VI The Risk for Fiscal Solvency and the Appropriate Policy Response
Author:
International Monetary Fund
Search for other papers by International Monetary Fund in
Current site
Google Scholar Close
Language:
English
Print Publication Date:
18 Sep 2009
Keywords:
OP; asset; GDP; debt ratio; cost; PPP GDP weight; GDP ratio; ratio reduction; growth differential; nominal interest rate; financial crisis; Fiscal stance; Solvency; Global; Central and Eastern Europe; Eastern Europe; Europe; Africa; stimulus package; Aging
Download PDF (303.7 KB)

Abstract

The deterioration of the fiscal outlook highlighted in Section V raises issues of fiscal solvency, and could eventually trigger adverse market reactions. Doubts about fiscal solvency—the risk that governments find it more convenient to repudiate their debt or to inflate it away—could lead to an increase in the cost of borrowing. In turn, higher interest rates (and exchange rate depreciations in countries with significant borrowing in foreign currency, like most emerging economies) could further add to government debts—in some cases, resulting in “snowballing” debt dynamics. This scenario would be deleterious for global growth. Indeed, economic agents’ confidence in governments’ solvency has been a source of stability and has, so far, helped to avoid a complete meltdown of financial markets.

The deterioration of the fiscal outlook highlighted in Section V raises issues of fiscal solvency, and could eventually trigger adverse market reactions. Doubts about fiscal solvency—the risk that governments find it more convenient to repudiate their debt or to inflate it away—could lead to an increase in the cost of borrowing. In turn, higher interest rates (and exchange rate depreciations in countries with significant borrowing in foreign currency, like most emerging economies) could further add to government debts—in some cases, resulting in “snowballing” debt dynamics. This scenario would be deleterious for global growth. Indeed, economic agents’ confidence in governments’ solvency has been a source of stability and has, so far, helped to avoid a complete meltdown of financial markets.

Thus far, government debt market reaction to the weaker fiscal outlook has been relatively muted, but not all signs are reassuring. Long-term nominal interest rates have declined in the main advanced economies since the beginning of the crisis (Figure 6.1). However:

Figure 6.1.
Figure 6.1.

Long-Term Government Bond Yields and Spreads

Sources: IMF, World Economic Outlook database; Bloomberg; and IMF staff calculations.Note: 10-year government bonds. Nominal yields in the top panel; spreads vis-à-vis Germany in the middle and bottom panels. In the bottom panel, the slope coefficient is 1.3 (i.e., a 10 percentage point increase in the debt-to-GDP ratio is associated with a 13 basis point increase in spreads).

  • Real interest rates are broadly the same as in early 2007 (where these can be reliably observed from long-term inflation-indexed bonds traded on liquid markets, for example, in the United States and the United Kingdom),20 although one might have expected a decline as a result of cyclical developments.

  • For some highly indebted advanced economies (e.g., Greece and Italy), spreads have risen significantly, although government bond yields in those countries remain broadly similar to their precrisis levels (Figure 6.1).21

  • There has been an uptick in credit default swap (CDS) spreads in recent months for some of the major advanced countries, including the United States, though the implied perceived default risk remains relatively small.22

  • Sovereign bond spreads for emerging economies have risen sharply—reflecting increased risk aversion, and far in excess of what would seem warranted on the basis of domestic fundamentals. The EMBI Global composite spread rose to 750 basis points in December 2008 from 170 basis points in the beginning of 2007, and primary bond issuance slowed sharply—issuance by all emerging markets in August–December 2008 was half of its level during the same period in 2007.

More generally, recent history suggests that an abrupt market reaction to weakening fundamentals is possible. Thus, it is necessary to look closely at the risks arising from the deterioration of the fiscal outlook, and to draw implications for fiscal policy in the medium term.

The Level of Government Debt

The rise in government debt levels caused by the crisis does not, in itself, have major adverse implications for solvency:

  • Fiscal solvency requires that government debt is not on an explosive path (as this would violate the government’s intertemporal budget constraint—that is, the no-Ponzi-game condition that the government does not borrow just to pay interest on debt).23 Following the simple arithmetic of changes in the debt-to-GDP ratio (Box 6.1), a one-off rise in the government debt ratio only requires a small increase in the primary balance to ensure solvency: for example, a rise in the government debt-to-GDP ratio by 10 percentage points requires an improvement in the primary balance of less than 0.1 percentage point of GDP to stabilize the debt ratio (assuming an interest rate/growth differential of 1 percentage point, in line with the average of the past few decades).

  • The rise in government debt observed so far in advanced countries, while sizable, is not exceptional from a long-term perspective. Historically, large debt accumulations (bringing the debt to 100–200 percent of GDP) have resulted from war-related spending, prolonged recessions, or protracted fiscal problems (Table 6.1 and Figure 6.2).

  • Highly disruptive ways of reducing debt/GDP ratios have occurred in some instances, but not since the 1940s for advanced countries.24

  • A rise in debt ratios does not seem likely, in itself, to cause a large increase in interest rates. While such an increase would make the solvency arithmetic less favorable, empirical evidence shows that, in normal circumstances and in advanced countries, even a 10 percentage point of GDP increase in debt ratios would raise interest rates only by a few basis points (at least, if debt ratios are below 100 percent). (See Appendix VII.)

Table 6.1.

Historical Episodes of Major Accumulations and Decumulations of Government Debt

(As a share of GDP, in percent)

article image
Figure 6.2.
Figure 6.2.

