A Strategic Pivot in Global Fiscal Policy

IMF News, September 18, 2024

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Published: September 18, 2024

Context and speaker

Speech by Gita Gopinath, IMF First Deputy Managing Director, delivered at the Central Bank of Ireland’s Whitaker Lecture, Dublin, September 18, 2024.
Central message: advocate for a strategic pivot in global fiscal policy to ensure resources for structural transformations (including climate change) and preparedness for future crises.

Scale of fiscal risks

Global public debt reached 93 percent of GDP in 2023 and is projected to approach 100 percent of GDP by the end of this decade.
Debt in some of the largest economies like the US and China is projected to grow even faster than in the pre-pandemic years.
Europe: public debt is expected to broadly stabilize but remains well-above pre-pandemic levels.
Political economy shifts:
- Political manifestos increasingly favor higher government spending.
- Restraint discourse (calls for outright reduction of budget deficits or limitation of public spending) has declined across the board over time.
- Political redlines on raising taxes are becoming more entrenched in both advanced economies and emerging and developing economies, regardless of party ideology.
- These trends create upside risks to the debt outlook and raise the possibility that governments may delay necessary deficit reduction.
Structural spending pressures:
- Additional spending needs (climate mitigation and adaptation, healthcare, pensions, defense) could amount to 7-8 percent of GDP annually on average for the global economy by 2030.
- For Europe this would add up to 2.5-5 percent of GDP, that is 550 billion to 1.1 trillion euros by 2030.
- These pressures may not be fully reflected in baseline debt projections, amplifying upside risks.
Optimism bias in debt projections:
- Historical analysis (1990–2021) shows realized debt-to-GDP ratios often exceed projections over the medium term due to optimistic growth forecasts and fiscal adjustments falling short of plans.
- In Europe, if history repeats, debt could rise by 8-11 percentage points of GDP above baseline projections by 2030.

Consequences of elevated fiscal risks

Changing macro environment:
- The era of a global savings glut and large-scale central bank purchases of government bonds (which pushed yields to record lows) is over.
- Loose fiscal policy can increase term premia on government bonds as long-term debt sustainability comes into question.
Evidence and channels:
- Decomposition of US 10-year nominal yields: inflation risk premium has declined with inflation, while the real risk premium has risen sharply in the last two years, pushing long-term interest rates well above pre-pandemic levels.
- IMF April 2024 Fiscal Monitor finding: a 1 percentage point increase in the US primary deficit is associated with a rise in term premia of about 11 basis points in the quarters that follow.
- Example in Europe: recent increase in term premia in France.
- Fiscal policy uncertainty impacts:
- A two standard deviation shock to the IMF fiscal uncertainty index could, on average, increase private sector borrowing spreads in the Euro Area by 0.4 percent one month after the shock.
- The same shock could dampen economic activity by 1 percent after 6 months as financial conditions tighten.
- Cross-border spillovers:
- April 2024 Fiscal Monitor analysis: a 1 percentage point spike in US rates is associated with a rise in long-term nominal interest rates of up to 90 basis points in other advanced economies, with persistent effects; spillovers to emerging and developing economies are also substantial.

Recommended fiscal strategy: growth, guardrails, and grassroots

Overarching prescription: countries, especially those where output is close to potential (like the US and most in Europe), should start now on a path of gradual fiscal consolidation focusing on three pillars.

Growth (economic sustainability and fiscal friendliness)
- Higher growth improves prosperity, reduces debt durably, and creates policy space for mounting spending pressures.
- Fiscal adjustments should be growth friendly:
- Cuts in public investment have a much larger negative impact on output than reducing energy subsidies and untargeted transfers.
- Europe-specific recommendations:
- Raise productivity and stimulate innovation to lift medium-term growth prospects; productivity in the EU is only 78 percent of that in the United States.
- Strengthen the single market by removing remaining barriers to trading inside the block to incentivize R&D and investment in new technologies (examples: opening the electricity and telecommunications sectors).
- Advance the capital markets union to improve innovation-friendly allocation of financing within Europe.
- Complete the banking union to allow borrowing costs to converge further across the EU and improve credit allocation.
- These measures aim to raise business dynamism and be fiscally friendly.

Guardrails (insulation against political expediencies and optimism bias)
- Medium-term fiscal rules and independent fiscal councils provide guardrails that reduce fiscal uncertainty and strengthen transparency.
- Evidence: adoption of fiscal rules that impose operational constraints on the budget balance leads to a higher share of pro-restraint fiscal discourse in subsequent election cycles.
- Fiscal rules must be complemented by independent fiscal councils to:
- Provide oversight,
- Reduce optimism bias in economic forecasts,
- Inform the public about risks to public finances and policy tradeoffs.
- New EU fiscal rules constitute a major development; cumulative fiscal adjustment called for by these rules appears broadly appropriate and similar to IMF staff recommendations, but compliance is critical.
- National fiscal councils (many EU countries have them) can complement the European Fiscal Board; Ireland is cited as a positive example with a council formed after the Global Financial Crisis.

Grassroots (public engagement and ownership)
- Engage civil society and stakeholders to shape public discourse toward sustainable fiscal policy.
- Research evidence:
- Stefanie Stantcheva (Harvard): timely and nonpartisan information reduces misperceptions and can shape public support for difficult policies.
- IMF research: support for carbon pricing policies rises when information on positive impacts is shared with the public.
- Public ownership of complex reforms requires:
- Effective communication strategies,
- Mechanisms for stakeholder contribution to reform design,
- Strong institutional frameworks to foster trust.

Conclusion and policy imperative

Political and structural trends are pressuring governments to spend and borrow more; historical patterns suggest actual debt trajectories will be worse than current projections.
Not sustainable: countries where output is close to potential should begin gradual fiscal consolidation now.
The proposed strategy with the greatest chance of success:
- Focus on growth,
- Establish effective guardrails to ensure compliance,
- Foster close engagement with stakeholders, including civil society, to secure buy-in.

Source: Speech by Gita Gopinath, IMF First Deputy Managing Director, “A Strategic Pivot in Global Fiscal Policy,” Central Bank of Ireland Whitaker Lecture, Dublin, September 18, 2024.