Typical street scene in Santa Ana, El Salvador. (Photo: iStock)
October 14, 2009
Policymakers, buffeted by the global economic crisis, may be drawing a collective sigh of relief with signs of a tentative recovery.
Price reductions at U.S. shopping mall: “If people’s expectations about inflation go up, then long-term interest rates will have to increase” (IMF photo)
POST-CRISIS POLICIES
But, in fact, new challenges will soon loom large, according to an IMF study titled “A Strategy for Renormalizing Fiscal and Monetary Policies in Advanced Economies.” All agree that it is still too soon to unwind the policies put in place to fight the crisis. But policymakers need to start thinking about how to return their fiscal and monetary positions to a more normal state of affairs, now that recovery has taken hold.
In this interview, Carlo Cottarelli, head of the IMF’s Fiscal Affairs Department, and José Viňals, head of the Monetary and Capital Markets Department, look at the fiscal and monetary consequences of the crisis, and discuss what might happen if they are left unaddressed.
IMF Survey online: What is the magnitude of the fiscal and monetary challenges facing governments as they prepare for life after the crisis?
Cottarelli: We already know that public debt is increasing rapidly, and will continue to do so in the near future. This is a result of revenue losses from the recession, as well as fiscal stimulus packages and intervention to stabilize the financial sector—actions that were necessary to support the economy during this global economic crisis. But it has meant an increase in the public debt of advanced countries that is unprecedented in peace time. And, to make matters worse, it comes on top of the medium-term pressure from demographics.
Between 2007 and 2014, public debt as a percent of GDP will go up by 40 percent of GDP in advanced countries, hitting an average of 120 percent of GDP. The situation is a bit better in emerging market economies but there we have other challenges. Adding to the problems for advanced economies is the aging of their populations. The demographic shock will hit these economies in earnest five years from now.
Viňals: On the monetary side, things are more manageable than on the fiscal side, even though we shouldn’t underestimate the risks. I would say that 80 percent of the effort to ensure long-term sustainability needs to come from fiscal policy, with the remaining 20 percent left for monetary policy to deal with.
During the crisis, central banks basically did two things. They reduced interest rates to very low levels to support economic activity, and they used unconventional monetary policy tools to support the financial sector. As a result, they now face two related challenges.
First, they need to figure out when, and at what pace, to begin raising interest rates. Getting this timing right will be essential.
"Governments must continue to fully support the independence of their central banks."
Second, central banks need to shrink their balance sheets, which expanded significantly in the crisis. During this process, some central banks acquired some risky assets, which could lead to losses. If central banks experience important losses as they divest all these assets, they should be recapitalized by their governments.
IMF Survey online: Given how painful it will be for many governments to cut back on spending at a time when pressures from an aging population are set to escalate, wouldn’t it be easier on everybody to let inflation eat away some of the debt?
Viňals: That would be a really bad idea. If you agree to 5 percent inflation, why not 6 percent, or even 10 percent? Our research shows that an inflation rate of 5 percent would erode less than a quarter of the expected increase in debt during the next five years. So it’s definitely not worth running the risk of letting the inflation genie out of the bottle.
I would say that, no matter what happens, it is absolutely fundamental that price stability be maintained. If people’s expectations about inflation go up, then long-term interest rates will have to increase, making financing that much more expensive. Inflation reduces economic growth, hurts the poor, creates social and political instability, and is very difficult to bring back down.
IMF Survey online: Are you worried about stagflation?
Viňals: Most likely, what we will see is a very slow recovery with little inflationary pressure. But one cannot exclude alternative scenarios. There is a risk that the economy remains weak but that commodity prices increase regardless. Such a situation would pose a real dilemma for policymakers. If they increase interest rates to contain the inflationary effect of the commodity price increases, they risk killing off the recovery. But not raising interest rates would be bad for inflation.
The primary goal of monetary policy should be price stability. For this reason, it will be very important to preserve central bank independence. We know from experience that higher debt could lead to increased pressure on central banks to ease financing costs. Governments must continue to fully support the independence of their central banks.
IMF Survey online: Some countries have lived with high public debt for many years now, and have not faced a debt crisis. Aren’t you crying wolf a bit too early?
Cottarelli: Letting public debt stabilize around 100 percent is not a good idea because that is likely to constrain future growth. The two advanced countries with the highest levels of public debt—Japan and Italy—have both experienced slow growth during the past decade. Moreover, high debt will prevent fiscal policy from playing a countercyclical role in the future.
"The two advanced countries with the highest levels of public debt—Japan and Italy—have both experienced slow growth during the past decade."
But there is another big unknown. We simply don’t know what will happen to the global economy and to real interest rates if most advanced economies start to rely on debt ratios in excess of 100 percent. Do we want to run this risk?
IMF Survey online: Wouldn’t it be possible for countries to simply outgrow their debt?
Cottarelli: It’s true that higher growth raises revenues and makes it much easier to bring down public debt. If growth was increased by one percentage point during the next ten years, public debt would go down by almost 30 percent.
But governments should not rely only on optimistic growth projections. Higher growth would need to be triggered by reforms to improve productivity and create more jobs. And as we know, those can be difficult to implement. Higher growth can and would help. But it is too uncertain a linchpin on which to rely entirely for a credible debt reduction strategy.
IMF Survey online: So what should countries do?
Cottarelli: We think countries should work to get their public debt down to significantly lower levels. We have computed that in order to bring down public debt to about 60 percent of GDP over the next 20 years, advanced countries will need to improve their cyclically adjusted primary fiscal balance by at least 8 percentage points within the next 10 years, moving from a deficit of 3.5 percent of GDP to a surplus of 4.5 percent.
Needless to say, this will require action on many fronts. Governments should start with the obvious: allowing the current fiscal stimulus to expire once recovery is well established. This will improve the average fiscal position by 1½ percentage points. Entitlement reforms will be required to keep pension and health spending constant in relation to GDP, and spending in other areas must also be capped by freezing real public per capita spending at current levels. This would improve the fiscal balance by 3½ percentage points. The remaining 3 percentage points will have to come from higher revenues. Some of those revenues could come from a clampdown on tax evasion and introducing carbon pricing to help fight climate change.
IMF Survey online: You are suggesting that pension and health reforms will be necessary in all major advanced economies. This will come at a time when many people have seen their pension savings dwindle because of the crisis, and when health spending is increasing everywhere. Is it really realistic to expect governments to implement such difficult reforms?
Cottarelli: There is no doubt it will be very difficult. But when you look at the alternatives—accepting higher inflation, which will jeopardize hard-won price stability while doing little to reduce the debt, or deciding to live with a high public debt burden, which will cut into future growth—there really is no alternative.
What governments can do to make this process smoother is move forward decisively with structural reforms to raise growth. This, as I mentioned, will be a powerful tool to lower the burden from debt.
