the evolution of the fiscal balance and government debt in a prolonged low-growth scenario for G20 countries with respect to a baseline. Significantly lower growth means less sustainable debt dynamics. Growth could be lower not only because of larger output gaps but also because of lower potential output, a point which I will return to later.

The other variable that affects debt dynamics is the interest rate. A higher interest rate, other things being equal, also makes the debt dynamic less sustainable. One important element of this dynamic is that the interest rate is endogenous to the extent that interest rate spreads increase with the size of debt in the OECD (Figure 6 [ PDF 14.4KB | 1 page ]). Econometric evidence, surveyed in OECD (2009), suggests that interest rate spreads increase with the amount of debt and with unfavorable past fiscal records.

Putting all these things together, in the new fiscal landscape debt sustainability is bound to become even more problematic, at least for high debt countries and for those with a poor track record. A vicious circle of higher debt, lower growth, and higher interest rates cannot be ruled out. Worrying, in this respect, would be the risk of prolonged deflationary pressures which would increase the real interest rate. However, deflation risks seem to be fading.

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