Last week I participated in an academics consultant meeting at the Board of Governors of the Federal Reserve to discuss the question of achieving fiscal sustainability. I have posted the note I wrote for the meeting on my web site, but here is a quick summary of some of the points I made:
1. There is no doubt that governments in advanced economies will have to go through major fiscal policy changes in the coming years to keep the debt-to-GDP ratio under control. Given current policies, debt-to-GDP ratios are likely to explode in some cases to 300 or 400% of GDP over the next decades.
2. The required changes are large. The recovery will bring deficits somehow under control but this goes nowhere in terms of achieving sustainability. Most advanced economies need to find additional revenues (or cut spending) by a large amount, somewhere in between 4 and 10 percentage points of GDP depending on the country — and this has to happen every year for the foreseeable future (we are talking about many decades here).
3. There is no mystery to what needs to happen: governments need to increase taxes and reduce spending. Both have economic and political consequences and we need to be as smart as we can to choose changes that are efficient and have limited negative consequences on the economy (and growth).
4. Good news: We have seen large adjustments in government debt before so this adjustment is feasible. No need to go to the post-WWII decades, in the 80s and 90s we saw very large reductions in government debt in many advanced economies. We are talking about reducing the debt to GDP ratio by up to 40 percentage points in a short period of time, such as 10 years.
5. Good news (2): Some of these prior adjustments had limited consequences on growth. We normally tend to think about reductions in government spending and increases in taxes as having negative effects on growth but in several of these adjustments, growth accelerated rather than decreased (we refer to these events as “expansionary fiscal consolidations”). And when growth accelerates, this becomes a virtuous cycle as faster GDP growth reduces the debt-to-GDP ratio, generates tax revenues, etc.
6. Expansionary (growth promoting) fiscal consolidations tend to be associated to decreases in spending rather than increases in taxes and they tend to come together with a series of pro-growth reforms in other areas of the economy (Ireland post-1985 is a perfect example of this).
7. So can we hope for a nice, painless, expansionary fiscal consolidation over the next decades? Not obvious. There are several reasons why those experiences might not be easily replicated this time:
– In some countries, government spending levels have come down relative to where they were in the 80s or 90s. It is not easy to produce a significant decrease in government spending without affecting some basic services provided by the government. More so in the US where government spending is low relative to other (European) advanced economies.
– Some of the expansionary fiscal consolidations benefited from falling interest rates. As an example, Belgium reduced government debt by close to 40 percentage points in between 1996 and 2006 but most if not all of the decrease was linked to falling interest rates on government debt. Currently, there is no room for interest rates to go down. If any, they might go up.
– This time, the consolidation needs to take care of the past (the accumulated level of debt) and the future (the fact that projected deficits given current policies will be very large). The adjustment is larger than what was needed in some of those previous expansion.
8. So my guess is that a “painless” fiscal adjustment is unlikely this time. Taxes will have to play a stronger role and governments will need to strike a balance between the need for additional revenues and the potential negative growth effects that higher taxes might have. This balance will require a strong amount of political leadership and consensus.