Selected Countries: Public Debt-to-GDP Ratio

(In percent)

Sources: United Kingdom: Goodhart (1999) and IMF, World Economic Outlook database. United States: Historical Statistics of the United States, Millennial Edition Online; Office of Management and Budget; and U.S. Census Bureau. Japan: Bank of Japan, Hundred-Year Statistics of the Japanese Economy; and Toyo Keizai Shinposa, Estimates of Long-Term Economic Statistics of Japan Since 1868. Data for Japan refer to the central government.

However, the rise in government debt cannot be ignored:

  • There is a need to avoid the perception that all one-off shifts in debt ratios would be accommodated: in order to allow government debt to act as shock absorber in bad years, it must improve in good years. Thus, particularly in countries with relatively high debt ratios, it will be necessary not just to stabilize the debt ratio but to bring it back to its precrisis level (or even below, if the initial level was excessive). In this respect, in 2014, gross government debt ratios would stand above 100 percent of GDP in six advanced economies (Belgium, Greece, Ireland, Italy, Japan, and the United States) and between 60–100 percent of GDP in ten (Table 6.2).25 This level of debt sets a more demanding requirement on the primary balance: for example, for a 10 percent increase in the debt ratio, the primary balance would have to improve by more than 1 percentage point to bring back the ratio to its original level within 10 years.

Table 6.2.

Debt and Primary Balance

(In percent of GDP)

article image
Sources: IMF, World Economic Outlook (WEO), April 2009; and IMF staff calculations.

IMF, World Economic Outlook, October 2007. A direct comparison for Turkey cannot be made, as postcrisis numbers reflect a substantial revision in the GDP series.

Average primary balance needed to stabilize debt at end-2014 level if the respective debt-to-GDP ratio is less than 60 percent for advanced economies or 40 percent for emerging market economies (no shading); or to bring debt ratio to 60 percent (halve for Japan and reduce to 40 percent for emerging market economies) in 2029 (shaded entries). The analysis is illustrative and makes some simplifying assumptions: in particular, beyond 2014, an interest rate–growth rate differential of 1 percent is assumed, regardless of country-specific circumstances; moreover, the projections are “passive” scenarios based on constant policies. The primary balances reported in this table include interest revenue, which could be sizable in some countries.

Fiscal projections reflect IMF staff’s estimates based on the authorities’ policy intentions as stated in the EU Pre-Accession Program document.

Debt/GDP Stabilizing Primary Balance

Δ ( D Y ) t = ( r − g 1 + g ) ( D Y ) t − 1 ⁢   − p b

where D is the debt stock, Y is GDP, r is the nominal interest rate, g is the nominal growth rate, pb is the primary fiscal balance as a share of GDP, and Δ indicates a change over the previous year. The debt ratio is constant when pb= (D/Y)(r - g)/(1 + g).

  • Debt tolerance seems to be lower for emerging economies. Indeed, government debt was below 60 percent of GDP in most default cases recorded in emerging economies in recent decades, though there has been wide variation (Reinhart, Rogoff, and Savastano, 2003; and IMF, 2003). Lower debt tolerance in these countries may reflect factors related to liquidity and solvency risks, such as greater reliance on financing by nonresidents; low shares of long-term, domestic currency denominated debt; and low and volatile revenue-to-GDP ratios.

  • Rollover risks are likely to increase. Market analysts have recently focused on increased debt issuance by advanced countries in 2009. While roll-over risk has in the past been seen as affecting primarily emerging economies, higher-debt advanced countries may also be more exposed in coming years.

  • When considering lessons from history, it is important to bear in mind two important differences. First, in wartime episodes, debt financing was facilitated by comprehensive government control over the economy, including capital controls. Moreover, citizens may feel the “moral duty” to support the war effort by purchasing government debt. Second, the current crisis involves truly novel features compared with historical episodes: in particular, it involves large contingent liabilities associated with guarantees of financial sector obligations; and it takes place, in many countries, in a context where pension and health care systems will give rise to large future spending increases. We turn to these factors in the next section.

The Dynamics of Government Debt: Current and Future Deficits

Debt solvency is a forward-looking concept. Public debt dynamics are driven not only by current but also future deficits. As discussed earlier, the crisis has led to a weakening of fiscal flows, not just stocks.

Primary balances, in particular, are now at levels that, in many countries, are insufficient to ensure debt stabilization, let alone to reduce debt to precrisis levels. For some of the main advanced countries where the crisis has resulted in large increases in debt—including the United Kingdom and the United States—the primary fiscal balance would have to improve, starting in 2014, by a few percentage points of GDP (compared with “unchanged policies” projections) to gradually bring the debt back to, say, 60 percent of GDP over the following 15 years (Table 6.2). More generally, almost all the advanced countries reported in Table 6.2 will still have primary balances in 2014 that are below what is required to stabilize their government debts (or bring them gradually down to 60 percent), in spite of the projected cyclical recovery of output and revenues (assuming an interest rate/growth rate differential of 1 percent). For a sample of selected emerging markets, the share of countries with 2014 primary balances below the level needed to stabilize the debt ratio or reduce it to a benchmark level of 40 percent of GDP is lower, but still more than one-half. Primary gaps would be larger if the risks to the baseline materialize.

To make matters worse, primary balances are projected to weaken further owing to the demographic shock.

  • For the EU-25 countries, Eurostat 2008 projections suggest on average a doubling of the old-age dependency ratio (population older than 65 relative to working-age population) from 2005 to 2050, with the modal age-cohorts moving from mid-thirties to late fifties. These changes will exert upward pressure on public spending for pensions and health care (Table 6.3). The European Commission (EC, 2006) projects that for the EU-25, average spending will increase by 3.4 percent of GDP, with an increase in pension expenditures of 2.3 percent of GDP, and the rest accounted for by health and long-term care spending.26

  • For the United States, the Congressional Budget Office (CBO) projects annual federal budget spending on pensions to increase from 4.3 percent to 6.1 percent of GDP from 2007 to 2050 (CBO, 2007).27 Significant aging-related budgetary pressures are also present in Japan, particularly from spending on health and long-term care.

