Fiscal Policy Challenges in the Post-Crisis WorldSpeech by John Lipsky, First Deputy Managing Director, International Monetary Fund
At the China Development Forum
March 21, 2010
As Prepared for Delivery
Thank you for inviting me. It is a pleasure to be here.
As we are all aware, the global crisis has inflicted a major toll on output and employment. Today, however, increasingly hopeful signs indicate that a sustainable economic recovery has begun, led by vibrant activity in emerging and developing economies. Our latest World Economic Outlook (WEO) projections point to global growth of around 4 percent this year, and a somewhat faster pace in 2011. This recovery reflects the supportive role played in most countries by expansionary fiscal and monetary policies.
In my remarks today, I will focus on three key fiscal policy challenges that will need to be faced as the crisis recedes. First is to ensure that the recovery becomes firmly entrenched; second is to reduce high public debt ratios that the crisis is creating back to prudent levels. This challenge is particularly acute in the advanced economies. Third is the global rebalancing of savings patterns that will be needed to make the recovery sustainable.
I will begin by addressing the role of fiscal policy during the crisis. First, automatic stabilizers were allowed to operate fully in almost all countries on both the revenue and expenditure side. This is a marked difference with respect to the 1930s, and generally is not well appreciated: most of the increase in the fiscal deficits expected in 2009–10 reflects the revenue decline resulting from the downturn in activity.
Second, discretionary actions also were supportive of aggregate demand: As far back as January 2008, the IMF’s Managing Director called for discretionary fiscal stimulus equal to about 2 percent of worldwide GDP, emphasizing that discretionary stimulus measures were appropriate for those countries that possessed the required room for maneuver. In the event, this was close to the scale of stimulus that in fact was implemented.
The combined action of the automatic stabilizers and of discretionary stimulus provided a welcome boost to global demand in 2009 and they are doing so again this year. At the same time, we estimate that about four fifths of the stimulus is temporary, implying that it will tend to diminish more or less autonomously as the recovery takes hold.
As you know well, much of the force of the economic growth rebound has come from Asia, where the recovery has occurred earlier and with more force than elsewhere. Prompt action by this continent’s policymakers, including the rapid rollout of large and credible fiscal stimulus, has propelled the region's recovery and contributed to the global turnaround.
While the recovery is welcome, the crisis also is leaving deep scars in fiscal balances, particularly in the advanced economies. We project that gross general government debt in the advanced economies will rise from an average of about 75 percent of GDP at end-2007 to about 110 percent of GDP at end- 2014, even assuming that the temporary, crisis-related stimulus measures are withdrawn in the next few years. Indeed, we expect that all G7 countries except Canada and Germany will have debt-to-GDP ratios close to or exceeding 100 percent by 2014. Already in 2010, the average debt-to-GDP ratio in advanced economies is projected to reach the level prevailing in 1950, in the aftermath of World War II. Moreover, this surge in government debt is occurring at a time when pressure from rising health and pension spending is building up.
The situation is more favorable in most the emerging market economies. The average debt ratio in emerging economies is expected to decline next year, after rising in 2009 and 2010. Of course, there are some risks to this outlook. Our baseline projections assume that the fiscal tightening already announced in several emerging economies is implemented as planned, and economic recovery continues. Even so, the government debt ratio in some emerging market countries has reached a worrisome level.
As I noted earlier, the projected government debt increase in the advanced economies is only partly due to discretionary fiscal stimulus. In fact, such measures has accounted for only about one-tenth of the projected debt increase. Thus, merely winding down the stimulus will not come close to bringing deficits and debt ratios back to prudent levels, considering the projected increases in health care of other entitlement spending.
Addressing this fiscal challenge is a key near-term priority, as concerns about fiscal sustainability could undermine confidence in the economic recovery. Already in several countries with particularly high debt and deficits, sovereign risk premia have risen sharply, imposing strains for the countries affected and raising risks of possible broader spillovers. Over the medium term, large public debts could lead to high real interest rates and slower growth. We have estimated that maintaining public debt at its post-crisis levels could reduce potential growth in advanced economies by as much as ½ percentage point annually compared with pre-crisis performance.
How can the needed fiscal adjustment be achieved? Inflation clearly is not the answer. A moderate increase in inflation would have only a limited impact on real debt burdens, while accelerating inflation would impose major economic costs and create significant risks to a sustained expansion. In contrast, robust and sustained growth -- if combined with appropriate spending controls -- can make a major contribution to reducing debt ratios.
