Paying the Piper

• Author: Carlo Cottarelli
• Position: Director of the IMF's Fiscal Affairs Department
• Pages: 27-30

Page 27

The role of medium-term fi scal policy in rebounding from the crisis

Massive and unprecedented intervention by governments in the United States and other advanced economies aims to restore economic growth and clean up the fi nancial sector. But the impact of the crisis on public finances is substantial: the increase in government debt (as a share of GDP) in advanced economies is projected to be the largest and most pervasive since World War II. And this increase is taking place against the background of preexisting long-run pressures from pension and health care spending, especially in countries that will soon experience a rapid shift toward an older population.

Governments have had little choice but to intervene to save the financial system from collapse, and to provide fiscal stimulus to counter the sharp contraction in private sector demand. And we may not be finished yet. It is not difficult to imagine a scenario in which higher interest costs and lower economic growth snowball into even higher debt-to-GDP ratios, ultimately leading investors to raise questions about the sustainability of government finances around the world. So far, in general, this has not happened (although credit default swap spreads have been on the uptick in many countries), and the perceived likelihood of default remains small. But because investor confidence in governments' creditworthiness has been key in preventing a complete meltdown of the financial and economic system, preserving such confidence is of paramount importance. Perceptions of fiscal solvency problems, pushing interest rates up as debt holders demand a higher risk premium, would also undermine the effectiveness of fiscal stimulus measures.

So how should governments respond in the wake of a crisis that is leaving nations with far more demands on the public purse? This article presents the quantitative findings of a recent study by the IMF's Fiscal Affairs Department about the direct and indirect costs of the financial crisis. We examined the size of interventions in the financial sector; indirect, nondiscretionary costs, such as those from the impact on revenues of the economic slowdown and the collapse in asset prices; and indirect costs from discretionary fiscal stimulus, intended to jump-start economic growth. The crisis is also placed in a broader context by (1) comparing it with previous episodes of major debt accumulation and contraction in some of the largest economies; and (2) comparing the costs of the ongoing crisis with the preexisting, and far more severe, long-run challenges from aging populations. The article concludes by summarizing a possible strategy whereby fiscal policy can foster the resumption of normal economic growth while maintaining public sector solvency, and by indicating a few key areas where the IMF can play a constructive role.

Mounting direct costs and liabilities

The unprecedented scale and nature of the financial crisis have prompted policymakers to be remarkably inventive in their efforts to support troubled financial institutions and markets. These interventions have essentially involved capital injections, asset purchases, or direct lending or guarantees by governments or central banks. In most cases, operations undertaken directly by governments have led to increases in gross public debt, though notPage 28 necessarily a change in net worth or the overall defi cit, after taking into account the related acquisition of assets-at least to the extent that specific asset transactions reflect actual market value, without any subsidy element.

The combined gross cost of capital injections and purchases of assets, plus direct lending by governments has amounted to 5 percentage points of GDP, on average, for the advanced economies in the Group of Twenty (G-20) (see box). Over time, however, the net fiscal impact will depend on the recovery rate from the sale of the acquired assets. Experience from previous banking crises suggests that recovery rates on these operations vary widely, and recoveries only become significant once economic growth has resumed on a solid footing.

Beyond these operations, which have an immediate impact on gross government debt, new contingent liabilities in the form of central bank lines of credit and guarantees for bank deposits have been far larger. Indeed, most countries...