By John Lipsky, First Deputy Managing Director, International Monetary Fund
China Development Forum, Beijing, March 30, 2011
It’s a great pleasure and honor to be invited to address this year’s Development Forum. Many notable changes have occurred since I participated in last year’s Forum, and I am grateful for the opportunity to discuss them with you today.
Although the world’s attention has been focused during the past week on the impact of the tragic Japanese earthquake — and on the terrible suffering that it has caused — on balance, the economic and financial news of the past year has been positive. Most important, global economic growth has been advancing at a much faster pace than the average annual expansion of the past 20 years. Our World Economic Outlook forecast anticipates global growth this year of almost 4 ½ percent, following the 5 percent gain registered last year.
The current solid global growth rate obscures some more difficult details, however. As anticipated — and as has been the case for many years — emerging economies are growing much more rapidly than advanced economies. While this is neither new nor surprising, the current growth rates nonetheless imply challenges for both groups of economies.
With the advanced economies expanding at an annual average rate of about 2½ percent, growth simply is not strong enough to reduce quickly the substantial margins of unused capacity that resulted from the Great Recession of 2008/2009 begin_of_the_skype_highlighting 2008/2009 end_of_the_skype_highlighting. In particular, job growth remains sluggish in most advanced economies, and as a result, unemployment rates remain high and consumption gains remain no better than moderate.
In contrast, the emerging economies are growing at a 6½ percent annual rate. Of course, these economies in general escaped the Great Recession without the damaged financial systems, depleted household balance sheets and high public debt that have hampered recoveries in the advanced economies. As a result, their post-recession expansion is being driven by domestic demand as well as by the rebound in global trade.
Despite the contrast in growth rates, both sets of economies face near-term and longer-term challenges. In advanced economies, reducing unemployment is a priority. At the same time, however, public debt is piling up to unprecedented heights, creating worries in many advanced countries about fiscal sustainability. In fact, IMF analysis indicates that advanced economy fiscal deficits will average about 7 percent of GDP in 2011, and the average public debt ratio will exceed 100 percent of GDP for the first time since the end of World War II.
As is increasingly obvious, such a fiscal trend simply is not sustainable. While expansionary fiscal policy actions helped to save the global economy from a far deeper downturn, the fiscal fallout of the crisis must be addressed before it begins to impede the recovery, and to create new risks. The central challenge is to avert a potential future fiscal crisis, while at the same time create jobs and support social cohesion.
The situation is quite different in many key emerging economies. Although fiscal sustainability is not a major near-term concern, in general both monetary and budget policies in these economies are still expansionary – reflecting earlier anti-crisis measures – despite evaporating margins of excess capacity and accelerating inflation. With early signs of overheating becoming visible, the need is clear for near-term fiscal and monetary policy adjustment.
I will focus the balance of my remarks today on fiscal policy and structural fiscal challenges, particularly in the advanced economies, but also in many emerging economies. I also will discuss the role of fiscal policy in the global rebalancing process.
Advanced economy challenges
The immediate fiscal task among the advanced countries is to credibly reduce deficits and debts to sustainable levels, while remaining consistent with achieving the economy’s long-term growth potential and reducing unemployment. Achieving the fiscal adjustment alone is no small task: The reduction in advanced economies’ cyclically adjusted primary budget balance that will be needed to bring debt ratios back to their pre-crisis levels within the next two decades is very large—averaging around 8 percent of GDP – although there is considerable variation across countries. Large gross financing requirements—averaging over 25 percent of GDP both this year and next—only add to the urgency of creating credible medium-term fiscal adjustment plans.
Up to now, the advanced economies have been fortunate in one important way: Low interest rates have kept debt service burdens manageable, despite the recent large increases in public debt outstanding. In particular, the G7 countries’ interest payments on government debt outstanding have remained broadly stable at 2¾ percent of GDP over the last three years, even as debt to GDP ratios increased by over 25 percentage points.
