By Jonathan D. Ostry

Public debt sustainability in most advanced economies used to be a non-issue, or at most a back-burner one. A couple years back, if the topic came up, most people associated it with developing or emerging market countries. Defaults, rising sovereign risk premia, getting shut out from capital markets were, let’s face it, 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. While the financial crisis may be a convenient scapegoat for the debt blowout in the advanced countries, blame lies elsewhere, in how fiscal policy was managed before the great recession, not during it. And, 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 maneuver—“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. A new staff position note, which I co-authored with several IMF colleagues, aims to remedy this, providing an operational definition of the fiscal space concept as well as empirical estimates of available fiscal space for 23 advanced economies.

Our estimates indicate that advanced countries are not all in the same boat in terms of available fiscal space. Some have a lot, others have none, and some are in the middle. Fiscal space varies across countries for two reasons: differing indebtedness, and different debt limits. Our results indeed underscore that there is no “one size fits all” on these issues—debt limits and fiscal space are country-specific and depend on each country’s track record of adjustment.

So how did we approach these complex issues? Some have questioned the relevance of debt limits for advanced-economy sovereigns. They assume that a government’s right to tax and (not) spend means that, in the future, changes in fiscal policy can always ensure that public debt is repaid. Our take is different, not least because markets will not be impressed by promises of policy change when a country has little or no track record of adjustment—words unsupported by deeds. For this reason, we focus on fiscal solvency in terms of the actual track record of countries—how policy responded in the past to changes in public debt. If governments were able to raise the primary budget balance (that is, net of interest payments) when public debt went up, then they had (at least) an implicit rule of making sure debt would be repaid. As such, markets could take comfort that, in the very long run, the sovereign would honor its financial obligations.

But this finding of a positive response of the primary balance to rising debt can be true only up to a point. As debt grows, it becomes increasingly difficult—reflecting both economic and political realities—to improve the primary balance enough to offset higher debt service costs. Eventually there is a threshold—a debt limit—when debt simply gets too big, adjustment fatigue sets in, and the surplus cannot keep pace with rising debt repayments.

Of course, markets don’t usually sit idly by as debt approaches its limit. Instead they add a risk premium to the interest rate they charge to sovereigns, reflecting the potential for default. And, by adding to the cost of debt, the higher risk premium means a country will be more likely to reach its debt limit. When concerns are acute, only policy adjustments that are dramatically different from past efforts will be enough to maintain capital market access.

What are the policy implications?

• First, there is a definite wakeup call in the finding that a country has little or no fiscal space. In these cases, fiscal policy needs to break fundamentally from the past to credibly signal to markets that debt limits will not be reached: business as usual simply won’t cut it.
• But, second, a finding of little or no fiscal space does not imply that default is inevitable—debt limits are not etched in stone. Our estimates of fiscal space are based on the assumption that future policy reactions will mirror those in the past. Since behavior can change, history is not destiny as long as policy changes credibly.
• Third, countries will generally want to target debt levels well below the limits. As public debt rises or views about fiscal risks—or the reliability of fiscal data—change, our results imply that markets may give little or no warning about imminent spikes in borrowing costs or curtailed access to debt markets. With the inevitable uncertainty around where precisely debt limits lie, and the potential for market perceptions to change in the bat of an eye, there is a need for caution—a few successful auctions are not grounds for complacency.

 Many of these points resonate with the experience of some southern European countries in recent months and underscore the need for countries to maintain a comfortable degree of fiscal space at all times. And, if fiscal risks rise, there needs to be political willingness—already evident in a number of countries—to undertake adjustment efforts that are extraordinary by historical standards, in a timely fashion, to preserve, or to restore, sustainability.

We hope the framework in our note helps to bring clarity to discussions of fiscal space—getting to grips with a fuzzy concept—and that it provides a practical sense of where a change of course is called for, as well as the size and nature of adjustments needed to manage fiscal risks.

By Olivier Blanchard 1

The Group of Twenty industrialized and emerging market economies (G-20) has broken new ground over the past year or two. It has embraced the type of collaborative approach to policy design and review that is well suited to today’s interdependent world, where policies in one country can often have far-reaching effects on others.

Collective action by the G-20 in response to the recent crisis was critical in avoiding a catastrophic financial meltdown and a potential second Great Depression. Exceptional policy responses around the globe—including macroeconomic stimulus and financial sector intervention—indeed helped avoid the worst. These actions were notable, both for their scale and force, but also for their consistency and coherence.

Keen to build on this success, G-20 Leaders pledged at their 2009 Pittsburgh Summit to adopt policies that would ensure a lasting recovery and a brighter economic future. To meet this goal, they launched the “Framework for Strong, Sustainable, and Balanced Growth.” The backbone of this framework is a multilateral process, where G-20 countries together set out objectives and the policies needed to get there. And, most importantly, they undertake a “mutual assessment” of their progress toward meeting those shared objectives. With this, the G-20 Mutual Assessment Process or the “MAP” was born.

But, what exactly will the G-20 Framework imply in terms of prospective actions? And what have we learned so far from the MAP?

The MAP—led and owned by the G-20

The MAP is a new approach to policy collaboration, entirely conceived and owned by G-20 members. Leaders have set the tone and substance for the initiative. The aim is to ensure that the collective policy action will benefit all. Like any new initiative, the MAP will be fully fleshed out over time, in large part through learning by doing. In the meantime, however, all G-20 members have signaled their “buy-in” to the process through their full cooperation in providing the information required for the analysis and assessments.

