Fiscal fragility: What the past may say about the future

Joshua Aizenman, Gurnain Pasricha

07 November 2010

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The global crisis has brought to the fore the fiscal vulnerabilities of OECD countries, and in particular, some countries of the Eurozone such as Greece, Ireland, Italy, Portugal, and Spain (Baldwin et al. 2010 and Corsetti 2010). The US faces similar fiscal challenges, although its ability to obtain relatively cheap funding of its debt allows it to delay dealing with them.

During the “Great Moderation” period, the sharp decline in the price of risk and the risk-free interest rate fostered a growing sense of complacency in Europe and the US regarding the exposure to fiscal challenges (Wyplosz 2009). The 2008-2009 global crisis made clear that the spell of the Great Moderation may have been a transitory hiatus.

In a recent paper (Aizenman and Pasricha 2010), we evaluate the possible distribution of the fiscal burden of debt for each OECD country in 2010, based on the historical realisations of the real interest rate and real GDP growth differential during the past four decades. The gap between the real interest rate and the real growth rate measures the flow cost of the public debt, which has been dubbed the “snowball effect”, has been applied to evaluate adjustment in Europe (Alcidi and Gross 2010).

Specifically, a public-debt-GDP ratio, d, grows over time at a rate equal to the gap between the real interest rate on the debt, r, and the growth rate of the real economy, g, assuming a primary balance of zero. Henceforth we refer to the gap (r – g) as the “flow cost” of public debt. The fiscal burden, associated with a given public-debt-GDP ratio d, equals (r-g)*d. We evaluate, for a given future projected public debt/GDP, the possible distribution of the fiscal burden, if the distribution of the flow cost of funding debt in future decades resembles that in past decades. While there is no obvious threshold of public debt/GDP that would indicate a funding crisis, a higher burden of public debt [(r – g)*d] increases the need for fiscal adjustment in the form of some combination of lower government expenditure and transfers, and higher taxes.

Lessons from the past

Looking at the past to provide insight about the future has been a somewhat neglected perspective, both before and after the crisis. The low real interest rate and the moderate growth rate of OECD countries during the era of the “Great Moderation” implied a very low fiscal burden. One might interpret the Great Moderation as an enduring state instead of a lucky draw induced fiscal laxity. Likewise, derailing short-term economic stabilisation based on projections of permanently gloomy growth rates today may be an equally invalid perspective. Taking the past decades as guidance for possible future developments helps to avoid the danger of framing the future in terms of a unique scenario, a strategy that may lead to either too optimistic or too pessimistic priors, possibly magnifying the resultant macro volatility. Looking at the past data is useful, as it indicates that growth rates and real interest rates are highly volatile over time, with low correlations across decades (Easterly et al. 1993 and Mishkin 1981). In sum, fiscal projections may be alarmist if one jumps from the priors of a Great Moderation to the prior of a permanently higher future burden. This suggests that countries exposed to heightened fiscal vulnerability may consider both short-term stabilisation and forward-looking fiscal reforms.

Average flow costs of public debt since 1970

We first collect data on the current average effective maturity of general government debt for OECD countries (Table 1 in the Appendix).1 We then use the series of average annual real interest rates on the government debt of maturity that most closely corresponds to the actual effective maturity of general government debt. Combined with the growth rate of real GDP, we compute the annual flow cost, (r-g) for each country.2 The annual series of (r-g) is then averaged over five-year intervals starting in 1970. The average flow costs for the five-year periods are shown in Table 2 in the Appendix. The table illustrates the large swings in flow costs for each country, indicating that the debt burden associated with any given d can vary considerably.

In order to evaluate the various outlooks for the future debt burdens for OECD countries, we use the World Economic Outlook (IMF 2010a) projections of gross general government debt-GDP ratio, d, for each country, for the year 2015 (Table 1).3

For the projected debt-GDP ratios, we compute the implied debt burdens for each country, for each of the scenarios in Table 2. Figure 1 plots, for each country, the best case, the worst case, the average of the best- and the worst-case scenarios and the average debt burden over all years for which data are available. The countries are sorted, from left to right, by the last of these series, i.e. by their average projected debt burden using all the historical realisations of (r-g).

