Public debt sustainability and sovereign default in advanced economies used to be a non-issue. 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. If the topic came up at all, most people associated it with developing or emerging market countries – not advanced economies.
All that has changed. Today, concerns over debt sustainability in countries like Greece, Spain and Ireland are making the headlines. And it is not only in the Eurozone. Financial bailouts, stimulus spending, and revenue declines during the Great Recession have also taken their toll on the public finances in a number of other advanced economies such as Japan, the UK, and the US. At the same time, many of these countries continue to face public spending needs, including continued stimulus spending in the context of an uncertain recovery, making their available “fiscal space” a hotly debated topic and a pressing policy question.
Yet, surprisingly, much of the talk about fiscal space – how to measure it and the policy implications – has so far been rather fuzzy. When it comes to advanced economies, the empirical literature covers exhaustively topics such as intertemporal fiscal solvency (e.g. Hamilton and Flavin 1986, Blanchard et al. 1990, Bohn 1998) and fiscal multipliers (e.g. Blanchard and Perotti 2002, Hall 2009, Ilzetzki et al. 2010), but is very sketchy on studying how and whether these economies can reach limits in public debt financing. In two recent contributions Ostry et al. (2010), and Ghosh et al. (2011), we aim to remedy this, providing an operational definition of two key concepts:
- the government’s debt limit (the debt ratio above which debt dynamics become explosive), and
- the government’s fiscal space (which we define as the distance between current debt ratios and the corresponding debt limit).
We then apply our framework to compute empirical estimates of available fiscal space in advanced economies.
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 by looking at the actual track record of countries – how policy responded in the past to changes in public debt.
Our starting point is the observation, based on the seminal work on fiscal solvency and fiscal reaction functions by Henning Bohn (see in particular Bohn 1998 and 2007), that the US government has typically behaved responsibly, increasing primary surpluses in response to rising debt in order to help stabilise the debt ratio. Theoretically, Bohn established the classic result showing that a sufficient condition for fiscal solvency is that the fiscal reaction function be characterised by primary balances that rise at least linearly with past debt. But it cannot literally be true that primary surpluses would always keep pace with rising debt, as this would eventually require surpluses that exceed GDP. Instead, “fiscal fatigue” sets in (empirically, at debt ratios around 100% of GDP), whereby it becomes progressively more difficult to keep increasing the primary surplus by raising taxes or lowering non-interest expenditures. Once the primary surplus does not keep pace with the higher interest payments on rising debt, there comes a point – a debt limit – beyond which, in the absence of extraordinary fiscal adjustment, debt dynamics become explosive and default becomes inevitable. Our definition of fiscal space is then simply the difference between current debt ratios and this debt limit.
Empirical studies, like those of Bohn for the US and Mendoza and Ostry (2008), provide evidence showing that primary balances indeed respond positively to rising debt in a number of advanced economies. Interestingly, Mendoza and Ostry also find that this is not the case for countries with relatively high debt ratios. The empirical findings in Ostry et al. (2010) and Ghosh et al. (2011) go further, however, and can explain the breakdown of the primary balance-debt link at high debt ratios, by showing that the fiscal reaction function is not linear after all, but follows a non-linear pattern consistent with our “fiscal fatigue” argument (i.e. at high debt levels the primary balance’s response weakens and eventually becomes negative).
Figure 1 illustrates these findings by plotting primary balances against lagged debt (both as ratios of GDP) using data for the 1970-2007 period. In the paper we provide more formal evidence based on panel regressions subject to a large battery of robustness checks.
We derive analytical results showing the implications of fiscal fatigue for debt dynamics and debt limits focusing first on a deterministic setup. Although the analysis gets somewhat more complicated in an explicitly stochastic framework (because the interest rate increases as default becomes more imminent, while the default point itself is endogenous to the interest rate charged by the market), the basic intuition for the debt limit (and hence fiscal space) remains the same. The stochastic setting with shocks to the primary balance yields some additional insights – most importantly, that any revision in market expectations about the magnitude of possible shocks to the primary balance (even if those shocks have not materialised) could lead to higher interest rates, possibly pushing a formerly sustainable debt situation into unsustainability; and second, that the jump from the risk-free interest rate at which the government typically borrows to a complete loss of financing and shut out of the capital markets can occur over a very short range of rising debt (technically, less than one support of the shock to the primary balance, which in data is around 5% of GDP).
In our application of this framework to a sample of 23 advanced economies, we find that by no means are all advanced in the same boat in terms of available fiscal space. Some have a lot, others have none, and some are in the middle (Figure 2). Fiscal space varies across countries for two reasons, i.e. 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.
What are the policy implications?
- First, there is a definite wake-up 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 behaviour 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.
The views expressed herein are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management
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