Growth-enhancing reforms, such as liberalization of goods and labor markets and the removal of tax distortions therefore should be pursued vigorously. But the link between reforms and growth is subject to lags and uncertainties. As a result, ensuring fiscal sustainability will require direct measures to improve fiscal primary balances.
As a gauge of the potential magnitude of effort that will be required -- but not a recipe or recommendation -- bringing general government debt ratios in advanced economies back to the pre-crisis average of 60 percent by 2030 would require steadily raising the structural primary balance from a deficit of about 4 percent of GDP in 2010 to a surplus of about 4 percent of GDP in 2020—an 8 percentage point swing—and keeping it at that level for the following decade. This would by itself represent a huge effort, but in fact any primary surplus improvement in the coming years will have to be accomplished while swimming against the already rising tide of entitlement expenditures on healthcare and retirement.
Thus, just keeping debt ratios at a post-crisis level will require new policy action. Unwinding the discretionary anti-crisis stimulus measures would contribute only 1½ percent of GDP to the fiscal adjustment. As a result, the bulk of the required progress will have to reflect reforms of pension and health entitlements, containment of other primary spending, and increased tax revenues -- possibly through the implementation of both tax policy and tax administration measures.
The appropriate timing of a move to fiscal tightening will depend on country-specific circumstances—in particular, on the pace of recovery and the fiscal position. For most advanced economies, including several of the largest, maintaining fiscal stimulus in 2010 remains appropriate, but fiscal consolidation should begin in 2011, if the recovery occurs at the projected pace.
In fact, some actions should be undertaken now by all countries that will need fiscal adjustment. First, policymakers should be making it clear to their citizens why a return to prudent policies is a necessary condition for sustained economic health. Second, strengthening fiscal institutions will help to steady the course of fiscal policy, to withstand adjustment fatigue, and to provide a predictable framework for adjustment. This could include such measures as reinforcing fiscal responsibility legislation and expenditure management systems, and improving tax administration. Third, entitlement reforms such as increases in the retirement age would have favorable long-term fiscal effects but little near-term adverse impact on aggregate demand.
Tailoring actions to individual country circumstances will represent an important consideration In China, for example, it is fully appropriate—as underscored in the 2010 budget announcement a few weeks ago—to maintain fiscal stimulus through this year, while seeking to rein in the very rapid loan growth. In addition, the structure of public spending is being shifted away from physical infrastructure and toward actions that will improve human capital and also boost consumption. These include structural improvements in education, health, and social security that will increase productivity and also directly support consumption by lessening the perceived need for precautionary savings.
For instance, a recent IMF staff study shows that a sustained one percent of GDP increase in China’s public spending on health, education and pensions could result in a permanent increase in household consumption of more than one percent of GDP. There also may be a case for reexamining the structure of taxation in China and to consider boosting household income by shifting the tax burden away from labor income, and toward property and capital gains taxes.
Fiscal policy also has a role to play in global rebalancing. From this perspective, fiscal consolidation will be appropriate in the United States, where a higher public savings rate will be required to ensure long-term fiscal sustainability. An increase in public saving would augment an expected rise in household saving to boost national saving and reduce the current account deficit. In emerging markets with current account surpluses, expanded social safety nets can help to lower excess household saving rates and boost consumption. Moreover, if oil prices remain high as currently forecast, some oil exporting countries will have room to increase domestic demand and to boost spending on social infrastructure.
In Europe and Japan, the goal of reaching fiscal sustainability while restoring growth underscores the importance of growth-enhancing reforms, including in the fiscal area. In view of the already high tax burden on labor, fiscal adjustment will need to focus, for example, on better targeting of social benefits, and on reducing exemptions on indirect taxes. More generally, all countries have a shared interest in fostering sustained growth while keeping their fiscal houses in order, to reduce the risk of further.
Indeed, at the recent G20 Pittsburgh summit, leaders pledged to adopt policies aimed at strong, sustainable, and balanced growth. Moreover, they agreed to implement an innovative mutual assessment procedure, in order to assess progress toward that objective. I have just arrived from a meeting that is part of the planning process for the June 2010 Toronto Leaders Summit. In fact, the G20 Framework process will be a key focus of the two Leaders Summits planned for this year.
In sum, the world economy is making notable progress on the path out of the Great Recession of 2008/2009. However, it is also true that we continue to face major challenges. With firm resolve and continued international cooperation, however, I firmly believe that these challenges can be met and overcome.
Thank you for your attention.