Figure 1. General government gross debt burden of selected OECD economies: Historical best-case, worst-case and average scenarios (using projected 2015 debt/GDP)

Note: Countries are sorted by the lowest to highest average over all years. The gross debt burden representing the lowest (best scenario) and the highest (worst scenario) flow costs is calculated by taking the lowest and the highest historical values, respectively, of the r-g from Table 1, and multiplying it with the projected debt to GDP ratio. Real rates for Austria are based on the average return on bonds with maturities greater than one year for 1970-1982, and with a 9-10 year maturity for 1983-2010. Real rates for all other countries are the real rates on the maturity closest to the most recent average maturity of general government debt in Table 2. The growth rate of GDP deflator was used to convert nominal interest rate to real rate.

We define the best-case scenario as the one with the lowest flow cost, based on the historical average flow costs in Table 2. The worst-case scenario is analogously defined. All but three OECD countries in Figure 1 will have a negative debt burden in the best-case scenario.4 A negative debt burden implies that the government can run a primary deficit and yet keep the debt/GDP ratio constant (or more precisely, that it would have to run a primary deficit in order to keep the debt/GDP ratio constant, which would otherwise shrink). In fact, should the (r-g) turn out to be negative, the higher the debt/GDP ratio, the lower the debt burden, suggesting that higher debt level need not always be associated with a greater fiscal burden. These calculations highlight the pitfalls in focusing only on projected debt to assess fiscal sustainability. Should the best-case scenario prevail, Italy’s debt burden would be lower than that of Sweden and Denmark, even though its projected debt is 124.7% of GDP, while Sweden and Denmark have low projected debts of 37.6 and 49.8% of their GDP, respectively. In the best-case scenario, the US debt burden would be lower than that of UK and Canada, although the projected US debt is higher than both countries.

Most OECD countries have worst-case projected debt burdens over 2% of GDP, which, if realised, would likely be onerous, given their population dynamics and the commitments of the welfare state. The US has an above-average debt burden in the worst-case scenario, of about 3.9% of GDP. Greece by far has the highest debt burden in the worst-case scenario, of about 12.4% of GDP. Another interesting case is that of Portugal, which has recently seen a cut in its sovereign rating by all three international ratings agencies, but whose debt burden, at about 1.5% of GDP, is moderate relative to peers even in the worst-case scenario– this is before taking into account the budget cuts announced on 10 May 2010.

The prudence of fiscal adjustment increases with the uncertainty of the future debt burden, since greater uncertainty implies a greater likelihood of bad outcomes. In Figure 2, we rank the countries by the difference between their historical worst- and best-case scenarios. The country with the greatest uncertainty in the future debt burden is Japan, followed by Greece, Belgium, Ireland, and France – the US has the 11th highest uncertainty in terms of (worst-best) scenarios. While most countries that have low projected debt ratios occupy the lower end of the scale, that is, they have lower uncertainty in future debt burdens, this uncertainty does not increase monotonically with the size of projected debt. The US projected debt for 2015 is higher than the projected debt of seven of the countries that face greater uncertainty in debt burden than the US. Figure 2 also reports the standard deviation of the annual series of (r-g), times d. The size of the uncertainty faced by most countries, those with high projected debt and those with relatively lower projected debt, indicates a need for caution in formulating short-term policy based on overtly pessimistic scenarios, and also for forward looking fiscal reforms.5

Figure 2. Uncertainty: (worst – best) scenarios and standard deviation of annual (r-g) times debt/GDP

Note: Countries are sorted by the (Worst-Best) Scenarios. The gross debt burden representing the lowest (best scenario) and the highest (worst scenario) flow costs is calculated by taking the lowest and the highest historical values, respectively, of the r-g from Table 1, and multiplying it with the projected debt to GDP ratio. Real rates for Austria are based on the average return on bonds with maturities greater than one year for 1970-1982, and with a 9-10 year maturity for 1983-2010. Real rates for all other countries are the real rates on the maturity closest to the most recent average maturity of general government debt in Table 2. The growth rate of GDP deflator was used to convert nominal interest rate to real rate.

Several caveats apply to the above analysis. In so far as the debt projections do not include unfunded liabilities, the actual debt burden may be higher in all scenarios. The debt burden, or the primary balance needed to keep the debt/GDP ratio constant, is computed here using gross government debt (due to easier data availability), but an accurate measure of the debt burden would use net government debt. While these considerations would change the actual numbers of projected debt burdens, they wouldn’t undermine the overall message, which is that the debt burden, (r-g)*d, depends on both the realisation of (r-g) and on the size of d.

