1 A Strategy for Fiscal Adjustment When the Recovery Takes Hold Paolo Mauro November 17, 2009 Bangkok

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3 Fiscal outlook in advanced G-20 countries (all variables in percent of GDP) General Government Gross Debt Overall balance Cyclically-adjusted primary balance Primary balance

4 What’s driving the change in the deficit in the advanced G20 economies? 6½ percentage points of GDP from 2007 to 2010 Fiscal stimulus: 1½ percent of GDP Automatic stabilizers: ~ 2½ percent Other structural change: ~ 2½ percent –Expenditure increases: ~ 1½ percent –Revenue losses: ~ 1 percent Losses on financial sector support: –0.8 percent of GDP in 2009 (U.S., Japan)

5 Decomposition of government debt increase, (Total debt increase: 40 percent of GDP) Financial Support (4.9) (3.3) Fiscal Stimulus (11.9) Automatic Stabilizers Assets and Commodity Prices (9.3) Other (4.5) Higher Interest Payments (5.9)

6 Fiscal balances and debt in emerging G- 20 countries (in percent of GDP) General government gross debt (right scale) Fiscal balance (left scale)

7 Fiscal challenge: Stylized facts The scale of the problem is unprecedented The scale of the problem is unprecedented Demographic trends are unfavorable Demographic trends are unfavorable Financial sector support only a small part of the increase in gross debt. Financial sector support only a small part of the increase in gross debt.

8 Are markets worried? Maybe; maybe not…yet? Sovereign CDS Spreads and EMBI Index Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov EMBI Global Index 3/ (lhs) Emerging Markets CDS Index (lhs) Advanced Economies CDS Index (rhs) Sources: Markit, CMA, Datastream, and IMF Staff calculations JAP ITA DEU FRA USA GBR ` Change in Sovereign CDS Spreads since / 1/ Change between October 2009 average and 2007 average. Some signs of regularization……some signs of differentiation?

9 Should we be concerned? Can’t we live with high debt? High debt may lead to high interest rates High debt may lead to high interest rates Interest rates are historically low Interest rates are historically low 40 percent increase in debt => 2 percent rise in rates? 40 percent increase in debt => 2 percent rise in rates? Crowding out of other spending Crowding out of other spending Markets might react abruptly if they worry that governments do not have a plan for fiscal adjustment Markets might react abruptly if they worry that governments do not have a plan for fiscal adjustment Reduced capacity to respond to future shocks Reduced capacity to respond to future shocks High debt may lead to slow growth? High debt may lead to slow growth?

10 Fiscal exit strategy: What should not be in the strategy Inflation… Inflation…...can raise seigniorage…but fiscal relief is modest...can raise seigniorage…but fiscal relief is modest …can reduce the real value of debt …can reduce the real value of debt But interest rates would rise with refinancing at higher rates But interest rates would rise with refinancing at higher rates Inflation ↑ (6%)  debt ratio ↓ (8-9%) Inflation ↑ (6%)  debt ratio ↓ (8-9%)

11 The role of growth in lowering debt ratios Initial debt ratio at 100% Increase the growth rate for 10 years by 1 p.p. Spending constant in per capita terms, assuming a 40% tax ratio Would lower public debt by 29% of GDP Role of Growth in Debt Reduction Year Debt in Percent of GDP 29% Difference With growth increased by 1 percentage point Baseline

12 Assumptions Goal: debt ratios < 60% of GDP by 2030 Goal: debt ratios < 60% of GDP by 2030 Adjustment in the primary balance will start in 2011 Adjustment in the primary balance will start in 2011 Adjustment will last 10 years; constant primary balance afterwards Adjustment will last 10 years; constant primary balance afterwards

13 General government gross debt-to-GDP ratio Cyclically- adjusted primary balance Primary balance Overall balance Fiscal Balances in Advanced Economies (in percent of GDP)

14 Required Fiscal Adjustment in Structural Primary Balance Between 2010 and 2020 Australia Austria Belgium Canada Denmark Finland France Germany Greece Iceland Ireland Italy Japan Korea Netherlands New Zealand Portugal Spain Sweden United Kingdom United States Percent of GDP For most advanced economies, major fiscal adjustment is required

15 Why Is So Much Adjustment Needed? To reverse discretionary stimulus To reverse discretionary stimulus To offset higher interest payments To offset higher interest payments To address already-high structural deficits in some countries To address already-high structural deficits in some countries To address rising spending pressures not linked to crisis To address rising spending pressures not linked to crisis To account for revenues that may not come back To account for revenues that may not come back

16 An optimistic angle on a big problem The scale of adjustment is large… The scale of adjustment is large… … But Not Unprecedented … But Not Unprecedented 20+ advanced economies have improved their structural primary balances by at least 5 percentage points in sustained adjustments in the past four decades. 20+ advanced economies have improved their structural primary balances by at least 5 percentage points in sustained adjustments in the past four decades. 10 have achieved adjustments of at least 10 percent. 10 have achieved adjustments of at least 10 percent. Primary adjustment was the bedrock of these efforts Primary adjustment was the bedrock of these efforts Inflation is not the answer Inflation is not the answer

17 Examples of large fiscal adjustments 22 Emerging Economies 13 Advanced Economies

18 How fiscal adjustment could be attained Not renewing the stimulus measures Reform entitlements to fix as share of GDP (otherwise would rise by 3-4% of GDP by 2030) Target stable real primary spending per capita (excluding entitlements) Tax measures: Broaden the tax base, correct externalities (carbon taxes ½ % of GDP) 8% Improvement in Cyclically Adjusted Primary Balance Fiscal Stimulus Expiring (1.5%) Freeze in Real Spending (3.5%) Tax Measures (3%) Percent of GDP

19 Conclusions Too soon to tighten fiscal policies Too soon to tighten fiscal policies Not too soon to: Not too soon to: 1. Communicate strategies and measures to ensure fiscal solvency 2. Implement actions without a negative impact on demand (transparency and medium-term fiscal frameworks) 3. Substantive reforms of entitlements with an impact only in the medium term should start now