  • While less affected, the share of the populations older than 65 is projected to increase in all emerging economies, with the old-age dependency ratio expected to triple, on average, by 2050 (United Nations, 2006). Korea faces the steepest increase, but there are also significant pressures in China and many other countries (Figure 6.3). Outside the G-20 countries, demographic trends are expected to be particularly negative in most of central and eastern Europe. Overall, budgetary aging-related spending is likely to increase in emerging economies, but given the smaller role of the public sector in the provision of pensions and health care (with some exceptions such as in eastern Europe), less so than in advanced economies.

  • An illustrative additional “cost pressure” scenario (Table 6.3, 2050 CPS columns) indicates that budget strains could be substantially larger if the increase in the relative price of health and long-term care services are higher than assumed in the relatively conservative baseline scenario. The high income elasticity shown by the price of these services in many countries and the rapid increase in social demand for them make this alternative scenario a plausible possibility.28

Table 6.3.

Fiscal Costs of Aging

(In percent of GDP)

article image
Sources: Organization for Economic Cooperation and Development (2001 and 2006); European Commission (2006); Hauner (2008); World Bank (2006); and Congressional Budget Office (2007). Data for other G-20 countries were not available.

CPS = cost pressure scenario. For health spending, assumes additional 1 percent annual growth in spending on top of the demographic and income effect. For long-term health care, it assumes full “Baumol” effect, that is, long-term costs per dependent increase.

Total increase includes change in the fiscal cost of aging due to pension, health, and long-term health care between t and 2050 for the base-case scenario only.

Figure 6.3.
Figure 6.3.

Population Aging in Emerging Market Countries, 2005 and 2050

(Old-age dependency ratio)1

Source: United Nations (2006).1 Population aged 65 or over relative to population aged 15–64, in percent.

Altogether, the global fiscal outlook is somber. The debt ratio of G-20 advanced countries is projected to increase by an additional 59 percentage points by 2030 (Figure 6.4).29 Strains are also likely to appear in emerging economies (as demographic forces will operate also there), though long-term projections in those economies are subject to greater uncertainty, owing to data limitations.

Figure 6.4.
Figure 6.4.

Advanced G-20 Countries: Government Debt1,2

(In percent of GDP)

Source: IMF, World Economic Outlook (WEO), April 2009 projections up to 2014.1 After 2014, projections assume (1) structural primary balance deteriorates due to demographic factors (Table 6.3); (2) if the debt-to-GDP ratio falls below 20 percent, the fiscal balance loosens to ensure the debt ratio remains above 20 percent; in the case of Korea, which faces particularly severe demographic pressures, the debt ratio is permitted to fall below 20 percent; and (3) the interest rate/growth differential converges to 1 percentage point.2 Debt data correspond to general government if available, otherwise most comprehensive fiscal aggregate reported in the WEO. Averages based on PPP GDP weights.

The Way Forward

This somber outlook raises two critical, and related, questions:

  • Should the economic outlook deteriorate further, how much room does fiscal policy have to continue its supportive action?

  • What should be done to reassure markets that fiscal solvency is not at risk?

The issue of how much further room there is for fiscal support cannot be answered in absolute terms, but should be addressed as a risk management issue. Governments will have to balance two opposite risks:

  • The risk of prolonged depression and stagnation. From this perspective, the economic and fiscal costs of inaction could be even larger than the costs of action. The higher this risk, the more it will be necessary for governments to take risks on the fiscal side by providing further support (to the financial sector—as a key priority—but possibly also to directly support aggregate demand).30

  • The risk of a loss of confidence in government solvency. Fiscal balances are expected to deteriorate in bad times. But the risks have increased and there is a need to closely monitor developments in real interest rates, spreads, and debt maturity. The more these indicators weaken, the less would be the room for further fiscal action.31

Balancing these risks will be challenging but the trade-off can be improved if governments clarify, in a credible way, their strategy to ensure fiscal solvency. Indeed, greater clarity is urgently needed. The problem cannot simply be ignored.

A strategy to ensure fiscal solvency should be based on four pillars:

  • Fiscal stimulus packages should consist as much as possible of temporary measures;

  • Policies should be cast within medium-term fiscal frameworks that envisage a gradual fiscal correction, once economic conditions improve, with proper arrangements to monitor progress;

  • Governments should pursue growth enhancing structural reforms; and

  • There should be a firm commitment and a clear strategy to contain the trend increase in aging-related spending in countries exposed to unsustainable demographic shocks.

These prescriptions are, of course, not new. Some of them are part of the long-standing policy advice provided by the IMF. However, the weaker state of public finances has now raised the cost of inaction.

The Composition of the Stimulus Package

The fiscal stimulus should not raise deficits permanently. As noted in Spilimbergo and others (2008), fiscal stimulus measures will likely have to be prolonged—because the decline in private sector demand is likely to be long-lasting—but should not be permanent. Ideally, what is needed is an intertemporal shift that, with respect to the precrisis baseline, raises deficits for the expected duration of the crisis and reduces them later, so as to leave long-run debt levels unchanged. Stimulus measures (or sets of measures) should thus be self-reversing, to the extent possible, or at least temporary.