Conclusions

Our analysis highlights the importance of future real interest rates and growth rates in determining the debt burden, particularly for countries with high projected debt-GDP ratios. If short-term stabilisation during or in the aftermath of a financial crash and a deep recession, increases future growth and therefore the possibility of a favourable future (r-g), the additional debt incurred for such stabilisation may not translate into excessively high future flow costs of public debt.

However, we also emphasise the uncertainty in future debt burdens facing OECD countries and the fact that this uncertainty is likely to increase with the size of the future debt-GDP ratios. Prudent fiscal policy may therefore involve both short-term stabilisation and forward-looking fiscal reforms. Yet, going overboard with only one of the two adjustments (i.e., focusing only on short-term stabilisation, or only on forward looking fiscal reforms in the form of early belt tightening) may increase vulnerabilities. Focusing only on stabilisation in the form of fiscal stimulus and monetary easing raises concerns about the cost of government borrowing (as in the case of Greece and the periphery countries in the Eurozone). Focusing only on belt tightening today may delay the global recovery. Finding the proper balance remains a work in progress.

The views in this article are those of the authors. No responsibility for them should be attributed to the Bank of Canada or the National Bureau of Economic Research.

References

Aizenman, Joshua and Gurnain K Pasricha (2010), “Fiscal fragility: what the past may say about the future”, NBER Working Paper 16478.

Alcidi, Cinzia and Daniel Gros (2010), “Is Greece different? Adjustment difficulties in southern Europe”, VoxEU.org, 22 April.

Baldwin, Richard, Daniel Gros, and Luc Laeven (2010), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.

Corsetti, Giancarlo (2010), “Fiscal consolidation as a policy strategy to exit the global crisis”, VoxEU.org, 17 June.

Easterly, William, Michael Kremer, Lant Pritchett, and Lawrence Summers (1993), “Good Policy or Good Luck? Country Growth Performance and Temporary Shocks”, Journal Of Monetary Economics, 32:459-83, December.

IMF (2010a), “Rebalancing Growth”, World Economic Outlook, International Monetary fund, April.

IMF (2010b), “Navigating the Fiscal Challenges Ahead”, Fiscal Monitor, International Monetary fund, May.

Mishkin, Frederic S (1981), “The Real Interest Rate: An Empirical Investigation”, in The Costs and Consequences of Inflation, Carnegie-Rochester Conference Series on Public Policy, 15:151-200 and 21:3-218.

Obstfeld and Rogoff (1996), Foundations of International Macroeconomics, MIT Press.

Wyplosz, Charles (2009), “Greece: The party is over”, VoxEU.org, 14 December

Appendix

Table 1. Summary statistics on general government gross debt by country
Average effective debt maturity (years) Projected 2015 debt as % of GDP

Source: Average effective maturity from Bloomberg and national sources. Projected debt/GDP percentages are IMF staff calculations, as reported in IMF (2010a) and IMF (2010b).

Table 2. Average difference between real interest rate and real growth rate

a. Eurozone OECD Economies

*Real rates for Austria are based on the average return on bonds with maturities greater than one year for 1970-1982, and with a 9-10 year maturity for 1983-2010

b. Non-Eurozone OECD Economies

Note: The real interest rate is the average annual real interest rate on general government debt of maturity most closely corresponding to the latest available average maturity of general government debt. These average maturities are listed in Table 1. The growth rate of GDP deflator was used to convert nominal interest rate to real rate. For New Zealand, the 1985-89 values were computed using the growth rate of the OECD forecast series for real GDP. Source: Authors' calculations using data from OECD, BIS, EU and national sources.


1 The effective maturities in Table 1 correspond to the year 2010 or the latest available values. The data are sourced from Bloomberg, BIS, EU and national sources. The average OECD country had an effective maturity of general government debt of around 6 years. UK debt had the highest maturity, about 14 years and Hungary the lowest, of 3 years.
2 The nominal interest rates on debt were converted into real interest rates by subtracting the rate of growth of GDP deflator.

3 The figures are as reported in IMF (2010b).

4 Only Italy, Denmark and Sweden have positive debt burdens under the historical best case.

5 In Aizenman and Pasricha (2010), we also estimate uncertainty after excluding periods of highest g and lowest r for each country. The overall message from this remains unchanged.

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Topics:  Macroeconomic policy

Tags:  fiscal policy, Fiscal crisis, Eurozone crisis, government debt

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER

Senior Analyst at the Bank of Canada

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