From Here to Eternity: The Outlook for Fiscal Adjustment in Advanced Economies Carlo Cottarelli Director, Fiscal Affairs Department Peterson Institute May 2, 213 1
Main Questions How bad is the fiscal position in advanced economies? What are the risks arising from the poor state of the fiscal accounts? What is the appropriate strategy to address these fiscal challenges? Is the current fiscal adjustment strategy working? 3
How Bad is the Fiscal Position in Advanced Economies?
General Government Gross Debt 125. Advanced Economies, 188-213 (Percent of GDP) 213 Level 1. 75. 5. 25. 188 1887 1894 191 198 1915 1922 1929 1936 1943 195 1957 1964 1971 1978 1985 1992 1999 26 213 5
Gross Public Debt to Household Financial Net Worth 14 G-7 Economies, 197-213 (Percent of GDP) 7 12 6 1 Debt to Household Financial Net Worth (right) 5 8 4 6 Debt to GDP (left) 3 4 2 2 1 197 198 199 2 21 6
The Outlook is Worse than at the End of WW2 for Four Reasons Most of the fiscal adjustment then consisted of cuts in military spending Spending for pension and health care will be on the rise over the coming decades Growth prospects are not great Financial sector in most advanced economies was repressed Advanced Economies: Population between Ages 15-64 14 195=1 13 12 11 21=1 1 9 t=1 t=5 t=9 t=13 t=17 t=21 t=25 t=29 7
Large Advanced Economies Where Public Debt-to-GDP Ratio Exceeds 9 Percent and Is Still Rising 4 percent of world GDP 8
-1. 1. 3. 5. 7. 9. Public Debt and Deficit Since 27 16 (General Government) AUS KOR Headline deficit, percent of GDP 12 8 4 29 21 212 211 213 28 27 AUT NDL CAN SVK NZL EST DEU CHE FIN SWE CZE DNK -4-1 1 12 23 34 45 56 67 78 89 1 Increase in gross debt-to-gdp ratio since 27 9
Public Debt and Deficit Since 27 16 (General Government) Headline deficit, percent of GDP 12 8 4 27 28 29 21 211 212 213 GRC JPN GBR IRL ESP ITA FRA PRT USA BEL -4-1 1 12 23 34 45 56 67 78 89 1 Increase in gross debt-to-gdp ratio since 27 1
Focus of Long-term FM Scenarios: Degree of Fiscal Tightening Needed to Lower Public Debt to 6-8 percent by 23 5. 21-3 Cyclically Adjusted Primary Balance (Percent of GDP) 2.5 Level of the primary balance Size of the adjustment -2.5-5. 1. 9. 8. 7. 6. 5. 21 211 212 213 214 215 216 217 218 219 22 21 211 212 213 214 215 216 217 218 219 22 221 222 223 224 225 226 227 228 229 23 21-3 Gross Debt (Percent of GDP) 6 percent 221 222 223 224 225 226 227 228 229 23 11
Illustrative Long-term Adjustment Scenarios Level of structural primary balance, 22-3 9 8 7 6 5 4 3 2 1 ITA BEL FRA (Percent of GDP) ESP GBR PRT -2 2 4 6 8 1 12 IRL USA Improvement in structural primary balance, 213-22 6 8 BBR 1/ Legend -1 bp Baseline +1 bp 1/ The BBR (balanced budget rule) scenario targets a debt ratio of 6 percent but caps the balance at.
Illustrative Long-term Adjustment Scenarios Level of structural primary balance, 22-3 9 8 7 6 5 4 3 2 1 (Percent of GDP) JPN -2 2 4 6 8 1 12 14 16 18 Improvement in structural primary balance, 213-22
What Are the Risks Arising from the Poor State of the Fiscal Accounts?
Two Reasons for Concern About High Public Debt Effect of high public debt on long-term economic growth High public debt raises risk of fiscal crises 15
Empirical Literature on Debt and Growth Kumar and Woo (21) in 46 AEs and EMEs for 197-27 Kumar and Woo (213) in 79 AEs, EMEs and LICs for 197-28 Checherita and Rother (21) in 12 Euro economies for 197-28 Ceccetti et al. (211) in 18 OECD countries for 198-25 Balassone et al. (211) for Italy for 1861-21 Ursua and Wilson (212) in AEs and EMEs for 195-21 Baum et al. (213) in 12 Euro economies for 199-21 Afonso and Jalles (213) in 155 AEs, EMEs and LICs for 197-28 Panizza and Presbiterio (212) in 17 countries for 198-25 16
Initial Government Debt and Growth of Real GDP Per Capita Over the Following Five-Year Period 15! Real per capita GDP growth (% per annum), average for subsequent 5 years 1 5-5 5 1 15 2 25 Initial gross government debt (% of GDP) 17
Public Debt, Deficits and CDS Spreads Headline deficit Advanced Economies, 212 (Percent of GDP) 1/ 12. 1. ESP JPN 8. GBR USA IRL 6. 4. 2. AUS CZE NZL SVK DNK SVN FIN ISR NLD MLT AUT CAN CYP FRA BEL ISL PRT ITA. EST SWE HKG CHE DEU -2. KOR -4. 2 4 6 8 1 12 14 Gross debt 1/ Balloon size based on 212 average CDS spread. 18
Monetization of Public Debt 3. Base Money (Percent of GDP) 26. 22. 18. 27 28 29 21 211 212 18. 15.4 12.8 1.2 7.6 5. 27 28 29 21 211 212 22. 17.8 13.5 9.3 5. 27 28 29 21 211 212 19
What is the Appropriate Strategy to Address these Fiscal Challenges?