Thus far, not all the stimulus provided conforms to this prescription. The deficit increases related to automatic stabilizers will, of course, be reversed when output recovers, but only part of the announced stimulus packages involves temporary or self-reversing measures. It will, therefore, be important that governments indicate at an early stage how these measures will be offset over the medium term.

Medium-Term Fiscal Frameworks

Ensuring fiscal solvency would be facilitated by medium-term fiscal and debt targets buttressed by a clear adjustment strategy and strong institutional setup (Kumar and Ter-Minassian, 2007). Governments should have a medium-term plan on how to move public finances back to a more sustainable level, backed up by clear policies and supported, where appropriate, by fiscal responsibility laws, fiscal rules, or independent fiscal councils. With the recovery, this approach would help mitigate pressures from procyclical spending increases or tax cuts, allowing more robust buffers to be built. Such an approach has been followed successfully by some countries that had to face a surge of government debt as a result of financial crises (Box 6.2; see also Henriksson, 2007). More specifically:

  • Medium-term frameworks setting credible targets over the following four–five years can help clarify vulnerabilities, and impel policymakers to take steps to improve the medium-term viability of public finances. But stating medium-term targets is not sufficient: the credibility of these targets—more than in the past—should be buttressed by the definition of clear policy actions through which they will be reached. This is not always the practice in countries with medium-term scenarios.

  • To capture fiscal risks, such frameworks should also assess debt solvency under different scenarios. This is particularly important in the current context in which the contingent liabilities of governments have increased.

Post-Banking-Crisis Fiscal Consolidation: Finland and Sweden During the 1990s

In the early 1990s, both Finland and Sweden experienced recession and sharply deteriorating fiscal positions following major banking crises. The general government balances of both countries deteriorated by about 14 percent of GDP from 1990 to 1993, to –8 percent of GDP in Finland and –11 percent of GDP in Sweden. This contributed to a substantial increase in general government debt, up to 58 percent of GDP in Finland and 72 percent of GDP in Sweden by the mid-1990s, some of which was attributable to the gross direct fiscal costs of the banking crises, estimated at 13 and 4 percent of GDP for Finland and Sweden, respectively. The fiscal expansions in 1992–94 fueled anxiety over fiscal indiscipline; moreover, they did not stimulate private sector activity, because they preceded the financial sector resolution. Thus, risk premia spiked in 1994.

To restore sustainability, fiscal consolidation programs were adopted, based primarily on spending restraint and supported by institutional reforms.

In Finland, two key reforms were adopted. First, a medium-term expenditure framework was introduced to prioritize resource use in a strategic and transparent manner, and to provide spending departments with greater autonomy in managing their resources. Second, entitlements were reformed to reduce spending and structurally increase employment. This included tighter qualification rules and temporary lifting of inflation adjustment for unemployment benefits; reduction of benefits for early retirement; and determination of the pensionable wage on the basis of the last 10 (rather than 4) years of employment.

In Sweden, the authorities implemented a Consolidation Program aimed at achieving fiscal balance. Key measures included: tighter rules on transfers to households (housing grants and subsidies, sick leave benefits, unemployment insurance, family allowances and social insurance benefits); and revenue enhancing measures, such as increases in income taxes, social security fees, and employee payroll taxes.

These fiscal consolidations helped entrench the economic recovery (post-1994) and reduce general government debt/GDP ratios to below 45 percent in Finland and 55 percent in Sweden by 2000. The economic recovery, which contributed to the improvement in the fiscal position, was led by falling interest rates and the rise in exports (following the currency devaluations and the restoration of financial sector health). The redirection of policy toward fiscal balance reduced interest rates and reinforced the economic turnaround.

  • Effective and transparent processes should be set in place to maximize revenues from management and recovery of assets acquired during the financial support operations. Losses incurred by central banks as a result of support to financial institutions should be promptly covered through transfers recorded in the government’s budget.

  • Fiscal rules may help to maintain or restore solvency if they are supported by the requisite political commitment, allow sufficient flexibility to respond to exceptional circumstances, and are designed and implemented in a way that avoids excessive constraints on policy or is simply non-binding. Whether or not formal rules are introduced, governments should be committed to tighten fiscal policy in good times, now that fiscal policy has been relaxed during bad times.

  • A complementary role can be played by fiscal councils, already established in many countries, to provide independent monitoring and forecasts.

Growth-Enhancing Structural Reforms

Rapid growth has been a key factor in bringing about sustained improvements in government debt ratios. For example, the aftermath of World War I saw a further increase in the debt ratios in several advanced economies (e.g., France and the United Kingdom) as a result of the Great Depression, whereas the aftermath of World War II was characterized by declining debt ratios fostered by rapid economic growth (Table 6.1). Strong growth has also been a key source of debt reduction in more recent emerging market episodes (Table 6.4; see also World Bank, 2005; and IMF, 2005).

Thus, together with other structural reforms, expenditure and tax policies will need to focus on fostering growth (Daniel and others, 2006; Gupta, Clements, and Inchauste, 2004). Expenditure-led adjustments supported by tax base broadening, creating scope for tax rate reductions, have in some cases reduced interest costs and spurred economic growth, resulting in especially successful debt reductions (see Box 6.2). More specifically:

  • Expenditure policies. The fiscal stimulus measures that are being adopted should be consistent with boosting growth potential. Similarly, in identifying the measures needed to consolidate the fiscal accounts, governments should seek to reduce unproductive spending while preserving expenditures that are likely to yield high-quality growth and a high social rate of return (e.g., basic transportation infrastructure, education, preventive health care). Distributional objectives should be pursued by targeted spending measures.

