Looking ahead
| Author | Carlo Cottarelli/José Viñals |
| Position | Director of the IMF’s Fiscal Affairs Department/Financial Counsellor and Director of the Monetary and Capital Markets Department |
| Pages | 20-23 |
Page 20
Countries must begin now to devise economic strategies to accompany recovery
THE global economy is showing signs of improvement—there is light at the end of the tunnel—but prospects remain highly uncertain. So while it is too early to exit from crisis-response policies, it is vital to begin defining a strategy to accompany recovery. Failure to do so would destabilize expectations and weaken the effect of the fiscal and monetary support now being provided.
Fiscal authorities and central banks have fought the global economic downturn by replacing sagging demand from consumers and businesses and by providing substantial support for the financial and other key sectors. As a result, their balance sheets have grown—and have grown riskier.
Not only did the crisis-related policies weaken public balance sheets, the surge in public debt took place while health and pension spending were increasing because of aging populations—especially in advanced economies. The ongoing debt surge has overwhelmed more than a decade of efforts in many countries to strengthen public budgets in anticipation of an aging population. An easing of the monetary policy stance and the use of unconventional central bank policy measures may have been essential to preventing the collapse of the financial sector, but the substantial acquisition of impaired assets has exposed a number of central banks to potential losses, and the quasi-fiscal nature of some of these policy actions may lead to political pressures on central bank independence.
What does this mean for policies to accompany recovery? First, the fiscal problems that stem from population aging must be attacked with greater vigor. Second, the capacity of central banks to control inflation must be preserved and even enhanced. Third, policies will have to foster strong and sustainable economic growth by restoring private sector control of the financial and other sectors to allow competition and the improvement in productivity this will bring.
Three factors are contributing to a major weakening in the state of the public finances:
Page 21
• the plunge in economic activity and the slowdown in economic growth in the next few years compared to pre-crisis projections;
• fiscal stimulus packages; and
• government intervention operations in support of the financial sector.
The ratio of debt to gross domestic product (GDP) is expected to rise to 115 percent in the advanced economies in 2014, based on the July WEO Update projections, from 75 percent in 2007. Debt ratios will be close to, or exceed, 90 percent by 2014 in all G-7 economies except Canada (that is, France, Germany, Italy, Japan, the United Kingdom, and the United States).
This surge in public debt is unprecedented during peacetime. Major increases occurred in the 1930s, but started from lower levels (for example, about 20 percent of GDP in the United States in 1929). Moreover, demographic trends were favorable in the 1930s.
Only a relatively small portion of the debt surge in advanced economies—6 percent so far—is due to financial support operations. The bulk of the debt increase stems from fiscal stimulus and, especially, tax revenue losses associated with the recession and the collapse in asset prices. Thus, the fiscal problem cannot be solved simply by unwinding financial support operations.
Failure to address the trend of rising debt could lead to concerns that the debt will ultimately be “inflated away” or that default is inevitable. Interest rates would then rise, making the fiscal problem worse and potentially killing the recovery; debt maturities would shorten; and refinancing crises could occur. These concerns would be especially severe where perceived risks of currency depreciation are high.
Consensus forecasts and market indicators of expectations derived from inflation-indexed bonds in major advanced countries suggest that inflation is expected to remain low over the next decade. And, while interest rates on government paper have been on the rise for some months, they also remain low. Markets, however, often react late and suddenly, so the benign market response to date does not provide firm reassurance for the future.
Some commentators have suggested that inflation—which could occur if central banks are unable to shrink their balance sheets and tighten monetary policy fast enough when the recovery begins—could play a helpful role in reducing the debt...
To continue reading
Request your trial