How Grim a Fiscal Future?

• Author: Mark Horton
• Position: a Division Chief in the IMF's Fiscal Affairs Department.

THE abrupt deterioration of fiscal positions in advanced economies, emerging markets in central and eastern Europe, and elsewhere has been a key consequence of the global financial crisis. These large budget deficits have caused a sharp rise in public debt in advanced economies that likely will continue through the next five years, pushing government debt well above levels seen at any time since the end of World War II (see chart).

Sharply elevated deficit and debt levels may well place pressure on interest rates and undermine economic growth in these economies and could spill over to other emerging and developing economies. Financial markets have become increasingly unsettled both by the surge in debt and by uncertainties about future taxation and expenditure policies, particularly in Europe. To preserve the recovery, markets must be reassured. In the short run, policymakers face a crucial dilemma. If they consolidate too soon—that is, they take actions to reduce budget deficits in the near term—they could kill the recovery. But inaction or policy mistakes could lead to concerns about further debt accumulation and ultimately reignite a crisis.

Those are the short-run problems. The longer-run issues may be even more difficult. A major consolidation—reining in spending and increasing revenue—will be needed to restore fiscal positions and to reduce debt to more prudent levels to ease pressures on interest rates and growth. The need for fiscal adjustment is particularly acute in advanced economies, but consolidation is also needed for many emerging and developing economies. The path will be steeper in many countries where intense spending pressures will arise from aging populations (see “A Hidden Fiscal Crisis,” in this issue of F&D).

Hit hard by the crisis

Budget deficits worldwide have grown dramatically as a result of the global financial crisis. The crisis hammered economic activity in advanced economies and devastated trade and financial flows to emerging and developing economies (although capital inflows have recovered in some regions and emerging market countries). In the mid-2000s, some country authorities reacted to exceptionally buoyant tax revenues by cutting taxes or by increasing spending in sensitive categories, such as wages and transfer payments, including pensions. The falloff in economic activity during the crisis caused tax revenues to decline markedly, and many countries also increased spending to shore up their economies. In the advanced economies, budget deficits rose, on average, about 8 percentage points, from 1 percent of gross domestic product (GDP) in 2007 to nearly 9 percent of GDP in 2009. Deficits exceeded 10 percent of GDP in several countries—Greece, Iceland, Ireland, Japan, Spain, the United Kingdom, and the United States. Advanced economy fiscal balances are likely to worsen further in 2010, driven by continued weaknesses in revenue collections and stepped-up stimulus in Germany and the United States (and higher U.S. defense spending).

Fiscal positions should begin to improve in 2011, as the recovery continues and crisis-related stimulus is withdrawn. Beyond the withdrawal of stimulus, other adjustment measures are planned in most countries. However, on average, budget deficits in advanced economies will remain substantial—5 percent of GDP or higher through 2015—unless further measures are taken. The persistence of sizable deficits reflects, in large part, sustained revenue losses from the steep decline of potential GDP during the crisis—with the financial and real estate sectors taking a permanent hit. Higher spending on health, pensions, and interest payments is another factor underlying the high deficits. The result will be a nearly 40 percentage-point rise in advanced economy public debt ratios during 2007–15, two-thirds of which is linked to the output collapse and the hit on tax revenues.

Doing better than advanced economies

The impact of the crisis on public finances in emerging and developing economies has been more muted, except for economies in central and eastern Europe. For emerging...