  • Tax reform. Reforms should focus not only on broadening the tax base and reducing rates, so as to minimize distortions and promote equity, but also on improving incentives to work and to invest, simplifying administration and compliance, and enhancing the transparency of the tax code. Changes to the tax structure should give greater emphasis—beyond externality-correcting taxes (e.g., carbon pricing schemes)—to consumption taxes (especially a broad-based VAT) and property taxes (with income tax and benefit systems addressing equity considerations more directly) and to reducing remaining taxes on international trade. It will also be important to reduce the bias in favor of debt vis-à-vis equity financing, present in most tax systems.

Table 6.4.

Emerging Economies: Selected Debt Reduction Episodes

(In percent of GDP)

article image
Sources: IMF, World Economic Outlook; and IMF staff estimates.

Containing Age-Related Spending

Two considerations are relevant in the current context:

  • In spite of the large fiscal costs of the crisis, the major threat to long-term fiscal solvency is still represented, at least in advanced countries, by unfavorable demographic trends. Net present value calculations illustrate the differential impact of the crisis vis-à- vis aging: in particular, for advanced countries, the fiscal burden of the crisis is about 11 percent of the aging-related costs (Table 6.5, last column). Addressing pressures arising from aging can go a long way in allaying market concerns about fiscal solvency, in spite of the current fiscal weakening.

  • The strategy followed so far in many advanced countries (notably in Europe) has focused not only on entitlement reforms, but also on prepositioning the fiscal accounts for the demographic shock, by cutting the level of debt and reducing spending in other areas (or keeping relatively high tax rates) to make room for expected future increases in pension and health spending. However, this strategy has been derailed, or at least delayed, by the crisis (see Figure 6.5, reporting the pre- and post-crisis outlook in the fiscal balances of five large European countries).

Table 6.5.

Net Present Value of Impact on Fiscal Deficit of Crisis and Aging-Related Spending1, 2

(In percent of GDP, unless otherwise indicated)

article image
Source: IMF staff estimates.

Table reports net present value of the impact on fiscal balance of the crisis and of aging-related spending. Source data for advanced G-20 economies are OECD (2001) and EC (2006); see also Table 6.3. The third column reports the ratio of the first column to the second column in percent. The discount rate used is 1 percent a year in excess of GDP growth for each country. Given that real growth is expected to average 3 percent a year, this is equivalent to applying an average real discount rate of 4 percent a year. For years after 2050, the calculation assumes the impact is the same as in 2050.

Averages based on PPP GDP weights.

Figure 6.5.
Figure 6.5.

EU-5 Countries: Outlook for Fiscal Balance Versus 2006 Stability Program1

(In percent of GDP)

Sources:1 Solid line refers to 2006 Stability Program. Dashed line refers to IMF, World Economic Outlook (WEO), April 2009 estimates and projections. EU-5 denotes simple average of France, Germany, Italy, Spain, and the United Kingdom.

The fiscal impact of the crisis thus reinforces the urgency of entitlement reform. With larger headline debt and lower primary balances, pressures from aging will need to be addressed directly by reforming pension and health entitlements. The amount and speed of adjustment should be country-specific, depending on factors such as demographic and economic growth prospects, cost of borrowing, debt tolerance, and public attitudes toward the tax burden, expenditure needs, and the size of the public sector. Nevertheless, for most countries, postponing required reforms would likely result in larger and more painful adjustment in later years. Moreover, compared with the previously pursued strategy of prepositioning the fiscal accounts for the demographic shock, a direct reform of health and pension entitlements may have some advantages, as it involves smaller cuts in other priority spending (or lower taxation).

Effective entitlement reform should abide by well-known principles. In the area of pensions, savings must be attained while sufficiently preserving intergenerational equity. The main tool should be increases in the effective retirement age, although other parametric changes may be needed. Any assistance to funded pension plans that incurred major losses as a result of the financial crisis should be targeted to lower-income households for whom current retirement income is likely to be seriously reduced. Regarding health care, reforms will need to be equitable to secure broad public support when limiting the service coverage, or shifting costs to the private sector (Verhoeven, Gunnarsson, and Carcillo, 2007).

A specific challenge in the current conjuncture is to take early action in these areas without undermining ongoing efforts to jumpstart economic growth. The key objective should be to ensure that entitlement reform yields savings for the government without reducing aggregate demand. Some steps are less controversial, from an economic perspective. For example, in the area of pensions, an increase in the retirement age would seem unlikely to lead to a decline in consumption. Other steps are more controversial: an increase in contribution rates would reduce workers’ disposable incomes and, as a result, consumption; this latter type of measure would thus seem less desirable in the current conjuncture. In the area of health care, while most countries will need to limit the types of services covered under public systems to ensure solvency, reforms aimed at expanding the provision of basic health care coverage to greater shares of the population—in countries where no major fiscal correction is needed even after the crisis—could help reduce precautionary savings by households. Consideration could also be given to reducing entitlements in a gradual way so that any adverse economic reaction would be spread out over time. What is critical, in any case, is the clear communication of a stronger commitment than in the past to address entitlement reforms decisively, supported by the identification of the necessary actions and their timing.

Enacting major reforms in this area at times of severe economic weakening is likely to be challenging from a political economy perspective, but there are opportunities too. If the fiscal stimulus succeeds in supporting activity, the climate for reform would also improve. Indeed, it may also be that the crisis environment offers in some countries an opportunity for a comprehensive “big bang” approach, where a strong package of immediate stimulus to support the economy would provide the quid pro quo for the introduction of long-lasting reforms in entitlements and other areas. Moreover, times of crisis have in the past provided opportunities for enacting politically difficult reforms.

