Calls for coordinated fiscal stimulus to lift the world out of recession were joined at the weekend by Larry Summers, Barack Obama’s top economic adviser. Such coordination has been absent up to now, though that could change at the meeting of G20 leaders in London in early April. But there has been plenty of fiscal stimulus, led by America’s $787 billion package, as many governments seek to offset a collapse in private demand. There are worries not only about how much these measures cost up front but their longer-term effects on government finances.
The direct costs of such packages are indeed large. The IMF reckons that for G20 countries stimulus packages will add up to 1.5 percent of GDP in 2009 (calculated as a weighted average using purchasing power parity.) Together with the huge sums used to bail out firms in the financial sector (3.5 percent of GDP and counting in America, for example), these are immediate ways in which the crisis is affecting public finances across the world. But they are not the only ones.
A downturn affects government finances in other ways. Shares in most rich countries have plummeted. The MSCI developed-world index, which tracks stocks in 23 rich countries, has lost more than half its value since the beginning of 2008. Falling share prices hit government revenues as capital-gains tax takes decline. Similarly, taxes on financial-sector profits, a significant part of government revenue in many countries, have evaporated. And expenditures on automatic stabilisers such as unemployment insurance rise in a recession. All this widens budget deficits.
Direct stimulus measures also push up government deficits and debt, although the type of intervention affects how long-lasting its effects are. Most expenditure, such as infrastructure spending, is temporary (although it affects debt permanently). Revenue measures, such as tax cuts, are politically difficult to reverse. The question is whether this threatens the solvency of governments.
A paper on the state of the world’s public finances issued by the IMF in the run-up to the G20 meetings takes a stab at identifying and measuring the fiscal implications of the crisis for both rich and developing countries. Its conclusions are sobering. For rich G20 countries, fiscal balances will worsen by 6 percent of GDP between 2007 and 2009. Government debt will come off worse. Between 2007 and 2009, the debt-to-GDP ratio of rich countries is projected to rise by 14.5 percentage points. In the medium term, the outlook is even more worrying. Government debt for the average rich country will be more than 100 percent of GDP by 2014 compared with 70 percent in 2000 and 40 percent in 1980.
A great deal of uncertainty surrounds these estimates because so much depends on guesswork. Economic recovery, for example, could be slower than the IMF’s current projections: growth forecasts were revised down several times in 2008. Governments may also have to shoulder more burdens — private pension plans, which have been hammered by the crisis, may require government support. And the eventual cost of financial-sector bailouts will depend on how quickly and at what level prices stabilise of the assets governments have taken on. Past experience suggests that there is enormous scope for variation. Sweden had a recovery rate of 94 percent five years after its crisis in 1991; Japan had recovered only 1 percent of assets in the five years after its troubles of 1997.
The IMF points out that debt levels, while high, are not unprecedented by historical standards. But the worry is that primary fiscal balances in four-fifths of the rich countries studied by the IMF will be too high even in 2012 to allow debt to be stabilised, or brought down to 60 percent of GDP (which is the IMF benchmark for debt levels), even though revenues will recover as countries emerge from the crisis. What this implies is that, over time, fiscal deficits will have to be trimmed. And therein lies the rub.
Most rich countries have rapidly ageing populations. Unless entitlement systems are reformed (by reducing benefits) or tax bases broadened, fiscal deficits will rise still further. Some of the IMF’s ideas about how to do this will seem unpalatable: it argues that health systems, for example, will have to become less generous. But rich countries were always going to have to come to terms with the fiscal consequences of demographic pressures on existing welfare systems sooner or later. The crisis will bring this problem more urgently to the fore.