Posted by Andrea Schaechter
Today’s record public debt levels in most advanced economies are not only a direct fall-out from the global crisis. Public debt has ratcheted up over many decades. It has been used in most of the G-7 countries as a one-way shock absorber—rising in bad times but not declining much in good times. A recent paper by Cottarelli and Schaechter (2010) looks at the long-term trends in public finances in G-7 economies and reviews policies to address the formidable challenge of reducing debt ratios at a time when age-related spending will put additional pressures on public finances.
Higher public debt and larger public sectors – What are the causes
Following World War II, the public debt burden in the G-7 countries on average declined rapidly during the 1950s and 1960s, as strong growth helped lift its weight in the countries that had won the war (while public debt had already been eroded by inflation in the countries that lost it). In 1974, the trough was reached with an average gross general government debt-to-GDP ratio of 35 percent. Since then public debt has ratcheted up on average for the G-7 economies. By 2007, ahead of the crisis, the average debt ratio had more than doubled to over 80 percent of GDP (Download Figure 1). An exception to the strong upward debt trend among the G-7 countries was Canada, where, as a result of a major fiscal correction in the 1990s, the debt burden was lowered by over 35 percentage points. On average, however, the G-7 countries entered the crisis with historically high levels of public debt. As a result of the crisis, and largely reflecting revenue losses as well as the drop in output—and only in part stimulus measures—public debt is projected to rise to about 110 percent of GDP by end-2010.
The second fiscal trend that characterizes the last decades is the increase in the size of government—measured by the ratio of spending to potential GDP. This is true for overall spending as well as primary spending—spending excluding interest payment. Most of the increase took place between 1965 and 1985, a trend which was present in all G-7 countries (Download Figure 2). It is often argued that this increase reflects a change in the nature of the state: from a state providing “core functions” such as security services—defense, policy, justice—as well as large public works, to a state that was providing a much wider range of social services (see e.g., Tanzi and Schuknecht, 2000; Tanzi, 2005). This is correct but with one important caveat. The bulk of the increase in public spending (over 80 percent) is due to two items: health care and pensions (Download Figure 3).
Public finances today in dire straits
In all G-7 economies, public finances have deteriorated substantially due to the crisis. Overall fiscal balances have widened on average by more than 7 percentage points between 2007 and 2010 to about 9¼ percent of GDP. Part of this deterioration is cyclical, with the cyclically-adjusted primary balance weakening by about 5 percentage points of GDP. The much-needed discretionary fiscal stimulus only accounts on average for 2 percentage points of GDP. Most of the remaining deterioration is due to the loss of potential GDP, and related revenue loss, that is estimated to have been caused by the crisis. Large adjustments are now needed simply to keep the debt-to-GDP ratio constant (some 6½ percentage points of GDP improvement in the cyclically-adjusted primary balance) and an even larger adjustment to lower public debt.
Major additional pressures on public finances are arising from pension and health care spending. If pension reforms are implemented as enacted, pension expenditure is projected to rise by 1 percentage point of GDP over the next two decades, compared to 3 percentage points without reforms. This is not trivial and further reforms will be needed, but the challenge seems to be manageable. The bigger challenge is health care spending. Drawing on recent U.S. Congressional Budget Office projections of federal spending on Medicaid and Medicare, IMF staff estimate that general government spending on health care will rise by 4½ percentage points of GDP in the United States over the next twenty years. For Canada, the European G-7 countries, and Japan, IMF staff project health care to rise by about 3 percentage points. These sharp increases reflect expectations that past trends for non-demographic cost components, including technological progress, will continue: better medical services will become available, but also more expensive ones. Health care reform will be the fiscal challenge of the twenty-first century for the advanced G-7 economies.
How to respond to the key challenges?
To ensure fiscal sustainability and regain room for fiscal maneuver, in particular to respond to possible future negative fiscal shocks (e.g., to mitigate risks stemming from private sector weakness), fiscal adjustment is crucial. Decisive action is needed while minimizing the impact on near-term growth. Some key features of fiscal strategies that are consistent with both short- and long-term requirements include (see also Blanchard and Cottarelli, 2010) the following: (i) implementing structural reforms that boost potential growth as it eases considerably the debt dynamics, (ii) providing clearly defined fiscal actions with a medium-term orientation to assure markets that there is a medium-term plan and commitment to sustained efforts, (iii) supporting the medium-term adjustment through stronger fiscal institutions (including fiscal rules, fiscal agencies, and budgetary procedures), (iv) focusing on those adjustment tools that are conducive to strong potential growth (i.e., for the G-7 economies adjustments primarily on the spending side, but where the tax ratio is relatively low and the fiscal challenges are more daunting also on the revenue side), and (v) ensuring an equitable adjustment that maintains an adequate social safety net and provision of public services that allow a level playing field, regardless of conditions at birth.
References
Blanchard, O., and C. Cottarelli, 2010, Ten Commandments for Fiscal Adjustment in Advanced Economies, iMFdirect.
Cottarelli, C. and A. Schaechter, 2010, Long-Term Trends in Public Finances in the G-7 Economies, IMF Staff Position Note SPN/10/13 (Washington: International Monetary Fund).
Tanzi, V., 2005, “The Economic Role of the State in the 21st Century,” Cato Journal, Vol. 25, No. 3 (Fall), pp. 617–638.
Tanzi, V., and L. Schuknecht, 2000, Public Spending in the 20th Century: A Global Perspective, (Cambridge University Press).
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