Cutting debt and deficits January 23, 2012 Keith Wade, Schroders Chief Economist James Bilson, Economist How much tightening is needed, how will growth be impacted and who faces the hardest journey? The financial crisis has taken a heavy toll on government finances as the authorities stepped in to bail out institutions and support their economies. At a macro level the surge in private debt up to the crisis has largely been replaced by public borrowing on nations balance sheets. Recent estimates from the IMF put the collective budget deficit for the G-20 advanced economies at 7½% of GDP in 2011 with the US, UK and Japan all running at around 10%. For the G-20 outstanding government debt was estimated to have been close to 110% of GDP last year and rising. This compares with less than 80% in 2006, and around 60% in many economies. In this Talking Point we look at the action required to return government finances to a pre-crisis level and the challenges this poses to growth. We also ask who faces the greatest challenge and whether markets reflect this. Key points Returning to pre-crisis public debt levels looks hopelessly unrealistic given the turnaround required to stabilize debt ratios, let along bring them down. Taking into account the current level of debt, the structural budgets currently in place and the increasing burden placed on public finances by demographic trends, developed nations such as the US, Japan, UK and Eurozone members require significant consolidation measures to improve the public finances. The task of bringing debt levels down is made more difficult by the number of countries who need to tighten policy simultaneously. The effects of co-ordinated fiscal consolidation by countries generating the majority of global GDP is likely to place a limit on world growth, absent a major technological innovation or policy transformation in the emerging world. The problem is made worse in the current environment by the inability of monetary policy to stimulate demand and provide an offset to the fiscal headwind. Our cross country analysis of who faces the greatest challenge does not seem to be reflected in the pricing of default by the market. The accepted explanation for this is that markets are discriminating on the basis of countries which can print their own currency (Quantitative Easing). The danger though is that this leads to inflation - a risk that investors seem to be ignoring in overlooking the scale of the fiscal challenges faced by the major economies.
How much tightening is needed? As a starting point we look at the results of an IMF study 1, which estimated the task facing the authorities across the globe in returning public debt ratios to pre-crisis levels. The focus of the IMF estimates is to attempt to return gross public debt-to-gdp ratios to the lower of 60% or end-2012 levels 2, which it targets through a specific level of the structural or cyclically-adjusted primary balance (CAPB). The CAPB is simply the overall budget deficit excluding interest payments, adjusted to reflect the position of the economy within its cycle. Under the IMF s framework, in order to achieve the target ratio by 2030 countries need to achieve a certain CAPB by 2020, which they are then expected to maintain throughout the decade to 2030.This turnaround in CAPB s, shown below in chart 1, provides a daunting challenge for many of the world s largest economies. For instance, the US would need to turn an estimated CAPB of -6.2% of GDP in 2010 into a surplus of around 5.1% in just ten years. Bearing in mind these are cyclically adjusted numbers, and therefore not allowing us to rely on improvements in the cyclical performance to boost the outlook, this adjustment is required to come from significant fiscal tightening and/or a dramatic increase in the trend level of growth. Currently, neither looks to be on the table. The UK faces a similar challenge with a required swing in borrowing of 9% of GDP needed by 2020. By contrast emerging economies, Brazil, Russia and China have less adjustment as do the more advanced Germany and Switzerland. Chart 1: Required consolidation by country for 60% debt-to-gdp (2010 to 2020) Source: IMF Fiscal Monitor, April 2011 The story gets even gloomier if the worsening demographics faced by the majority of the developed world are taken into account. Adding estimates for the forecast increase in age related spending required by 2030, primarily through pension and healthcare provisions, leaves many nations with a near insurmountable task to achieve the IMF s target. 1 Shifting Gears: Tackling Challenges on the Road to Fiscal Adjustment IMF Fiscal Monitor; April 2011 2 For Japan, the target is 80% net debt/gdp by 2030; for Brazil, Russia, India and China the target is the lower of 40% gross debt/gdp or end-2012 levels. 2