Cited By

Within Same Series

Other IMF Content

Other Publishers Content

  • Collapse
  • Expand
Cover Fiscal Implications of the Global Economic and Financial Crisis
Fiscal Implications of the Global Economic and Financial Crisis
ISBN:
9781589068506
ISSN:
0251-6365
Publication Date:
18 Sep 2009
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589068506.084
Pages:
85
Figure 6.1.

Long-Term Government Bond Yields and Spreads
Figure 6.2.

Selected Countries: Public Debt-to-GDP Ratio

(In percent)
Figure 6.3.

Population Aging in Emerging Market Countries, 2005 and 2050

(Old-age dependency ratio)1

Figure 6.4.

Advanced G-20 Countries: Government Debt1,2

(In percent of GDP)
Figure 6.5.

EU-5 Countries: Outlook for Fiscal Balance Versus 2006 Stability Program1

(In percent of GDP)

  • Aisen, Ari, and David Hauner, 2008, “Budget Deficits and Interest Rates: A Fresh Perspective,” IMF Working Paper 08/42 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Alesina, Alberto, 1988, “The End of Large Public Debts” in High Public Debt: The Italian Experience, ed. by Francesco Giavazzi and Luigi Spaventa (Cambridge, United Kingdom: Cambridge University Press).

    • Search Google Scholar
    • Export Citation

  • Ardagna, Silvia, Francesco Caselli, and Timothy Lane, 2007, “Fiscal Discipline and the Cost of Public Debt Service: Some Estimates for OECD Countries,” The B.E. Journal of Macroeconomics, Vol. 7, No. 1 (Topics), Article 28.

    • Search Google Scholar
    • Export Citation

  • Baldacci, Emanuele, Sanjeev Gupta, and Amine Mati, 2008, “Is It (Still) Mostly Fiscal? Determinants of Sovereign Spreads in Emerging Markets,” IMF Working Paper 08/259 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Barro, Robert, and Xavier Sala-i-Martin, 1990, “World Real Interest Rates,” in NBER Macroeconomics Annual, ed. by Olivier Blanchard and Stanley Fischer (Cambridge, Massachusetts: MIT Press).

    • Search Google Scholar
    • Export Citation

  • Black, Fischer, and Myron Scholes, 1973, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, Vol. 81, No. 3, pp. 637–54.

    • Search Google Scholar
    • Export Citation

  • Burtless, Gary, 2009, “Stock Market Fluctuations and Retiree Incomes: An Update” (Washington: Brookings Institution).

  • Cantor, Richard, and Frank Packer, 1996, “Determinants and Impact of Sovereign Credit Ratings,” Economic Policy Review, Vol. 2 (October), pp. 37–53.

    • Search Google Scholar
    • Export Citation

  • Canzoneri, Matthew B., Robert E. Cumby, and Behzad T. Diba, 2002, “Should the European Central Bank and the Federal Reserve Be Concerned About Fiscal Policy?” paper presented at the Federal Reserve Bank of Kansas City’s symposium on “Rethinking Stabilization Policy,” Jackson Hole, Wyoming, August.

    • Search Google Scholar
    • Export Citation

  • Carroll, Christopher D., Misuzu Otsuka, and Jirka Slacalek, 2006, “How Large Is the Housing Wealth Effect? A New Approach” NBER Working Paper No. 12746 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation

  • Cebotari, Aliona, 2008, “Contingent Liabilities: Issues and Practice,” IMF Working Paper 08/245 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Congressional Budget Office (CBO), 2007, The Long-Term Budget Outlook, December (Washington).

  • Congressional Budget Office (CBO), 2008 Monthly Budget Review, December (Washington).

  • Cottarelli, Carlo, and Mauro Mecagni, 1990, “The Risk Premium on Italian Government Debt, 1976–88,” IMF Working Paper 90/38 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Dai, Qiang, and Thomas Philippon, 2004, “Government Deficits and Interest Rates: A No-Arbitrage Structural VAR Approach” (New York: New York University).

    • Search Google Scholar
    • Export Citation

  • Daniel, James, 1997, “Fiscal Aspects of Bank Restructuring,” IMF Working Paper 97/52 (Washington: International Monetary Fund).

  • Daniel, James, Jeffrey M. Davis, and Andrew M. Wolfe, 1997, “Fiscal Accounting of Bank Restructuring,” IMF Paper on Policy Analysis and Assessment 97/5 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Daniel, James, Jeffrey Davis, Manal Fouad, and Caroline Van Rijckeghem, 2006, Fiscal Adjustment for Stability and Growth (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Dell’Ariccia, Giovanni, Isabel Schnabel, and Jeromin Zettelmeyer, 2006, “How Do Official Bailouts Affect the Risk of Investing in Emerging Markets?” Journal of Money, Credit, and Banking, Vol. 38, No. 7 (October), pp. 1689–1714.

    • Search Google Scholar
    • Export Citation

  • Deposit Insurance Corporation of Japan. Available via the Internet: www.dic.go.jp/english/e_katsudou/_katsudou1.html.

  • Eichengreen, Barry, and Ashoka Mody, 1998, “What Explains Changing Spreads on Emerging-Market Debt: Fundamentals or Market Sentiment?” NBER Working Paper No. 6408 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation

  • Engen, Eric, and R. Glenn Hubbard, 2004, “Federal Government Debts and Interest Rates,” NBER Working Paper No. 10681 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation

  • European Commission (EC), 2006, The Impact of Aging on Public Expenditure, Special Report No. 1 (Brussels).

