Fiscal Challenges in Advanced Countries

Jakob Ekholdt Christensen and Rasmus Tommerup, Economics

Introduction and summary

The global economic crisis has led to historical deterioration of the public finances of the advanced countries. Debt is mounting at a pace not seen since World War II. Even countries such as Ireland, Portugal, Spain and the UK, which entered the crisis with reasonably strong fiscal positions, are now in dire fiscal straits. Denmark's public finances have also deteriorated significantly. However, Denmark posted considerable government budget surpluses in the years up to the crisis.

In the countries most severely affected, the development has generated concerns about an outright debt crisis. These concerns have been exacerbated by the most recent turn of events in Greece – the extremely large widening of interest-rate spreads and the need for urgent implementation of austerity measures. Ultimately, it was necessary to introduce a financial support programme from the International Monetary Fund, IMF, and the euro area member states. There are now clear signs of the market concerns having a spill-over effect on other countries.

The largest emerging economies have been less affected by the economic downturn. Coupled with less pronounced automatic stabilisers, this has limited the deterioration of public finances.

For many advanced countries, government debt as a ratio of the gross domestic product, GDP, will rise to more than 100 per cent if they fail to implement fiscal consolidation in the coming years. The higher debt as a result of higher interest payments will make future consolidation more difficult. Moreover, new research shows that a large debt impedes economic growth through such factors as elevated real interest rates.

Using stylised projections, this article examines the fiscal challenges of these countries if they are to stabilize or reduce their debt. The extent and duration of the necessary fiscal consolidation are of a magnitude rarely seen in recent times. The need for consolidation is most pronounced in Japan, Greece, the USA, Ireland and the UK.

Denmark enjoys a good position in an international context. However, is should be remembered that many other advanced countries are facing serious fiscal challenges. Moreover, recent years' developments in e.g. the UK and Ireland illustrate how public finances can deteriorate strongly in a very short time. It is thus paramount to rein in fiscal policy in time, so as to ensure that the debt is kept under control and that there is scope for tackling future fiscal challenges, especially against the backdrop of the age-related increases in public expenditure facing the advanced countries.

Ambitious tightening of fiscal policy in the advanced countries will require unprecedented fiscal discipline and probably dampen growth temporarily. The need for synchronous fiscal tightening across the countries will exacerbate the negative economic effects, especially in strongly export-oriented countries. However, it is not unlikely that the countries facing the greatest fiscal challenges will see positive effects of their fiscal tightenings already in the short term. In the longer term, there is no doubt that tighter fiscal control and sustainable government debt will benefit the advanced countries substantially.

government deficit and debt dynamics during the crisis

Prior to the crisis, many countries¹posted strong economic growth without sufficient fiscal consolidation. Budget deficits remained considerable and some countries experienced mounting government debts. This made many countries more vulnerable to the subsequent cyclical downturn.

The crisis has brought the deficit of the OECD countries from 1.3 per cent of GDP in 2007 to 8.3 per cent in 2010, which is the highest level in the post-war period. Ireland, Spain, the UK, Finland and Denmark account for the strongest deteriorations of public finances, as their balances have worsened by around 10 per cent from 2007 to 2010, cf. Chart 1.

Part of the increase can be attributed to falling output and rapidly growing unemployment, which has resulted in reduced tax revenue and rising expenditure. Cases in point are Denmark, Ireland, Spain, the UK and the USA. Moreover, the latter two countries are also severely affected by reduced tax revenue from their relatively large financial sectors.

In addition, several countries have eased fiscal policy as a consequence of the crisis. While fiscal accommodation has been particularly pronounced in the USA, the European countries have shown more restraint, relying on the automatic stabilisers instead. Exceptions are Denmark, Sweden and the Netherlands, where the automatic stabilisers are relatively substantial, but where discretionary fiscal expansion has also been considerable, cf. Winther (2009).

Some of the accommodative measures are temporary and will expire over the coming years. Nevertheless, the OECD assesses that three quarters of the government deficits in the OECD countries are structural and will not be reversed automatically when the economies return to more normal economic growth rates. Finally, crisis packages² to the financial sector have contributed to the rising deficits.

A number of countries are now facing a very difficult fiscal situation with large structural deficits combined with substantial government debts³, cf. Chart 2. This also applies to countries that had moderate debt before the financial crisis, such as Ireland, Portugal, Spain and the UK, while Greece has struggled with a debt ratio in excess of 100 per cent of GDP for many years. Unemployment continues to be elevated, and the sustainability of the economic upswing remains uncertain.

On top of the immediate fiscal challenges, another threat is notable increases in age-related expenditure⁴over the next decades, cf. Chart 3. The average increase is expected to be around 5.5 per cent of GDP in the period 2009-50. The largest increases are expected in some of the countries that already have heavy debt burdens, particularly the GIPS countries. However, the timing of the surges in age-related expenditure varies across the countries. In the coming decade, age-related expenditure is expected to rise most substantially in Denmark, Finland, the Netherlands and Greece.⁵

The historical deterioration of public finances has generated concerns about a government debt crisis in several advanced countries⁶. These concerns were amplified by Greece's experience of such a crisis since the autumn of 2009 with rising interest rates, austerity measures and ultimately a financial support programme from the IMF and the euro area member states. This has had a knock-on effect on other GIPS countries and affected the global financial markets. The concerns have caused risk premiums and Credit Default Swap, CDS, spreads to soar, increasing the financing costs for the sovereign issuers. Moreover, fiscal sustainability is also a concern in countries traditionally regarded as having a high credit standing, including the USA and the UK. This has led to renewed focus on the risks associated with a large government debt, cf. Box 1.

