Watch This (Fiscal) Space: Assessing Room for Fiscal Maneuver in Advanced Countries

IMF Blog, September 1, 2010

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Public debt sustainability in most advanced economies moved from a non-issue to a key policy concern.
The reassessment of sovereign risk is a palpable threat to global recovery.
The debt blowout in advanced countries reflects pre-crisis fiscal management as well as the financial crisis.
Taming public debt will require steadfast policy efforts over the medium term; quick fixes will not do the trick.

The note provides an operational definition of “fiscal space” and empirical estimates of available fiscal space for 23 advanced economies.
Fiscal space is assessed by focusing on fiscal solvency in terms of the actual track record of countries—how policy responded in the past to changes in public debt.
Key empirical premise: if governments historically raised the primary budget balance (net of interest payments) when public debt rose, they exhibited an implicit rule of making sure debt would be repaid.
The analysis recognizes that the positive response of the primary balance to rising debt holds only up to a point; beyond a threshold a debt limit is reached when adjustment fatigue sets in.
The framework incorporates the role of market-imposed risk premia: as debt approaches its limit, markets add a risk premium to sovereign interest rates, making hitting the debt limit more likely.

Advanced countries differ substantially in 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 determined by each country’s track record of adjustment.
Markets require credible historical evidence of adjustment; promises unsupported by past deeds are unlikely to reassure markets.
When debt nears its limit, markets typically add a risk premium that increases borrowing costs and accelerates the path to the debt limit.
A finding of little or no fiscal space does not imply inevitable default—debt limits are not etched in stone because behavior and policy can change.

Where a country has little or no fiscal space, 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.
Because estimates assume future policy reactions will mirror past behavior, credible policy change can expand fiscal space—“history is not destiny.”
Countries should generally target debt levels well below estimated limits because:
- Markets may give little or no warning about imminent spikes in borrowing costs or curtailed access to debt markets.
- There is inevitable uncertainty about where precisely debt limits lie and potential for rapid changes in market perceptions.
If fiscal risks rise, political willingness is required to undertake adjustment efforts that are extraordinary by historical standards, and to do so in a timely fashion, to preserve or restore sustainability.
Maintaining a comfortable degree of fiscal space at all times is prudent policy given the potential suddenness of market reassessments.

The framework aims to clarify a fuzzy concept—fiscal space—and provide practical guidance on where a change of course is called for, as well as the size and nature of adjustments needed to manage fiscal risks.
The framework underscores that there is no “one size fits all”: debt limits and fiscal space are country-specific and depend on each country’s track record of adjustment.

Source: Jonathan D. Ostry, September 1, 2010. The IMF is an organization of 191 countries, based in Washington D.C.