  • Evans, Paul, 1985, “Do Large Deficits Produce High Interest Rates?” American Economic Review, Vol. 75, No. 1 (March), pp. 68–87.

  • Evans, Paul, 1987, “Do Budget Deficits Raise Nominal Interest Rates? Evidence from Six Countries,” Journal of Monetary Economics, Vol. 20, No. 2, pp. 281–300.

    • Search Google Scholar
    • Export Citation

  • Fouad, Manal, Richard Hemming, Davide Lombardo, and Wojciech Maliszewski, 2004, “Fiscal Transparency and State-Owned Banks,” in The Future of State-Owned Financial Institutions, ed. by Gerard Caprio and others (Washington: Brookings Institution).

    • Search Google Scholar
    • Export Citation

  • Gale, William G., and Peter R. Orszag, 2004, “Budget Deficits, National Saving, and Interest Rates,” Brookings Papers on Economic Activity:2, pp. 101–210.

    • Search Google Scholar
    • Export Citation

  • Girouard, Nathalie, and Christophe André, 2005, “Measuring Cyclically-Adjusted Budget Balances for OECD Countries,” OECD Economics Department Working Paper No. 434 (Paris: Organization for Economic Cooperation and Development).

    • Search Google Scholar
    • Export Citation

  • Goodhart, Charles, 1999, “Monetary Policy and Debt Management in the United Kingdom: Some Historical Viewpoints,” in Government Debt Structure and Monetary Conditions, ed. by K. Alec Chrystal (London: Bank of England).

    • Search Google Scholar
    • Export Citation

  • Gray, Dale F., Robert C. Merton, and Zvi Bodie, 2007, “New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability,” NBER Working Paper No. 13607 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation

  • Gray, Dale F., Robert C. Merton, and Zvi Bodie, 2008, “New Framework for Measuring and Managing Macrofinancial Risk and Financial Stability,” Harvard Business School Working Paper No. 09-015 (Revised) (Cambridge, Massachusetts: Harvard University, August).

    • Search Google Scholar
    • Export Citation

  • Gray, Dale F., and Samuel Malone, 2008, Macrofinancial Risk Analysis (New York: John Wiley & Sons).

  • Gupta, Sanjeev, Benedict Clements, and Gabriela Inchauste, 2004, Helping Countries Develop: The Role of Fiscal Policy (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Hauner, David, 2008, “The Macroeconomic Effects of Pension Reform,” Russian Federation: Selected Issues, IMF Country Report No. 08/308 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Henriksson, Jens, 2007, “Ten Lessons About Budget Consolidation,” Bruegel Essay and Lecture Series (Brussels: Bruegel).

  • Hoelscher, David, and Marc Quintyn, 2003, Managing Systemic Banking Crises, IMF Occasional Paper No. 244 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Hoelscher, Gregory P., 1983, “Federal Borrowing and Short Term Interest Rates,” Southern Economic Journal, Vol. 50, No. 2 (October), pp. 319–33.

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 1986, Manual on Government Finance Statistics (Washington).

  • International Monetary Fund (IMF), 2000, “Transition Economies: An IMF Perspective on Progress and Prospects.” Available via the Internet: www.imf.org/external/np/exr/ib/2000/110300.htm.

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 2001, Manual on Government Finance Statistics (Washington).

  • International Monetary Fund (IMF), 2003, “Public Debt in Emerging Markets: Is It Too High?” Chapter 3, World Economic Outlook, September 2003 (Washington).

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 2005, “Is Public Debt in Emerging Markets Still Too High?” Box in World Economic Outlook, September 2005 (Washington).

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 2007a, World Economic Outlook, October 2007 (Washington).

  • International Monetary Fund (IMF), 2007b, Manual on Fiscal Transparency (Washington).

  • International Monetary Fund (IMF), 2008a, World Economic Outlook, October 2008: Financial Stress, Downturns, and Recoveries (Washington).

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 2008b, “The Fiscal Implications of Climate Change,” Fiscal Affairs Department, February 22. Available via the Internet: www.imf.org/external/np/pp/eng/2008/022208.pdf.

    • Search Google Scholar
    • Export Citation

  • International Monetary Fund (IMF), 2009, “The Implications of the Global Financial Crisis for Low-Income Countries.” Available via the Internet: www.imf.org/external/pubs/ft/books/2009/globalfin/globalfin.pdf.

    • Search Google Scholar
    • Export Citation

  • Kim, Sun-Young, and Raymond E. Lombra, 1989, “Why the Empirical Relationship Between Deficits and Interest Rates Appears So Fragile,” Journal of Economics and Business, Vol. 41, No. 3 (August), pp. 241–51.

    • Search Google Scholar
    • Export Citation

  • Kroszner, Randall S., 2003, “Is it Better to Forgive Than to Receive? An Empirical Analysis of the Impact of Debt Repudiation” (Chicago: University of Chicago Graduate School of Business). Available via the Internet: http://gsbwww.uchicago.edu/fac/randall.kroszner/research/.

    • Search Google Scholar
    • Export Citation

  • Kumar, Manmohan S., and Teresa Ter-Minassian, eds. 2007, Promoting Fiscal Discipline (Washington: International Monetary Fund).

  • Laeven, Luc, and Fabian Valencia, 2008, “Systemic Banking Crises: A New Database,” IMF Working Paper 08/224 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Mascaro, Angelo, and Allan H. Meltzer, 1983, “Long- and Short-Term Interest Rates in a Risky World,” Journal of Monetary Economics, Vol. 12, No. 4 (November), pp. 485–518.

