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IMFSurvey Magazine: Policy

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Governments' Role in Economy at Heart of Debts, Deficits Debate

Panelists at the Fiscal Forum: mounting concern over U.S. deficits dominated discussions in Washington on April 14 (photo: IMF)

GOVERNMENT DEBT AND DEFICITS

Governments' Role in Economy at Heart of Debts, Deficits Debate

IMF Survey online

April 18, 2011

  • IMF hosts discussion on government debt and deficits
  • Daunting fiscal challenges include healthcare costs
  • Countries' priorities at heart of how to spend public money

The current discussion about countries cutting public debts and deficits has reopened the larger debate about the role of government in a country’s economy.

Amid concerns over large and increasing debts and deficits in advanced economies, and their potential risks to global economic and financial stability, the IMF’s 2nd Annual Fiscal Forum brought together policymakers from 35 countries, along with academics, to debate global fiscal issues a day after U.S. President Barack Obama announced $4 trillion in budget cuts.

Earlier in the week, the IMF released its latest global analysis of government debts and deficits, and said the outlook for 2011 is a mixed bag, with most advanced economies reining in fiscal deficits, but not fast enough to keep their debt from rising over the next few years.

The top four priorities outlined by the IMF are

• Decide on goals and put in place plans quickly to reduce debts over the next few years

• Make a downpayment on the deficit in the next few years

• Control spending on health care and pensions

• Strengthen the institutions charged with governments’ budgets, revenues, and spending.

One lesson from the crisis is the importance of countercyclical policy, which is designed to lean against the direction the economy is moving, such as increasing spending in times of recession or raising interest rates in times of inflation. As emerging markets experience strong economic growth, the fiscal situation can shift rapidly when growth slows.

“This is the real opportunity for emerging markets to be tough on fiscal policy, and to reduce deficits and increase their budget surpluses as much as possible,” said Kemal Derviş of the Brookings Institution, a Washington D.C.-based think tank.

Culture clash

The current political debate in the United States about when and how to cut deficits says a lot about a country’s culture and priorities when it comes to using taxpayers’ money, the forum heard.

“It’s not just a discussion about cutting debts and deficits, it’s a debate on the public good and what the state provides and what the private sector provides,” said Derviş.

The rising cost of healthcare remains a hot topic, along with the increasing size of the aging population in many advanced economies and a decreasing number of taxpayers. Earlier in the day, Larry Summers, a former U.S. Treasury Secretary, said healthcare “is the most difficult issue” in the United States “because of its complexity and paradoxes.”

The head of the IMF’s Fiscal Affairs Department, Carlo Cottarelli, reminded the audience that it is possible to have healthcare system that delivers good services without having spending at levels that are not sustainable.

Connection between financial, fiscal risks

Governments also need to keep an eye on the potential for public finances to become a risk to the overall economy and the financial system, according to Jaime Caruana, head of the Bank for International Settlements, which serves as a bank for central banks around the world.

He said financial markets’ tolerance for a country’s debt levels can vary and change rapidly, as witnessed with current events in some European countries, with negative consequences for the economy.

So from a financial stability point of view, it is better for countries to get their fiscal house in order sooner rather than later.

Simon Johnson, a professor at the Massachusetts Institute of Technology and former head of the IMF’s Research Department, said the United States has seen a 40 percent increase in its debt-to-GDP ratio because of the financial crisis and the ensuing downturn in economic activity.

Johnson cited Ireland as an example of a country “ruined fiscally by what happened in the financial sector.”

Marriage of love and fiscal discipline

While institutions to help manage a government’s spending are important, and rules to manage government debts and deficits are often associated with better economic results, there are also examples of countries that enjoy good fiscal performance without rules.

In the case of the United States, rules are valuable ways to manage the details after a political deal on spending and cuts has been reached. They are not effective at forcing deals to happen, according to Douglas Elmendorf, director of the U.S. Congressional Budget Office, the agency charged with reviewing budgets and providing impartial assessment of their impact.

Institutions that help keep government accounts transparent are very important, according to Cottarelli.

Drawing an analogy to the institution of marriage, Cottarelli reminded the audience that fiscal adjustments, like marriage, require more than rules to succeed.

“Institutions are just institutions; marriage as an institution can prevent a breakup, but ultimately what matters is love,” said Cottarelli. “There must be a culture leading to a love of fiscal rectitude, and we’re not there yet.”

On borrowed time

The United States has been able to run large government deficits for a long time on the basis of borrowed money, as countries around the world use the U.S. dollar as their primary reserve currency.

With financial markets not yet worried about U.S. fiscal deficits, some say it is important to make some hard choices before it’s too late.

“The risk now is the world’s willingness to lend money to this country is just giving us enough rope to hang ourselves, and the question is whether we will be able to look ahead at the risks we are running, even if they aren’t right in front of us, and make changes before we get to a dangerous point,” said Elmendorf.