"Challenges of Budgetary and Financial Crisis in Europe", Presentation by Carlo Cottarelli, Director, Fiscal Affairs Department, International Monetary Fund
IMF News, November 18, 2011
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Bibliographic details
- Authors: Carlo Cottarelli, Laura Jaramillo
- Published: November 18, 2011
Context and scope
- Presentation delivered at the London School of Economics and Political Science (LSE), United Kingdom, November 18, 2011.
- Presentation based on the September 2011 issue of the Fiscal Monitor.
- Focus: state of public finances before the 2008 crisis, effect of the crisis on fiscal accounts, risks for advanced economies (especially euro area, United States, Japan), and IMF fiscal policy advice.
Pre-crisis public finances in advanced countries
- Long-run trend:
- Starting with the early 1970s the G7 average public debt to GDP ratio had been on an upward trend and in 2007 it had already reached the level reached in the aftermath of the Second World War.
- Structural caveats compared with post-WWII period:
- Population aging and the net present value of pension and health care spending increases (an implicit debt) amounted to hundreds of percentage points of GDP.
- Financial markets in the early 1950s were more constrained (banks often obliged to purchase domestic government paper, limited investment abroad), making debt rollover easier then than now.
- Cross-country differences in 2007:
- Debt in 2007 was high in all G7 countries except Canada and the United Kingdom (the UK faced large contingent liabilities due to its financial sector).
- Some smaller advanced countries had low debt (Korea, Australia, New Zealand); others had historically high debt (Portugal, Greece).
Effect of the 2008–11 crisis on fiscal accounts
- Dynamics (2008–2011):
- By 2008 the U.S. debt ratio had increased by 10 percentage points over 2007 and the deficit ratio by about 4 percentage points.
- 2009 produced major increases in deficits and debt; 2010 saw deficits edge down while debt kept rising fast.
- By 2010 debt had risen to 25-30 percentage points above the 2007 level for several countries.
- In 2011 there was more considerable fiscal adjustment in some countries, including the United States.
- Sources of debt increase:
- Most of the increase in the debt-to-GDP ratio in advanced countries comes from automatic revenue loss; only about 20 percent comes from discretionary fiscal stimulus.
Fiscal consolidation challenge and implied fiscal effort
- Debt reduction exercise (targeting a 60 percent debt-to-GDP ratio by 2030):
- Assumptions: improve cyclically-adjusted primary balance within next 10 years and keep it constant for another 10 years; starting point is 2010 averages for advanced countries.
- Result: the primary balance would have to improve in cyclically adjusted terms by about 8 percentage points of GDP to reach about 4 percentage points of GDP.
- Pressures from health care and pension spending are projected to rise by about 4 percentage points of GDP, making the task more difficult.
- For Japan, target uses 80 percent for net debt due to much higher debt.
- Historical feasibility:
- For about half of the countries, lowering the debt ratio to below sixty percent would require achieving a level of primary balance that had never been reached in any ten-year period before.
Determinants of sovereign market stress and observed patterns in 2011
- “Safety frontier” observation:
- A plot of deficit-to-GDP (vertical) versus debt-to-GDP (horizontal) with balloon size proportional to yield differential versus Germany shows that countries with large spreads (Greece, Portugal, Ireland, Italy, Spain, Cyprus, Belgium) lie on the right-hand side of a “safety frontier.”
- Basic fiscal fundamentals matter: being outside the frontier is a necessary condition for trouble; being inside is a sufficient condition for safety in this visual framework.
- Puzzles: United States and Japan
- Despite weak fiscal accounts, U.S. and Japan were not under the market pressure experienced by some euro-area countries.
- Explanations examined: past and future fiscal trends, long-term pension and health spending, bank condition, growth, sources of financing.
Key explanations and empirical findings
- Past and projected fiscal trends:
- Large improvements in deficits between 2009 and 2011 in almost all countries (including the U.S., but not Japan).
- Decline in the deficit in Europe was larger than previously projected; less improvement in the U.S.; no good news in Japan.
- Projected increases in debt-to-GDP during 2012-14: U.S. and Japan projections look worse relative to many euro-area countries.
- Long-term pension and health spending:
- Net present value of future pension and health care spending (2010-50) shows Japan not in worse shape but the United States is in a particularly weak position due primarily to health care spending.
