Greece, Iceland, Italy, Japan and Portugal all have limited or no available room for fiscal manoeuvre before markets force them to tighten policies sharply, raising taxes and/or cutting government spending in order to restore or maintain the sustainability of public debt.
That is one of the findings of research by Atish Rex Ghosh and colleagues, which develops a measure of ”fiscal space” – the distance between the current level of public debt and the maximum level that is compatible with fiscal solvency – and applies the methodology to a sample of advanced economies.
Their study, which is published in the February 2013 issue of the Economic Journal, finds ample fiscal space for Australia, Korea and the Nordic countries. For the UK and the United States, the study finds around 50-75% of GDP of remaining fiscal space.
The researchers note that public debt sustainability used to be a non-issue in most advanced economies. A few years back, most people associated the topic with developing or emerging market countries. Defaults, rising sovereign risk premia and getting shut out from capital markets were not really imagined to be possibilities for advanced economies. Of course there were fiscal challenges, demographic pressures being the obvious one, but these were issues for the long term, not the here and now.
But today, fiscal problems are a key concern of policy-makers in many industrial countries, and a reassessment of sovereign risk is a palpable threat to global recovery. Financial bailouts, stimulus spending and lower revenues during the Great Recession have all contributed to some of the highest debt ratios seen in advanced economies in the past 40 years. More sobering still, taming public debt will require steadfast policy efforts over the medium term: quick fixes will not do the trick.
What is the worry? At the heart of the issue is the extent to which governments have room for fiscal manoeuvre – ”fiscal space” – before markets force them to tighten policies sharply and, relatedly, the size of adjustments needed to restore or maintain public debt sustainability.
Yet surprisingly, much of the talk about fiscal space – how to measure it and the policy implications – has so far been rather fuzzy. The new study seeks to remedy this, proposing a new methodology for assessing debt sustainability and estimating fiscal space.
The basic premise, empirically verified, is that while governments typically behave responsibly, increasing the primary (that is, non-interest) fiscal balance as debt rises, eventually they run into ”fiscal fatigue” and are unable to keep cutting expenditure and raising taxes. Once this happens, debt dynamics can turn explosive.
Crucially, the methodology used in this research takes account of both the country”s track record of fiscal adjustment and of market reactions to rising debt. It explains why funding costs can rise dramatically – to the point of complete loss of market access – in the face of seemingly small increases in public debt.
”Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies” by Atish Rex Ghosh, Jun Kim, Enrique Mendoza, Jonathan Ostry and Mahvash Qureshi is published in the February 2013 issue of the Economic Journal. Enrique Mendoza is at the University of Pennsylvania. The other authors are at the International Monetary Fund.
Atish Rex Ghosh
aghosh@imf.org