 When the G-20 initiated the MAP, they asked the International Monetary Fund (IMF) to provide supporting technical analysis. In carrying out this task, the Fund was asked to seek help from other international institutions such as the World Bank, the OECD, the ILO and the WTO. Moreover, a G-20 Working Group (co-Chaired by Canada and India), which was established to substantively add value to each stage of the mutual assessment, has assisted the G-20 Deputies in providing guidance to the Fund and other organizations on the analysis. 

The initial assessment was based on three key steps.

• As a first step in this process, all G-20 countries supplied each other and Fund staff with information about their “policy and macroeconomic frameworks”—that is, their policy plans and the expected performance of their economies over the next 3-5 years.
• Fund staff aggregated the inputs to assess whether the policies were consistent on a “multilateral” basis. And also what they implied for growth, employment, poverty, and so on. This formed the basis for the G-20 “base case” scenario. In keeping with the G-20 ownership of the exercise, individual country policies were taken at face value and no judgments were made by IMF staff concerning their feasibility, timing, or effectiveness.
• Once the base case assessment was considered by the G-20, Fund staff liaised closely with the Working Group to analyze alternative policy scenarios. A key objective of this exercise was to show how the economic outcomes could be improved through collective action by G-20 members.

Providing the foundation—the G-20 “base case”

The G-20 base case collectively implied “strong” growth.  This enabled a decline in unemployment, which would, nevertheless, still remain quite high for several years. Growth was projected to be “balanced”, since it was broad-based across the G-20 countries.  Finally, growth was expected to be “sustainable,” since it was led by private demand.

The analysis, however, pointed to some shortcomings and risks. 

Budget balances in the base case were projected to improve noticeably, helped by strong growth. But deficits and debt levels would still remain high in the large advanced economies. Moreover, there is a risk that if strong growth projected in the submissions by the large advanced economies did not materialize, fiscal positions in these economies could worsen significantly and even trigger another crisis.

The forecasts were also associated with only a modest rebalancing of global demand. Countries with large current account deficits before the crisis did not expect a significant boost to growth from exports. And countries with large surpluses did not expect a significant boost from domestic demand.

Alternative policy scenarios—benefits of collective action

Based on the findings of the “base case” assessment, the G-20 asked IMF staff to explore two alternative policy scenarios. First, an “upside scenario” and associated policy requirements that would help improve the outlook. Second, a “downside scenario” aimed at assessing the implications of the risks identified in the base case, if they were to materialize.

Prior to carrying out the scenario analysis, Fund staff made technical refinements to the G-20 base case. This was made for two reasons. First, to ensure greater multilateral consistency in assessing the impact of the crisis and the estimation of output gaps; and Second, to update the macroeconomic frameworks for economic and market developments since the submission of G-20 inputs.

The “upside” scenario assessed—in a layered approach—the cumulative benefits of three sets of policy actions for groups of countries with similar circumstances.

• First, “growth-friendly” and credible fiscal consolidation in major advanced economies, beginning in 2011 and beyond countries’ existing medium-term plans.  Fiscal consolidation plans were conceived to be strong, credible, and, to the extent possible, supportive of growth. 
• Second, policies aimed at nurturing domestic demand in emerging economies with large external surpluses. These were aimed at offsetting the loss of demand as advanced economies further tightened their fiscal positions in coming years.
• Third, structural reform policies aimed at alleviating supply constraints and reducing high unemployment, particularly in advanced G-20 economies, along with measures to boost demand.  

The key takeaway from this exercise is that well-designed, collaborative policy actions by the G-20 economies can produce outcomes that will make everyone better off. For instance, considered in isolation, fiscal consolidation in advanced economies would dampen growth in the next year or two. And it would have a lasting adverse impact on partners in emerging Asia, given their high export dependence. But all G-20 countries stand to gain when fiscal consolidation in advanced economies is accompanied by key reforms in emerging economies. Benefits to all countries increase further when all three sets of policies noted above are undertaken together. Indeed, our simulations suggested that the payoff for collective policy action by G-20 countries could be high, raising global GDP by an estimated 2½ percent over the medium-term. This would also be good news for job creation and poverty reduction.

The “downside” scenario assessed the implications of the risks identified in the G-20 base case. What if growth in major advanced economies was lower than projected or what if market concerns about fiscal sustainability led to a sharp increase in sovereign risk premia? Not surprisingly, the outcome could be quite scary. There would be significant output and employment losses, with a large number of people falling into poverty. At the same time, it is clear that the implementation of the policies needed to reach the upside scenario would likely reduce the probability of such a downside scenario occurring.

So, where to next?

Reflecting on this assessment, G-20 Leaders agreed at the Toronto Summit in June 2010 that they could do a better job of achieving the objective of strong, balanced and sustainable growth by working together and pursuing reforms along those lines. Leaders committed to taking stronger policy actions that would get the world economy closer to the “upside” scenario in the staff’s report.

This set the stage for the second phase of the process, where the mutual assessment will be conducted at the country and regional level. During this phase, each G-20 member will identify policy actions that could help achieve an ambitious outcome of stronger growth than in the base case. These “country-level” policy plans will form the basis for a comprehensive plan that will be articulated by Leaders at the Seoul Summit this November.

As the G-20 moves forward with this shared approach to tackling today’s policy challenges, they have a unique opportunity to deliver a better outcome for all.

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1  This is a good opportunity to thank the Fund staff analysis team, led by Krishna Srinivasan and Hamid Faruqee, for their outstanding work.