- Banking sector condition:
- Market concern about European banks (reflected in bank stock prices) is higher than for U.S. and Japanese banks; part of European bank weakness arises from holdings of government paper whose yields increased.
- Growth:
- Interest rate spreads correlate with growth in 2010-11; relationship clearer for the United States than for Japan.
- Econometric literature indicates high debt beyond thresholds (~80, 90 percent) is associated with lower growth; the U.S. is beyond that threshold.
- Structural reforms to raise growth are crucial: for countries with revenue ratios of at least 40 percent, raising GDP growth by one percentage point would lower the debt-to-GDP ratio by 30 percentage points after ten years if all additional revenues are saved.
- Investor base and liability structure (major factor):
- Japan: almost all debt held by domestic residents, mostly financial institutions.
- United States: over one third of debt held by foreign central banks; another 20 percent held by the FED; limited reliance on foreign private sector financing.
- Euro-area pressured countries: much higher share of foreign financing.
- The share of foreign holdings is correlated with interest rate spreads for weaker-fundamental countries.
Empirical analysis of CDS spreads (Annex I summary)
- Data and sample:
- OLS cross-section regressions of 5-year CDS spreads for 31 advanced countries; dependent variable is log of CDS spreads (average for the first three quarters of 2011).
- Regressors included primary balance 2011 (pb2011), general government debt-to-GDP 2011 (gdebt2011), debt held by national central bank or foreign central banks (dfcb), inflation projected for 2011 (infl2011weo), real GDP growth 2011 (rgdp2011), net present value of pension and health care spending increases (pen2010, health2010), primary balance 2014 for euro area (pb2014), projected potential growth potlr.
- Key regression findings:
- Markets focus primarily on short-term variables: projected primary deficit and debt in 2011 matter; future variables (future debt, long-term spending trends) do not seem to matter much.
- Projected short-term growth lowers spreads, but long-term potential growth does not show the expected effect and was dropped.
- Central bank purchases of government paper (dfcb) reduce spreads; coefficient larger than that on debt ratio, suggesting confidence effects beyond reducing supply.
- Inflation is highly significant: central bank purchases are effective in moderating spreads only if not inflationary.
- Short-termism implies a fiscal tightening can raise spreads if fiscal multiplier exceeds about 1.2-1.3 (primary balance improves, but short-term GDP decline and rise in debt ratio push spreads up).
- Caveats and open questions:
- Results may reflect the particular state of markets in 2011 rather than permanent features.
- Need to assess direct effects of contingent liabilities from the banking sector.
- Potential simultaneity issues (e.g., between spreads and growth) require additional attention.
Policy implications and recommendations
- For the United States and Japan:
- Fiscal accounts are very weak and neither country has a clear plan to stabilize rapidly and then lower their debt-to-GDP ratio.
- U.S.: uncertainty due to stalemate in Congress; decline in deficit is large (more than 2 ½ percentage points of GDP projected) and possibly too fast given growth risks.
- Japan: plan exists but is not very ambitious (stabilization of debt ratio only in about 10 years).
- Both countries need to quickly clarify policy intentions; they remain exposed to changes in other central banks’ decisions (U.S.) or to changes in domestic financial institutions’ attitudes (Japan).
- For European countries under pressure:
- Need to adjust fiscal fundamentals; adjustment is underway but may be insufficient.
- Three priority areas:
- Growth: implement structural reforms to boost medium-term growth (large positive fiscal effect over time).
- Banking: increase capital buffers in the banking system to support confidence and credit supply.
- Financing: secure adequate nonmarket financing to offset short-term market short-termism (ECB support, EFSF, IMF financing for program countries conditional on reforms).
- Political communication: decisive and unambiguous communication of the political will to support adjusting countries and the euro area is critical; past communication has been weak.
Concluding observations
- Basic fiscal fundamentals matter for market assessment, but short-term market focus on immediate fiscal and growth variables amplifies risk.
- Investor base and financing structure are central explanations for why some high-debt sovereigns (U.S., Japan) avoided immediate market pressure in 2011.
- Adequate nonmarket financing and clear policy plans are essential to prevent tightening from becoming self-defeating via adverse short-term growth effects.
Presentation by Carlo Cottarelli, Director, Fiscal Affairs Department, International Monetary Fund, November 18, 2011.