Public debt sustainability in most advanced economies used to be a non-issue, or at most a back-burner one. A couple years back, if the topic came up, most people associated it with developing or emerging market countries. Defaults, rising sovereign risk premia, getting shut out from capital markets were, let’s face it, not really imagined to be possibilities for advanced economies. Of course there were fiscal challenges, demographic pressures being the obvious one, but these were issues for the long term, not the here and now.
But today, fiscal problems are a key concern of policy makers in many industrial countries, and a reassessment of sovereign risk is a palpable threat to global recovery. While the financial crisis may be a convenient scapegoat for the debt blowout in the advanced countries, blame lies elsewhere, in how fiscal policy was managed before the great recession, not during it. And, more sobering still, taming public debt will require steadfast policy efforts over the medium term: quick fixes will not do the trick.
What is the worry? At the heart of the issue is the extent to which governments have room for fiscal maneuver—“fiscal space”—before markets force them to tighten policies sharply and, relatedly, the size of adjustments needed to restore or maintain public debt sustainability.
Yet, surprisingly, much of the talk about fiscal space—how to measure it and the policy implications—has so far been rather fuzzy. A new staff position note, which I co-authored with several IMF colleagues, aims to remedy this, providing an operational definition of the fiscal space concept as well as empirical estimates of available fiscal space for 23 advanced economies.
Our estimates indicate that advanced countries are not all in the same boat in terms of available fiscal space. Some have a lot, others have none, and some are in the middle. Fiscal space varies across countries for two reasons: differing indebtedness, and different debt limits. Our results indeed underscore that there is no “one size fits all” on these issues—debt limits and fiscal space are country-specific and depend on each country’s track record of adjustment.
So how did we approach these complex issues? Some have questioned the relevance of debt limits for advanced-economy sovereigns. They assume that a government’s right to tax and (not) spend means that, in the future, changes in fiscal policy can always ensure that public debt is repaid. Our take is different, not least because markets will not be impressed by promises of policy change when a country has little or no track record of adjustment—words unsupported by deeds. For this reason, we focus on fiscal solvency in terms of the actual track record of countries—how policy responded in the past to changes in public debt. If governments were able to raise the primary budget balance (that is, net of interest payments) when public debt went up, then they had (at least) an implicit rule of making sure debt would be repaid. As such, markets could take comfort that, in the very long run, the sovereign would honor its financial obligations.
But this finding of a positive response of the primary balance to rising debt can be true only up to a point. As debt grows, it becomes increasingly difficult—reflecting both economic and political realities—to improve the primary balance enough to offset higher debt service costs. Eventually there is a threshold—a debt limit—when debt simply gets too big, adjustment fatigue sets in, and the surplus cannot keep pace with rising debt repayments.
Of course, markets don’t usually sit idly by as debt approaches its limit. Instead they add a risk premium to the interest rate they charge to sovereigns, reflecting the potential for default. And, by adding to the cost of debt, the higher risk premium means a country will be more likely to reach its debt limit. When concerns are acute, only policy adjustments that are dramatically different from past efforts will be enough to maintain capital market access.
What are the policy implications?
- First, there is a definite wakeup call in the finding that a country has little or no fiscal space. In these cases, fiscal policy needs to break fundamentally from the past to credibly signal to markets that debt limits will not be reached: business as usual simply won’t cut it.
- But, second, a finding of little or no fiscal space does not imply that default is inevitable—debt limits are not etched in stone. Our estimates of fiscal space are based on the assumption that future policy reactions will mirror those in the past. Since behavior can change, history is not destiny as long as policy changes credibly.
- Third, countries will generally want to target debt levels well below the limits. As public debt rises or views about fiscal risks—or the reliability of fiscal data—change, our results imply that markets may give little or no warning about imminent spikes in borrowing costs or curtailed access to debt markets. With the inevitable uncertainty around where precisely debt limits lie, and the potential for market perceptions to change in the bat of an eye, there is a need for caution—a few successful auctions are not grounds for complacency.
Many of these points resonate with the experience of some southern European countries in recent months and underscore the need for countries to maintain a comfortable degree of fiscal space at all times. And, if fiscal risks rise, there needs to be political willingness—already evident in a number of countries—to undertake adjustment efforts that are extraordinary by historical standards, in a timely fashion, to preserve, or to restore, sustainability.
We hope the framework in our note helps to bring clarity to discussions of fiscal space—getting to grips with a fuzzy concept—and that it provides a practical sense of where a change of course is called for, as well as the size and nature of adjustments needed to manage fiscal risks.