IMF Offers Solutions to High Government Debt

Econintersect: Economists Carmen M. Reinhart and Kenneth S. Rogoff paper A Decade of Debt asserted:

….. Historically, high leverage episodes have been associated with slower economic growth and a higher incidence of default or, more generally, restructuring of public and private debts.

The IMF has added a corollary to this theory

After reaching 100 percent of GDP, the debt-to-GDP ratio tends to decline, even though at a very moderate pace. This tendency to reverse is not present at lower levels of debt, for example when debt rises above 60 percent of GDP.

Conclusion of IMF report on:

The Good, the Bad, and the Ugly: 100 Years of Dealing with Public Debt Overhangs

For countries currently struggling with high public debt burdens, the historical record offers both instructive lessons and cautionary tales. The first lesson is that fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and monetary conditions need to be as supportive as possible. In Japan, for example, weaknesses in the banking system and corporate sector limited monetary policy efficacy and led to weak growth, which prevented fiscal consolidation. As a result, debt continued climbing until these issues were addressed. In Italy, Belgium, and Canada, debt did not fall until monetary conditions were supportive. Here, reforms to wage-setting mechanisms that broke the wage-price spiral were an important contributor to the establishment of the supportive monetary environment. Furthermore, monetary easing also fostered exchange rate depreciation, which supported external demand and growth.

The case of the United Kingdom reinforces this message but also offers a cautionary lesson for countries attempting internal devaluation. The combination of tight monetary and tight fiscal policy, aimed at significantly reducing the price level and returning to the prewar parity, had disastrous outcomes. Unemployment was high, growth was low, and — most relevant—debt continued to grow. Although the price level reduction the United Kingdom was attempting to achieve is larger than anything likely to happen as a result of internal devaluation today, similar dynamics are evident. A reduction in the price level, a necessary part of internal devaluation, comes at a high cost, and determining whether the cost outweighs the benefit to competitiveness from internal devaluation requires further work.

The case of the United States, although supporting the general finding about the contribution of monetary policy, points to more outside-the-box possibilities. U.S. monetary policy was very supportive in the immediate postwar years as a result of limits on nominal interest rates and bursts of inflation. This particular combination quickly reduced the debt ratio while growth remained robust. Whether financial repression could assist in reducing debt burdens in today’s environment, however, is much harder to gauge. Given that the major problem for the United States in those years was controlling excess demand and inflation—which is not a problem faced by the countries struggling with public debt today—it seems likely that financial repression as practiced by the United States after World War II would not be effective today for countries already benefiting from historically low sovereign interest rates. Moreover, the inflationary consequences of financial repression could endanger the institutional frameworks established over the past 30 years to control inflation. Whether policies inspired by this experience could help remains an open question.

The implications vary for countries dealing with high debt levels today. For some, such as the United States, where financial sector weakness has largely been addressed and monetary policy is as supportive as possible, it would seem that conditions are in place for fiscal consolidation. In others, such as the European periphery, where financial sectors remain weak and fundamental issues relating to monetary union remain to be addressed, progress may be limited until these issues are resolved.

A second lesson is that consolidation plans should emphasize persistent, structural reforms over temporary or short-lived measures. Belgium and Canada were ultimately much more successful than Italy in reducing debt, and a key difference between these cases is the relative weight placed on structural improvements versus temporary efforts. Moreover, both Belgium and Canada put in place fiscal frameworks in the 1990s that preserved the improvement in the fiscal balance and mitigated consolidation fatigue.

A third lesson is that fiscal repair and debt reduction take time—with the exception of postwar episodes, primary deficits have not been quickly reversed. A corollary is that this increases the vulnerability to significant setbacks when shocks hit. The sharp increases in public debt since the Great Recession — including in the relatively successful cases of Belgium and Canada—exemplify such vulnerability. Furthermore, the external environment has been an important contributor to outcomes in the past. The implications for today are sobering—widespread fiscal consolidation efforts, deleveraging pressures from the private sector, adverse demographic trends, and the aftermath of the financial crisis are unlikely to provide the supportive external environment that played an important role in a number of previous episodes of debt reduction. Expectations about what can be achieved need to be set realistically.

Based on these lessons, we suggest a road map for successful resolution of the current public debt overhangs. First, support for growth is essential to cope with the contractionary effects of fiscal consolidation. Policies must emphasize the resolution of underlying structural problems within the economy, and monetary policy must be as supportive as possible. Such policy support is particularly important at this point because all major economies must address public debt overhangs, which means they cannot rely on favorable external conditions. Second, because debt reduction takes time, fiscal consolidation should focus on enduring structural change. In this respect, fiscal institutions can help. Third, while realism is needed when it comes to expectations about future debt trajectories and setting debt targets in a relatively weaker global growth environment, the case of Italy in the 1990s suggests that debt reduction is still possible even without strong growth.

Steven Hansen