    • Search Google Scholar
    • Export Citation

  • Mauro, Paolo, Nathan Sussman, and Yishay Yafeh, 2006, Emerging Markets and Financial Globalization: Sovereign Bond Spreads in 1870–1913 and Today (Oxford and New York: Oxford University Press).

    • Search Google Scholar
    • Export Citation

  • Mercer, 2009, “Pension Plan Deficit Hits Record $409 Billion for S&P 1500 Companies; Pension Expense May Rise,” January 7, 2009. Available via the Internet: www.mercer.com/summary.htm?siteLanguage=100&idContent=1332250.

    • Search Google Scholar
    • Export Citation

  • Merton, Robert C., 1973, “The Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science, Vol. 4, No. 1 (Spring), pp. 141–83.

    • Search Google Scholar
    • Export Citation

  • Miller, Stephen M., and Frank S. Russek, 1996, “Do Federal Deficits Affect Interest Rates? Evidence from Three Econometric Methods,” Journal of Macroeconomics, Vol. 18, No. 3 (Summer), pp. 403–28.

    • Search Google Scholar
    • Export Citation

  • Min, Hong G., 1998, “Determinants of Emerging Market Bond Spread: Do Economic Fundamentals Matter?” Policy Research Working Paper No. 1899 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation

  • Morris, Richard, and Ludger Schuknecht, 2007, “Structural Balances and Revenue Windfalls: The Role of Asset Prices Revisited,” ECB Working Paper No. 737 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation

  • Munnell, Alicia, Jean-Pierre Aubry, and Dan Muldoon, 2008, “The Financial Crisis and State/Local Defined Benefit Plans,” Issue Brief 8-19 (Chestnut Hill, Massachusetts: Center for Retirement Research at Boston College).

    • Search Google Scholar
    • Export Citation

  • Organization for Economic Cooperation and Development (OECD), 2001, Fiscal Implications of Aging, Economics Department Working Paper No. 305 (Paris).

    • Search Google Scholar
    • Export Citation

  • Organization for Economic Cooperation and Development (OECD), 2006, Projecting OECD Health and Long-Term Care Expenditures: What Are the Main Drivers? Economics Department Working Paper No. 5 (Paris).

    • Search Google Scholar
    • Export Citation

  • Organization for Economic Cooperation and Development (OECD), 2008, “Pension Markets in Focus,” Issue 5 (Paris).

  • Pension Benefit Guaranty Corporation (PBGC), 2008, Annual Management Report: Fiscal Year 2008 (Washington).

  • Pension Protection Fund (PPF), 2008, Annual Report and Accounts, 2007/2008, London.

  • Perotti, Roberto, 2002, “Estimating the Effects of Fiscal Policy in OECD Countries,” ECB Working Paper No. 168 (Frankfurt: European Central Bank).

    • Search Google Scholar
    • Export Citation

  • Plosser, Charles I., 1982, “Government Financing Decisions and Asset Returns,” Journal of Monetary Economics, Vol. 9, No. 3 (May), pp. 325–52.

    • Search Google Scholar
    • Export Citation

  • Plosser, Charles I., 1987, “Fiscal Policy and the Term Structure,” Journal of Monetary Economics, Vol. 20, No. 2 (September), pp. 343–67.

    • Search Google Scholar
    • Export Citation

  • Quigley, Michael Regan, and Susan Porter-Hudak, 1994, “A New Approach in Analyzing the Effect of Deficit Announcements on Interest Rates,” Journal of Money, Credit and Banking, Vol. 26, No. 4 (November), pp. 894–902.

    • Search Google Scholar
    • Export Citation

  • Reinhart, Carmen, Kenneth Rogoff, and Miguel Savastano, 2003, “Debt Intolerance,” Brookings Papers on Economic Activity: 1, pp. 1–62.

    • Search Google Scholar
    • Export Citation

  • Spilimbergo, Antonio, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli, 2008, “Fiscal Policy for the Crisis,” IMF Staff Position Note 08/01 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Tanzi, Vito, 1985, “Fiscal Deficits and Interest Rates in the United States: An Empirical Analysis, 1960–1984,” Staff Papers, International Monetary Fund, Vol. 32, No. 4 (December), pp. 551–76.

    • Search Google Scholar
    • Export Citation

  • The Economist, “The Doctor’s Bill,” September 25, 2008.

  • Thomas, Lloyd B., Jr., and Ali Abderrezak, 1988, “Long-Term Interest Rates: The Role of Expected Budget Deficits,” Public Finance Quarterly, Vol. 16, No. 3 (July), pp. 341–56.

    • Search Google Scholar
    • Export Citation

  • United Kingdom Treasury, 2008, Pre-Budget Report 2008. Available via the Internet: http://prebudget.treasury.gov.uk/prebudget2008/.

  • United Nations, 2006, World Population Prospects: The 2006 Revision, United Nations Population Division (New York).

  • Verhoeven, Marijn, Victoria Gunnarsson, and Stéphane Carcillo, 2007, “Education and Health in G7 Countries: Achieving Better Outcomes with Less Spending,” IMF Working Paper 07/263 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

  • Whitehouse, 2007, Pensions Panorama (Washington).

  • World Bank, 2005, “Public Debt and Its Determinants in Market Access Countries” (unpublished; Washington).

  • World Bank, 2006, From Red to Grey: Report on Aging in Eastern Europe (Washington).

  • Zahid, Khan Hasan, 1988, “Government Budget Deficits and Interest Rates: The Evidence Since 1971, Using Alternative Deficit Measures,” Southern Economic Journal, Vol. 54, No. 3 (January), pp. 725–31.

    • Search Google Scholar
    • Export Citation