Posted by Jan Gottschalk
This IMF Staff Position Note (SPN/10/12) was prompted by the observation that default prophecies in market commentary did not seem to take into account some important differences between the situation currently faced by some advanced countries and that faced by countries that defaulted in the past. The debate over these countries’ fiscal future is not of mere academic interest but has real consequences: with much of the market commentary portraying default as inevitable, auctions of government paper in Europe are followed with apprehension and—in spite of progress on fiscal adjustment—spreads in some of the European peripherals remain high. In a nutshell, this note argues that markets are significantly overestimating the risk of default.
The key argument is that the fiscal challenge faced today by the advanced economies is not the interest bill, but large primary deficits. In fact, for countries currently experiencing market pressures, marginal rates of interest are high, but—with long maturity structures—average interest rates on the stock of government debt remain relatively low. Indeed, average interest rates and the projected interest–growth differential in today’s advanced economies are lower than for the economies that defaulted over the past two decades. More generally, debt structures in the advanced economies are more resilient to abrupt changes in market perceptions than was the case for emerging economy defaulters of the past. For example, today’s advanced economies have a larger share of long–term, non–indexed, domestic currency debt.
As the problem is not the interest bill, the needed fiscal adjustment would not be much lower even if a restructuring were undertaken with a large haircut, because default would reduce the interest bill, but the large primary deficit problem would remain. In fact, default would force countries to reduce their primary deficits to zero immediately, or even to run a small primary surplus, as defaulting shuts them out of the markets, leaving them unable to borrow for financing deficits.
In response, some commentators have suggested that, well, for a few years there will be fiscal adjustment but as soon as countries reach primary balance they will still have a large interest bill and that is when default would become irresistible. But there is little evidence for such behavior among advanced economies. The paper shows that several advanced economies found themselves exactly in that situation, and none chose to default. Once countries have incurred the initial pain of adjustment, they persevere and go to great lengths to avoid default.
This is not to say that the task ahead is easy. On the contrary, the requisite fiscal adjustment for many advanced countries in the years ahead is indeed very large. However, it is not unprecedented. During the past three decades, there were 14 episodes in advanced economies and 26 in emerging economies when individual countries adjusted their structural primary balance by more than 7 percentage points of GDP.
To conclude, a large fiscal adjustment is unavoidable for today’s advanced economies and a restructuring would be no substitute for that. A restructuring would probably end up as a distraction from the fiscal and structural reforms that are truly necessary for a durable increase in economic growth.
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