Shocks to the Purse

• Author: Benedict Clements, Xavier Debrun, Brian Olden, and Amanda Sayegh

Shocks to the Purse Finance & Development, December 2016, Vol. 53, No. 4

Benedict Clements, Xavier Debrun, Brian Olden, and Amanda Sayegh

Governments must understand and manage risks to public spending and debt

A key government task in managing public finances is to forecast how government revenues, expenditures, budget deficits, and public debt will evolve over time. Armed with this knowledge, policymakers can determine whether changes in tax and spending policy are needed to maintain overall economic stability.

Recent experience, however, indicates that public finances frequently evolve in unexpected ways. Adverse events often cause higher budget deficits and larger increases in public debt than anticipated. In other words, public finances are subject to “fiscal risks”—events that may cause fiscal outcomes to deviate from expectations or forecasts. These can arise from unanticipated macroeconomic developments (such as a slowdown in economic activity) or the realization of “contingent liabilities”—obligations that are triggered by an uncertain event. These can be either explicit liabilities that are legal in nature (such as government loan guarantees to farmers when there is a crop failure) or implicit liabilities, public expectation of government responsibility not established in law (for example, to bail out banks after a financial crisis).

A better understanding of fiscal risks and how to manage them is critical if countries wish to avoid large and unexpected increases in public debt that knock fiscal policy off course.

Fiscal risks To examine the size and nature of fiscal risks countries have confronted, the IMF undertook a comprehensive survey (2016), looking at fiscal “shocks”—that is, the point at which fiscal risks become reality and affect public finances—to government debt in 80 countries over the past quarter century. The survey confirmed that fiscal shocks are large and frequent, with countries experiencing an adverse shock of 6 percent of GDP once every 12 years on average and a large event—costing more than 9 percent of GDP—every 18 years on average (see chart). Because these figures are only averages, the size and frequency can vary greatly from country to country.

Fiscal shocks have a number of causes. Sharp downturns in economic growth (macroeconomic shocks) and financial sector bailouts have been the most damaging, averaging about 9 percent of GDP per event. But legal claims against the government, bailouts of troubled state-owned enterprises, and claims from subnational governments (such as provinces, states, or cities) have also imposed large fiscal costs—averaging about 8 and 3½ percent of GDP, respectively. While natural disasters, on average, cost about 1½ percent of GDP, these events are more frequent and the impact is much higher for disaster-prone countries. In some cases, fiscal costs have been...