As a result of the deterioration of public finances, substantial fiscal consolidation is required in these countries. The consolidation in EU member states whose deficits exceed the reference value of 3 per cent of GDP will be governed by the requirement in the Stability and Growth Pact of an annual reduction of the structural (cyclically adjusted) budget deficit of at least 0.5 per cent of GDP. However, considerably stronger tightening measures are required of most of the EU member states that have already received notice to correct their excessive deficits as from 2010. This applies especially to Greece⁷, Ireland and Spain. The UK and the USA are also planning relatively extensive tightening measures in 2010-11, in the range of 2 and 2.1 per cent of GDP, while Japan's deficit continues to grow. Despite the tightening measures, all the countries under review, except Sweden, are expected to post continually rising debt as a ratio of GDP until 2011.

General discussion of government debt

In limited periods, central-government expenditure may exceed revenue, which requires borrowing. A government may have good reason not always to aim at a balanced budget. Economic and financial crises may require expansionary fiscal policy or measures to support financial enterprises in order to mitigate the detrimental effects of the crisis, cf. Winther (2009).

In the long term, however, government revenue and expenditure must balance. Otherwise the government may at some point be forced to default on some of its obligations, by failing to service its debt or failing to honour its obligations to citizens, e.g. pensions.

Recent decades have seen relatively few examples of governments failing to honour their obligations and service their debts. Consequently, government bonds in advanced countries have been perceived historically as some of the most secure investment objects with a low credit risk, high credit rating and relatively low return compared with e.g. debt instruments issued by large corporations, cf. Thomsen (2005).

Fiscal policy is often examined by looking at fiscal sustainability, which is a measure of the solvency of the public sector economy. Public finances are regarded as sustainable if the present value of all future public expenditure, including interest payments on the debt, does not exceed the present value of all future public revenues, cf. the Economic Council (2004).

It follows that the sustainability concept does not take liquidity into account, i.e. current financing of the government debt. However, the two concepts are connected. Difficulties in connection with current financing of the government debt and consequent higher interest costs will put solvency under pressure. Moreover, uncertainty about long-term fiscal sustainability may result in difficulties in financing the current debt.

debt scenarios for selected countries

This section discusses the need for fiscal tightening on the basis of stylised projections of government debt under various assumptions (see the Appendix for details). Since the assumptions may not hold true, the sensitivity of the results to the various parameters is also examined.

The projections are based on equation 1 in Box 2. Until 2011, the European Commission's May estimate is used for the EU member states and OECD data from November 2009 is used for the USA and Japan. The data thus incorporates the convergence programmes of the EU member states. The growth-adjusted interest rate (the interest rate less the GDP growth rate) is assumed to be 1 per cent for all of the countries. The primary deficit is assumed to be back at its structural level in 2012 in step with the recovery of output to its structural level.⁸Consequently, the projection envisages fiscal adjustments of the primary structural balance from 2012 to 2020. The projections include estimated increases in age-related expenditure, except in Japan. The exact estimated need for fiscal tightening should, however, not be given too much weight, as the need depends heavily on the assumptions in the projections. The key issue is the magnitude of the fiscal challenges and the differences between the countries.

The first scenario envisages stabilisation of the government debt by 2015. However, several arguments foresee that stabilisation of the debt ratio is not enough, in view of the considerable negative real economic consequences of a high debt ratio, cf. Box 1. A reduction of the debt ratio to 90 per cent has thus been chosen as the second scenario. The last scenario illustrates the extent of the fiscal tightening required to reduce the debt to 60 per cent of GDP, i.e. the reference value in the Maastricht Treaty. It has been chosen that the debt targets of 60 and 90 per cent of GDP must be met in 2020.

Projection results

Even the softest scenario with debt stabilisation by 2015 requires considerable tightening of the primary structural balance in a number of countries. 10 out of 16 countries thus have to tighten fiscal policy by more than 0.5 per cent of GDP annually from 2012 to 2015, cf. Table 1.

The need for fiscal tightening is greatest in countries with large deficits, e.g. the UK, the USA, Ireland, Spain and Japan, as such countries suffer from both considerable deficits and large interest expenditure due to the high debt. For a number of member states in southern Europe with excessive deficits, including Greece and Portugal, the need for fiscal tightening from 2012 is smaller than could have been expected. The reason is the smaller structural element in their primary deficits ⁹, which entails a substantial improvement from 2011 to 2012 given the assumption that the primary balance will return to its structural level in 2012. The debt stabilisation level in 2015 ranges from 40-60 per cent of GDP in the Nordic countries to more than 140 per cent in Greece and more than 210 per cent in Japan. For many countries, the debt stabilisation level is above 90 per cent. Consequently, the target of debt stabilisation is only an emergency solution. This is also emphasised by the expectation that interest expenditure will exceed 5 per cent of GDP in Greece, Italy and the USA and 3 per cent of GDP in the other countries (except the Nordic countries).