Making Goldilocks Happy

IMF Blog, April 20, 2012

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Fiscal adjustment is taking place in economies around the world, but risks remain high.
Bringing debt and deficits down to more moderate levels is important to easing risks.
The pace of adjustment needs to be appropriate—not too fast, not too slow, but just right, for countries where financing conditions allow.

Compared to six months ago, there has been some decline in risks, primarily because of progress in policy implementation, with progress being made particularly in Europe.
Risks remain very high, underscored by continued market volatility and by the fact that public debt is still on the rise.
The public debt-to-GDP ratio for advanced economies is currently at a very high level—reached only once in the last 130 years, at the time of the Second World War.
The outlook is better in emerging economies, although they are still exposed to spillovers from advanced economies.
Fiscal adjustment is proceeding on average this year more or less at a pace regarded as appropriate, taking into account the need to balance different risks.
In a few countries there would be room to reduce the pace of deficit reduction for extra insurance against downside risks to growth, but overall the pace is broadly appropriate.

The structural balance strips out effects on the budget of faster or slower growth and one-time factors; the change in the structural balance indicates deficit improvement or worsening independent of cyclical and one-off factors.
In 2011, the change in the structural balance, country by country, amounted on average to 3/4 to 1 percentage points of GDP.
The same adjustment is taking place in 2012: 3/4 to 1 percent of GDP, on average.
The largest adjustment is observed in countries subject to market pressures.
Except for Japan (still responding to the effects of the earthquake and Tsunami), all the advanced economies are reducing structural deficits.
The United States and Germany, not subject to market pressure, are also adjusting over 2011–12 by about the same amount as each other.
The adjustment is proceeding and will continue next year.

For some countries, a lot of progress will be made during 2012 and 2013; for others, much will remain to be done in the following years to bring debt ratios down to pre-crisis levels.
Even for countries that have already made substantial progress, the challenge will be to maintain that progress for several years as debt ratios slowly come down.
What is needed in each country is a clear medium-term fiscal adjustment plan to reduce public debt over time.
Some countries already have such plans in place; others, like the United States and Japan, still have to clarify fully their plans to reduce public debt over the medium term and need to do so soon.
In the absence of such plans, which help anchor expectations, even more fiscal tightening may be needed than if there were a plan for gradual adjustment.
Example: In the United States, in the absence of any additional measures the deficit will narrow in 2013 by about 3.5 percentage points of GDP, which will be the largest fiscal adjustment in a single year since 1947.

Emerging economies saw considerable adjustment in 2011.
The adjustment is virtually coming to an end in 2012, which is regarded as broadly appropriate because, on average, the fiscal accounts of emerging economies are not in such weak shape as those of advanced economies.
Emerging economies with high deficits and high debt will also have to continue the adjustment over time.

Fiscal adjustment must proceed at a steady pace, and one that is neither too fast nor too slow, if there is fiscal space.
- If growth were to falter with respect to current projections, countries should let automatic stabilizers operate—like unemployment insurance or low-income tax credits.
- If there is a loss of revenues because there is less growth, this loss of revenue should not be offset by further tightening measures that would make things more difficult.
- In an uncertain environment, countries with fiscal space can consider slowing the pace of fiscal adjustment to minimize downside risks to growth.
A clear and credible medium-term fiscal adjustment plan is a key requirement for sustainable growth.
Fiscal institutions can help through this process; the Fiscal Compact in Europe is a significant step in this regard.
Further medium-term steps in Europe recommended:
- Move toward a stronger form of fiscal federalism.
- Develop better risk-sharing tools.
- Progress on the issue of Eurobonds (discussed but no decision yet taken).
- Consider a stronger role for the EU budget, including addressing cyclical downturns in some regions.
- The important element is having a plan and a shared consensus on actions.
Further reforms in fiscal institutions are needed elsewhere (example: the United States budget process is far from perfect).
Reform in spending for pensions and health care is crucial for long-term fiscal sustainability.

Bringing down public debt to pre-crisis levels may seem almost impossible, but faster long-term growth can greatly facilitate the task.
Calculated effect: an increase in annual long-term economic growth of just a quarter of a percentage point could set in place a virtuous circle that would lead, after ten years, to a decline in the public debt-to-GDP ratio by 6 percentage points.
- Mechanism: higher growth makes it easier to run a primary surplus and lowers the public debt-to-GDP ratio directly; this in turn lowers the interest rate, which in turn boosts economic growth.
If this virtuous circle is activated, lowering public debt to where it was before the crisis will look considerably easier.

Making Goldilocks Happy — Carlo Cottarelli, April 20, 2012.