Sunday, September 14, 2003

Fiscal Endgame

The world bank in it's Global Economic Outlook raised an interesting question last week:

the scope for substantial further macroeconomic stimulus is rapidly dissipating. Fiscal deficits threaten to become part of the problem instead of part of the solution, especially since a quick reversal of the deficit is not anticipated. The U.S. general government budget position (including Social Security), for example, shifted dramatically from a surplus of 2.3 percent of GDP in 2000 to a deficit of 3.2 percent as of the first quarter of 2003. The Congressional Budget Office projects that the budget position is unlikely to return to surplus until 2012. In Europe, several large countries have breached the 3-percent-of-GDP fiscal deficit limits embedded in the Maastricht criteria for the common currency. And Japan has limited fiscal scope, given persistent deficits in the 6–7 percent range.

There has been a good deal of discussion going the rounds about the difficulties of conducting monetary policy as interest rates approach zero, there has been a good deal less about the possibilities of sustaining fiscal deficits ad-infinitum. In fairness, much of the discussion in the US context has focused on the relation between the looming long term deficits, and the expediency of increasing short term deficit spending. The point is that at some stage the short-run becomes the long-run. Most of the debate to date has assumed that around-the-corner growth can put the numbers back in the black. But what if this 'anticipated' growth just doesn't materialise? What if the 'weak' spot means not recession, but extremely low growth. The consequence of this would mean deficits stretching out as far as the horizon. So it is at least worth asking the question: how far is far here?

At what point would we run out of fiscal leverage as well as monetary leverage. And if we did, what is the policy remedy? And why is this question worth asking? Simply because in the ex-US OECD we have a novel factor, serious population ageing. For GDP to grow either (a) more hours have to be worked or (b) the hours worked need to generate more value. Well at least some of the OECD countries are going to have great difficulty with (a), and (b) is going to get more and more difficult if serious 'global rebalancing' takes place. Simply put: if globalised labour markets become increasingly efficient, and if human capital levels in the developing world begin to seriously close the gap with those in the deveoped one, then (b) also becomes problematic. Doing the sums it's not difficult to see that paying down the debt becomes a bigger and bigger problem. Oh, I know. The easy government solution would be to stoke-up inflation: well try telling that to Japan (oops, that's just what they're doing, but look at the success they're having). So when Morgan Stanley's Eric Chaney tells us:

The Stability Pact is not a good law, because we now have full evidence of our old suspicion, that it is pro-cyclical -- in bad times, the Pact forces governments to raise taxes. If the law is not good, it has to be changed. Over the last two years, every single party has expressed views about what should be changed. These views did not always converge, but this is Europe: Nothing can change without negotiations. It is now time for the European Union to start the re-negotiation of the Pact, and the sooner, the better.

we should be aware that this is just fine, but that it is a reform which will come with a sell-by date, one day or another. Now I am not the first person to have had this thought:

The Limits of Credit: Could Aging Nations Lose the Fiscal Policy Lever?

In Moody's Sovereign Risk Unit, we spend a great deal of time studying and debating the very issues that are before us today. What we are really discussing is whether the industrialized countries can afford the pensions already promised by their respective governments? In some ways, you might find my answer somewhat surprising.

We expect almost every industrialized nation to "default" on its pension promises. What do I mean? We have concluded that it is impossible for almost every major developed nation to meet presently promised public sector pensions, including promised health care for seniors, without further changes in future benefits. In others words, future governments will probably renege on future pension and senior health care commitments as embedded in law today..........

We have looked at many of the most important academic studies, which analyze future pension burdens and their potential impact on government debt. For many of the most highly advanced industrialized countries, the conclusion one must almost inevitably come to is that the public sector debt level needed to fund existing promises over the long-term would raise serious solvency issues if these pension systems are not reformed. On balance, many continental European countries and Japan could not sustain the increased debt burdens implied by their existing pension systems when these future obligations are added to already existing public sector debt.

Pre-World War II experience gives some important insights into dimensioning the problem facing the industrialized world as the baby boom generation retires. Either pensions are paid as promised, implying huge future debt burdens, or the promises are decreased and/or contributions raised significantly, thereby implying much lower debt burdens. If the pensions are not reformed in most Western European countries and Japan, then future governments face the prospect of dealing with debt burdens reminiscent of those faced by post World War Germany, the UK and France. If we assume that such debt burdens will occur in the future, then we have to examine how governments might deal with them, once again by examining the historical record. As a rating agency, we are concerned with determining at what point would such affected governments be forced to default on their debt obligations? It is clear that the consequences of such a financial default would be very different from a "default" on a pension promise.

Once a sustainable recovery has begun, the hope is that the government will also be in a better position to readjust the country's pensions to make them more actuarially sound. The risk this approach presents is that if the economy doesn't respond to the fiscal stimulus and doesn't soon start growing on a sustainable basis, then the country runs the risk of having the worst of all worlds -- a massive public sector debt just as its demographics start becoming quite negative.
Source: Vicent Truglia, Moody's Investor Service, 2000

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