Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Countries Face Choices to Reduce Debt and Deficits

December 17, 2010

  • IMF hosts discussion about how best to reduce public debt and deficits
  • Benefits of government spending at crisis' peak debated
  • Countries' future plans to reduce debt need more detail

Changes in government policies designed to better align spending and revenues are needed to reduce debts and deficits in the years ahead, but the debate about how countries can and should adjust continues.

Countries Face Choices to Reduce Debt and Deficits

Bringing down government debt and deficits will help boost growth, the IMF said (photo: IMF)


As governments in advanced economies face mounting debt and nervous financial markets, policymakers face difficult choices about how best to put fiscal policy on a sustainable path, while also promoting economic growth after the worst economic crisis in 80 years.

In a discussion hosted by the IMF in Washington, D.C. on December 9 that included representatives of civil society, academia, and the media, officials and experts on fiscal adjustments debated the pros and cons of ways to reduce deficits and debts, in light of past experience with large fiscal adjustments.

It’s all about growth

Putting plans in place to reduce government debt and deficits, and beginning to implement them, will shore up confidence in public finances today, and give a boost to economic growth over the long haul.

“High debt ultimately affects growth, and that’s why we need to tackle it,” said Carlo Cottarelli, head of the IMF’s Fiscal Affairs Department and host of the event.

With advanced economies facing record levels of public and private debts, the panelists agreed on one thing—there needs to be fiscal adjustment at some point over the next few years through higher taxes and lower government spending, according to Caroline Atkinson, director of the IMF’s External Relations Department and moderator of the debate.

“Fiscal adjustment is absolutely necessary to get the house in order and to maintain credibility,” said Carmen Reinhart, with the Washington-based Peterson Institute for International Economics think tank and a former IMF staff member. “There is no substitute for plain vanilla, old-fashioned fiscal discipline — whichever way you slice it, you’re going to need it.”

Reinhart added that the order of magnitude of debt today requires all the tools a country can muster.

According to the IMF, an important part of the solution to the debt problem will involve cutting spending on entitlements that were on an unsustainable path before the crisis hit. This is needed to create savings well into the future.

“You need to have a medium term plan, and most advanced economies need long-term reforms of pensions and health care,” said Cottarelli.

Unorthodox strategies de-mystified

Faced with the challenge of cutting spending and borrowing, some have suggested unorthodox tools, including for example debt restructuring or a rise in inflation.

Cottarelli, quoting from a recent IMF paper, said the option of an advanced economy defaulting as a solution to its fiscal problems is unnecessary, undesirable, and unlikely.

Default would be a far from painless option. It would have a negative effect because much of the government debt is held by countries’ residents either directly or through financial institutions.

Reinhart agreed that “restructuring is quite a dirty job and is no panacea.” She also said that before distressed assets, such as housing mortgages, are taken on to government balance sheets, they should be valued at current market prices.

Cottarelli also said allowing inflation to rise moderately would not work. He said a 6 percent inflation rate for five years would only reduce the debt ratio by 8 percentage points of GDP, and the effect would disappear quickly as new debt is issued at higher interest rates.

Reinhart said the idea of “inflating away” debts is naïve.

The panel also debated the benefits of countries’ increased spending at the height of the global crisis.

When the economic recession began in 2008, the IMF suggested—to widespread surprise at the time—that countries should increase spending by 2 percent of GDP on average, in order to fight off the worst effects of the crisis. This advice, followed by most advanced economies, was criticized by one of the panelists.

“Discretionary policy programs, such as stimulus programs, are not likely to have a positive impact on the economy,” said Vito Tanzi, a former head of the IMF’s Fiscal Affairs Department. He said while they attracted a lot of media attention, the policy created distortions in the economy by favoring the beneficiaries of the funding, while adding to financial markets’ concerns about fiscal sustainability.

Cottarelli took on Tanzi’s views, and argued the fiscal stimulus only represented one-tenth of the increase in the net debt-to-GDP ratio, and the fiscal stimulus was small compared to the overall size of the public debt. He said the real problem for countries’ rising debt levels was the collapse in output and in revenues as a result of the crisis.

Tanzi countered that if the fiscal stimulus added only one-tenth to the net debt-to-GDP ratio, then “why bother, you shouldn’t have touched it, and instead just let the fiscal stabilizers work.”

Alan Auerbach, a professor with the University of California at Berkeley said the United States’ use of fiscal stimulus was the right approach, but going forward medium-term efforts are necessary to cut the deficit.

“Fiscal stimulus needs to be combined with a credible commitment to a medium-term fiscally responsible policy, and that’s completely absent in the U.S. discussion, and could have a negative effect on the economic recovery,” said Auerbach.

Countries’ plans could do more

The IMF Fiscal Monitor issued in early November reviewed 25 advanced and emerging market economies, and found that while most have produced plans aiming to bring down their deficits in the coming years, many countries could do more, including:

• Provide details beyond 2011 on measures to reduce deficits and debt accumulation

• Control health care and pension spending, which is projected to rise significantly in advanced economies in the coming years

• Strengthen the institutions charged with government budgets, revenues, and spending, and, where appropriate, introduce or strengthen fiscal rules and independent fiscal agencies to guide policy

• Improve targeting of social safety net spending on the most vulnerable groups in society

• Establish a long-run goal for their public debt ratio.

A book entitled Chipping Away at Public Debt, to be published in 2011 by a team of IMF authors, will draw lessons from past successes and failures with fiscal adjustment plans.

The next Fiscal Monitor will be issued by the IMF in April 2011.