The Austerity Debate Ten Commandments for Fiscal Adjustment in Advanced Economies Olivier Blanchard and Carlo Cottarelli June 24,21 21
Recommended Fiscal Adjustment Strategy For countries that are not subject to market pressure, fiscal adjustment should proceed at a moderate pace, within a MT adjustment plan These MT plans should be defined in cyclically adjusted terms so as to allow automatic stabilizers to operate Countries under market pressure should proceed more rapidly, but also for these there is a speed limit This fiscal strategy should be supported by relaxed monetary conditions, and structural reforms to boost trend growth 22
Nonlinearities of Fiscal Austerity and Profligacy Cost of policies Cost of profligacy Cost of austerity Degree of fiscal stimulus Cost of policies Total cost Degree of fiscal stimulus 23
Costs of Fiscal Tightening are Now High Fiscal multipliers are particularly large now reflecting downward inflexibility of nominal interest rates, the difficulty banks have in extending credit, the large share of households that are credit rationed, and in a recession, cuts in demand will affect output rather than prices. The cost of an output loss is larger when the economy is already growing slowly Higher than usual hysteresis effect 24
Fiscal Adjustment and CDS Spreads with Alternative Fiscal Multipliers 25 Change in sovereign five-year CDS spreads (basis points) 2 15 1 5-5 -1-15 Higher spending multiplier (1.) Spending multiplier (1.) Spending Lower spending multiplier multiplier (.1) (.1) 1 2 3 Reduction in government deficit (percent of GDP) Area where fiscal tightening increases CDS spreads 25
Three Issues on the Costs of Fiscal Profligacy A perfect commitment technology does not exist We tend to underestimate the cost of fiscal crises before they occur The risk of turmoil on the government paper market is not the same for all countries but black swan events do occur 26
Three Issues on the Costs of Fiscal Profligacy A perfect commitment technology does not exist In the past, advanced economies did not use their good times to lower public debt Fiscal twist already danced in 28-9 Gaining credibility by implementing entitlement reform is not so easy 27
General Government Gross Debt 125. Advanced Economies, 188-213 (Percent of GDP) 1. 75. 27 Level 5. 25. 188 1887 1894 191 198 1915 1922 1929 1936 1943 195 1957 1964 1971 1978 1985 1992 1999 26 213 28
CDS Spreads and Entitlement Spending 4 CDS Spreads, April 213, basis points 36 32 28 24 2 16 12 8 4-2 2 4 6 8 Increase in Entitlement Spending, 21-3, percentage points 29
Japan: General Government Deficit and Debt 11. Headline deficit (Percent of GDP) 7.3 3.7 25. 27 28 29 21 211 212 213 Gross Debt (Percent of GDP) 223.3 196.7 17. 27 28 29 21 211 212 213 3
Advanced Economies 213 Net Public Debt, Headline Deficit and Primary Deficit, percent of GDP Net Public Debt Primary deficit Deficit 31
Advanced Economies 21 Net Public Debt, Headline Deficit and Primary Deficit, percent of GDP Net Public Debt Primary deficit Deficit 32
United States: Largest Fiscal Tightening in the Last 3 Years 2. General Government, Improvement in Cyclically Adjusted Primary Balance (Percent of GDP) 1.5 1..5 1983 1984 1985 1986 1987 1988 1989 199 1991 1992 1993 1994 1995 1996 1997 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 213 33
United States: General Government Deficit Headline deficit (Percent of GDP) 15. 13.3 percent 1. 5. 6.5 percent 27 28 29 21 211 212 213 34
Stability Programs: 211 and 213 General Government Headline Balance Targets (Percent of GDP) Netherlands Portugal Old targets Old targets -2. -2. -4. New targets -4. New targets -6. 21 212 214 216-6. 21 212 214 216-3.7-7.3-11. 21 212 214 216-2.3 Spain Ireland Belgium Old targets New targets France Old targets -13.3-26.7 New targets Old targets -4. 21 212 214 216-1.7 Italy Old targets 1.7-1.7-3.3 Old targets New targets -5. 21 212 214 216-4.7 New targets -3.3 New targets -7. 21 212 214 216-5. 21 212 214 216 35
Is This Strategy of Steady Fiscal Adjustment Working and is it Realistic to Continue it in the Future?
Advanced Economies: Average Deficit Will Be Half of What It Was in 29 17 29 and 213, General Government Deficit (Percent of GDP) 11 213 29 GDP weighted average 29 6 GDP weighted average 213 - -6 JPN IRL GBR SVN ESP USA PRT GRC FRA ISR NDL SVK CZE CAN DNK BEL ITA AUT FIN NZL ISL AUS SWE DEU CHE EST HKG KOR SNG NOR 37
Advanced Economies: In 213, Average Public Debt Will Stop Rising 12. General Government Debt (Percent of GDP) 11. 1. 9. 8. 7. 27 28 29 21 211 212 213 38
23 Advanced Economies: Historical Evidence on Primary Balances, 195-211 (New FAD Database) Maximum Primary Surplus Maximum Improvement in Primary Surplus Number of Countries 1 2 3 4 2 4 6 8 Maximum 1-year Average Primary Surplus (Percent of GDP) 2 4 6 8-2 2 4 6 8 1 12 14 1 Maximum 7-Year Adjustment (Percent of GDP) 39
Illustrative Long-term Adjustment Scenarios (Percent of GDP) Level of structural primary balance, 22-3 7 6 5 4 3 2 1 IRL ITA PRT BEL USA ESP GBR FRA -2 2 4 6 8 1 12 14 Improvement in structural primary balance, 213-22 4
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