Getting Debt under Control

• Author: Emanuele Baldacci, Sanjeev Gupta, and Carlos Mulas-Granados
• Position: a Deputy Division Chief and is a Deputy Director, both in the IMF's Fiscal Affairs Department. is a Professor of Economics at Complutense University, Fellow of the ICEI Research Institute, and Executive Director of the IDEAS Foundation in Madrid.

THE severe financial crisis that hit the world economy in 2008 not only caused a large decline in output and brought about an uncertain economic outlook, it also harmed many countries’ public finances. Its legacy can be seen in the massive buildup of public debt around the world—more so in advanced than in emerging market economies.

In the advanced economies, public debt is projected to reach an average of 108 percent of gross domestic product (GDP) at end-2015. This is about 35 percentage points more than at end-2007, before the onset of the global crisis. That high a level of debt has not been seen in these countries since just after the end of World War II (see Cottarelli and Schaechter, 2010) and reflects in large part a permanent loss of revenue from the bursting of the asset price bubble, lower potential output, and countercyclical fiscal stimulus. Public debt had started to pile up before the crisis in these countries, mostly because of rising spending, but the increase in the aftermath of the global recession has been rapid and large, as some countries borrowed at wartime levels.

In the absence of policy changes, the fiscal position of advanced economies is projected to get even worse. Population aging is likely to exert significant upward pressure on health care and pension spending (IMF, 2010), creating a tide against which advanced economies will be forced to swim, even as they seek to implement policies aimed at reducing their debt burden (fiscal consolidation).

In emerging economies, the impact of the crisis has been milder and underlying fiscal conditions stronger than in advanced economies (with some exceptions, such as central and eastern European economies). Nonetheless, emerging economies have less tolerance for debt, because their ability to raise revenue is more limited—for example, their large informal sectors escape taxation—and their tax bases are more volatile than those in advanced economies. Emerging economies remain exposed to spillover from debt problems in advanced sovereigns and face possible problems refinancing existing debt as it comes due.

Crises spawn debt accumulation

High public debt levels in the wake of financial crises are not new. Studies have shown that banking crises have large fiscal consequences both in advanced and emerging market economies. For example, Rogoff and Reinhart (2009) found that in a sample of historical episodes, government debt on average rose by 86 percent in the three years following a banking crisis; Laeven and Valencia (2008) report that the average fiscal cost of banking crises was slightly less than 15 percent of GDP in the past three decades. Furthermore, the average increase in the ratio of public debt to GDP was about 40 percentage points during these episodes (see Baldacci, Gupta, and Mulas-Granados, 2009).

What is unprecedented this time is that many countries—those with the biggest slice of global output—have been piling up government liabilities in a fragile global economic environment amid a high degree of uncertainty. This can be problematic for four reasons.

First, high debt levels raise solvency risks and increase the cost of borrowing for sovereigns. Second, high debt can constrain the ability of a government...