The Debt Spiral of the G-7

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Today, I’m summarizing a paper titled, “Long-Term Trends in Public Finances in the G-7 Economies.”  It’s written by two IMF economists, Carlo Cottarelli and Andrea Schaechter.  Here’s the link.


Also, at the bottom of this article are a few amusing links.


PLEASE REALIZE: some sentences are lifted straight from their paper and all exhibits are straight from their paper.  I’m simply trying to convey some of their key ideas which are important.


My view is that this is an important paper because I’ve encountered too many people who will argue that while the US is in trouble, so is everyone else (as if that makes everything better).  I think that this paper confirms this trouble (with respect to the advanced economies) but also leads me to the conclusion that we could eventually have a massive international debt crisis.


Here are their key ideas:

Introduction

1. While deficit levels are reaching extremely high levels, this is due to much longer-term issues than simply the current recession.  For years, debt has increased during bad times, but not decreased during good times.
2. Fiscal tightening has eliminated deficits during some periods, but it has not reduced debt.
3. The situation is worse for the advanced economies than for the emerging economies.  See chart below.
   

II. Key Trends in Public Finance

Part A: Public Debt Levels Have Increased

1. After World War II, debt levels of the countries that won the war dropped due to growth.  The countries that lost the war had their debt eroded by inflation.
2. In 1974, the G-7 countries hit their average debt-to-GDP trough of 35%. Since then, the ratio has risen.  By 2007, it had reached 80%.
3. By the end of 2010, public debt is projected to rise to nearly 110% of GDP.  As seen in their exhibit, this is caused by revenue loss, interest growth, fiscal stimulus and financial sector support.  See chart below. 
   
4. Governments seem to view debt as a shock absorber – it is increased during bad times and it does not come down during good times.  The US and Canada were the only exceptions to this analogy.  But, the US was misleading…we reduced debt from the mid-1990s to 2000 (from tax revenue that came from technology stock options), but the US debt level has especially exploded since then.
5. The debt situation is a little misleading because you should also consider the financial assets that a country holds.  (Most of these assets are held as the result of support of the financial sector.)  The authors think that you should look at gross debt minus financial assets and think about net debt.

Part B: The Size of Government: Public Expenditure

1. The size of government (spending-to-potential GDP) has increased significantly. This is true for overall spending as well as primary spending (spending excluding interest payments).  Most of this took place between 1965 and 1985.
2. Many have argued that governments have moved from providing “core functions” (defense, policy, justice) to providing a much wider range of social services.  The authors say that this is true, but we need to be more specific…over 80% of the increase in public spending is due to health care and pensions. In the US, these two factors have accounted for more than 2/3 of the increase in the primary spending ratio.  See chart below.
   

Part C: Trends in Taxation

As a percentage of GDP, personal income taxes have risen for the G-7 nations, as have social security (or similar program) taxes.  Corporate taxes have remained steady as a percentage of GDP (lower tax rates, but a broader base).  Indirect taxes (such as VAT in many countries) have increased.


Part III: Future Challenges

A. The Impact of the Crisis on Public Finances

1. On average, the G-7 countries have seen their deficits widen by 7% (to 9.25%) of GDP from 2007 to 2010. This 7% is a combination of cyclical deterioration (5%) and discretionary fiscal stimulus (2%).

2. In addition, there has been a loss of potential GDP (how GDP could have grown if employment and productivity had continued at a constant pace).

3. There must be a huge fiscal adjustment (8.75% of GDP) in order to lower debt-to-GDP to 60% by 2030. Just to stay at a constant debt-to-GDP, there must be a 6.50 adjustment.  Like any average, some countries are worse off than others – and the US is worse off.  See exhibit below.

4. In the absence of a fiscal adjustment, the IMF estimates that public debt (for the G-7 countries) will have increased 40% between 2007 and 2015.  They estimate that this will raise real interest rates by 2% in the medium term and lower potential growth by ½%. This will make fiscal adjustment more difficult – a dangerous spiral.


B. LONG-TERM PRESSURES FROM AGE RELATED SPENDING

1. In addition to existing problems, additional problems will arise due to pension and health care.  With that said, much of the emphasis has been on pensions.  Yet, due to reforms, the increase in pension spending (as a percentage of GDP) will only increase from 7% to 8% (for all G-7 countries combined).   The big problem is health care.

2. Health care spending by the US government is expected to increase by approximately 4.5% of GDP over the next 20 years. Interestingly, in Europe, it is only expected to increase by approximately 1%.

3. The primary reason for the difference is that the EU projections do not consider “non-demographic” factors (these are the factors which have accounted for more of the cost increase over the past 50 years).  Non-demographic factors include technology, income growth and the expansion of insurance.  Most importantly, it ignores the fact that while technology has improved, procedures and projects have become more expensive.  If trends continue, Europe will see a 3% increase (as a percentage of GDP).


C. Risks of a Public Debt Spiral

1. In the absence of fiscal adjustment, public debt will spiral out of control.  The debt-to-GDP ratio of the G-7 countries would reach 200% by 2030 and exceed 440% by 2050. See exhibit below.

2. In my opinion (not that of the authors), this assumption is too pessimistic because it is assuming that our deficits will continue at 2010 levels (other than stimulus spending), but those numbers are particularly low (due to low tax revenue and low GDP).  Regardless, this is a serious problem (and it’s rare for me to say that something may overstate the issue).


IV. Responding to the Challenges: Key Principles

Concern for fiscal vulnerabilities can undermine confidence and threaten recovery.  Here are the important features of fiscal strategies:

1. Growth Friendly Structural Reforms

Fiscal consolidation is much easier in a context of high growth.  Ensuring growth is the key to debt sustainability.  Achieving higher growth potential will require reforms in product markets, labor markets, financial markets and the public sector.  Immigration policies will also be critical.  But, counting entirely on higher growth is not a credible strategy.

2. Clear Medium-Term Orientation

Markets need to be reassured that there is a plan and that it’s not far out in the future.  We have to balance debt sustainability with economic recovery.

3. Stronger Fiscal Institutions

Governments’ shortsightedness and the role of special interest groups have resulted in a deficit bias for most G-7 countries.  The problems that we have were not caused by how fiscal policy was managed during the crisis; the problems are based on how policies were managed before the crisis. The G-7 nations need better fiscal rules, better budgetary processes and better fiscal monitoring.

4. Expenditures and Revenue Reforms

Consolidation should focus on the spending side.  With that said, the authors note that the tax ratio is low in the US and it will be nearly impossible to avoid some action on the revenue side.  On the expenditure side, a target of freezing non-age-related spending in real per capita terms could create savings of 3 – 3.5% of GDP within ten years.  Public wage increases need to be moderated.  Subsidies and social transfers need to be reformed.

The authors also recommend that the US try to increase revenue by use of a VAT.  In addition, they recommend that tax expenditures be reduced and tobacco and alcohol excises be increased.

5. Equitable Adjustment

An adjustment strategy must be equitable from an intergenerational perspective and must also ensure and adequate social safety net that allows a level playing field.  Governments must fight against tax evasion and erosion (tax erosion is the idea that the income tax system may fail to tax income in a progressive way and may fail to tax the person who earned the income).


One Final Conclusion

If we wait until interest rates start to rise, fiscal adjustment will be even more challenging.


Two Amusing Links

1. Here’s an amusing video about salesforce.com:

http://www.xtranormal.com/watch/6985513/

2. Here’s an amusing video about a well-known economist being paid for research (you really need to watch the video rather than simply reading the article):

http://ftalphaville.ft.com/blog/2010/08/25/325376/mishkins-very-own-icelandic-blow-up/

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