Chart 2. Total consolidation - taking account of age related spending Source: IMF Fiscal Monitor, April 2011 While certain structural reforms would provide double dividends in terms of consolidation (raising the pension age, for instance, both reduces pension liabilities and increases the size of the labor force and broadens the tax base), other attempts to reduce long-term liabilities (such as limiting healthcare expenditures) may not be politically viable. In this instance, either significant consolidation will be required in other areas of fiscal budgets or large public debt ratios will become the norm. How would this impact growth? Clearly fiscal tightening in the developed markets will produce strong headwinds to world economic growth at an already unfavorable phase of the economic cycle. The extent of this drag on growth will in part be determined by the composition of the consolidation taking place between spending and revenue. Fiscal multipliers - the extent to which changes in spending and taxation affect real output - are difficult to predict with great accuracy at the best of times, but two factors suggest they may have become more powerful. First, the effect of fiscal policy is likely to be magnified in the current environment as, with interest rates at zero and households continuing to de-leverage, there is limited scope for monetary policy to offset higher taxes/ lower public spending. Recent research finds that the inability of monetary policy to offset fiscal changes greatly magnifies the multiplier, particularly on the spending side 3. Second, many estimates of the growth impact of fiscal consolidation neglect the effect of co-ordinated policy where several countries are tightening together, but work by the OECD suggests that the impact is likely to be significantly greater than autonomous tightening. This is unsurprising - in an age of austerity where domestic demand from corporates, the public sector and private households is weak, we would hope that an offset could be driven by net 3 Lawrence Christiano, Martin Eichenbaum& Sergio Rebelo When is the Government Spending Multiplier Large? NBER Working Paper, October 2009 David Cook and Michael B Devereux Optimal Fiscal Policy in a World Liquidity Trap European Economic Review, May 2011 3
exports, but this is unlikely during co-ordinated tightening. The lack of support from a weakening exchange rate against major trading partners (since not all currencies can devalue simultaneously) is likely to cause a serious limit on global growth. Table 1: OECD Estimates of simultaneous fiscal adjustment Source: OECD Global Model, OECD Preparing Fiscal Consolidation According to OECD estimates, the impact on the US of a unilateral consolidation of 1% of GDP will be to reduce output by 0.9%, but multilateral tightening across the OECD of 1% of GDP would reduce US output by 1.2%, a significant increase in the effects of consolidation. Given that the above estimates of required fiscal consolidation by the IMF involve nearly all the major developed economies tightening significantly at the same time, these estimates suggest that we are likely to see stunted economic growth in the foreseeable future due to fiscal headwinds. The IMF s analysis of how much tightening is needed is more illustrative than prescriptive in its nature, but it seems highly likely that to even get close to the targets suggested would create a sustained period of anemic global growth. Even this may understate the problem as structural budget deficits may be greater than indicated due to a slowdown in the trend rate of growth. The depreciation of human and physical capital, driven by several years of under-utilization, and the likely future limits on credit availability will be responsible for lower potential output growth in the upcoming years. To the extent that authorities cling to an out-dated overestimate of their potential growth rate, which leads them to report optimistic cyclically-adjusted budget figures, the eventual consolidation needed is greater. Who faces the hardest journey? We have ranked sixteen countries from best positioned (1) to worst positioned (16) across a range of six categories such as initial debt level, consolidation required, cost of funding and flexibility of monetary policy to give an indication of which countries face the hardest task in returning to a sustainable fiscal path (chart 3). Grouping these together those with the biggest challenge include the US, UK and Japan as well as Italy and Spain, whilst at the other end of the spectrum China and Sweden face a less formidable task. 4
Chart 3: Mean ranking of countries and CDS cost Black bars show cost of 5 year CDS (%). Red, yellow and green bars show mean ranking Source: Schroders, Bloomberg Our scores are designed to capture long run fiscal pressures rather than signal an imminent crisis, nonetheless it is instructive to compare them with current market perceptions of the risk of default as measured by the cost of a Credit Default Swap (CDS). We have seen market pressure increase on several of the nations in the most perilous positions such as Italy, Spain and to a lesser extent Belgium, and this is reflected in the elevated cost of insuring against the default of these issuers. However, the US, Japan and UK enjoy relatively low premiums despite facing a similar, if not an even greater task in turning around their fiscal position. The cost of CDS on these countries is also lower than in countries with more favorable scores. The general consensus is that the market is currently distinguishing between countries on their ability to mint their own currencies rather than focusing on the fiscal challenge they are facing. The danger for the market in taking this approach is that whilst a country that can print its own currency should always be able to pay its creditors, this process will ultimately lead to devaluation and inflation unless action is taken to bring the fiscal position under control. For investors concerned with real returns this is a default in all but name. Investors seem to be ignoring these risks in overlooking the scale of the fiscal challenges faced by the major economies. 5
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