This combination of rising debt but stable debt service payments is not likely to continue for long, however. Higher deficits and debts – together with normalizing economic growth – sooner or later will lead to higher interest rates. Evidence suggests that an increase in the debt to GDP ratio of 10 percentage points is associated with a rise in long-term interest rates of 30 to 50 basis points.
Given the post-crisis rise in debt ratios – and the projected medium-term increase in public debt – long-term bond yields could rise by 100 to 150 basis points for this cause alone. Were rates to rise even by the lower end of this estimated range, debt servicing costs for the G7 economies could increase by around 1½ percentage points of GDP by 2014 – to a total of around 4¼ percent of GDP. Moreover, our estimates suggest that maintaining public debt at its post-crisis ratio to GDP over the medium term could reduce potential growth in advanced economies by as much as ½ percentage point of GDP annually. Econometric analysis indicates that, on average, each 10 percentage point increase in the debt ratio leads to a slowdown in real GDP growth of around 0.15 percentage points per year, mostly through an adverse effect on investment, but also through lower productivity growth.
Clearly, it will take quite some time for the advanced countries to restore their debt ratios to prudent levels. While this has been widely recognized already, the crisis-related sharp rise in debt outstanding has heightened the public’s awareness that it is no longer sufficient to discuss prospects for fiscal consolidation. Rather, the time has arrived for generating concrete action plans, and in many cases it is time to begin implementing such plans. The cost of excessive delay could be very high: Recent experience demonstrates that financial markets can be slow to react to policy slippages, but they can react decisively—even excessively—once they do.
Many advanced economies, particularly in Europe, are acting this year to reduce fiscal deficits. A key fiscal policy task in the euro area will be to implement already-promulgated consolidation plans, that in some cases are exceptionally ambitious. Of course, these plans are being complimented by the development of a comprehensive pan-European approach for supporting member countries that are under market pressure because of excessive debt and deficits. In these cases, fiscal adjustment is one part of the solution.
At their recent EU Council meeting, European leaders agreed to raise the effective lending capacity of the newly-formed European Financial Stability Facility (EFSF) to E440 billion, and agreed on the key parameters of the future European Stability Mechanism (ESM). However, there are many details yet to be worked out and implemented before these new initiatives will be fully operational. Nonetheless, these initiatives, among other things, are intended to make more credible the process of medium-term fiscal consolidation and long-term budget control.
Of course, the two largest advanced economies—the United States and Japan—have deferred consolidation. The US authorities previously had announced plans to reduce the federal deficit by about 2 percent of GDP in the current fiscal year. In response to weaker than expected economic data – including disappointing employment growth – they announced a new package of stimulus measures consisting of tax cuts and new spending – that will increase the deficit by about ¼ percent of GDP.
Looking forward, a credible US fiscal consolidation program will likely have to encompass three elements: First, a set of near-term actions that will help to convince financial market participants and others of the United States authorities’ serious intent. Second, some sort of policy anchor – perhaps a medium-term target for the debt/GDP ratio – that will serve as a guide to the intended trajectory for future fiscal consolidation; and third, a credible medium-term approach to revenue and spending plans that will lead plausibly to the intended medium-term target. President Obama’s Fiscal Commission has done a good job in identifying several measures both on the revenue and expenditure side for medium-term fiscal consolidation. In particular its proposals for tax reform and steps to reduce long-term entitlement pressures are very useful.
In the case of Japan, the tragic recent events inevitably create the need for a supplementary budget – most likely including short-term increases in public expenditures in order to provide disaster relief, as well as to help finance reconstruction spending. Nonetheless, Japanese authorities will be expected eventually to stabilize market expectations by providing guidance regarding a credible medium-term adjustment plan that will encompass both revenue and expenditure reforms.
It seems very likely that advanced economies’ fiscal adjustment will include measures to reduce primary spending, as spending ratios already are relatively high in most of these countries. Given the size of the required fiscal adjustment in many countries, revenue measures also are likely to form part of the solution, especially in countries with large adjustment needs.
Without a doubt, innovative thinking is in order regarding possible future revenue measures. Of the 8 percent of GDP average primary balance adjustment referred to earlier, as much as one-third may have to come from additional revenues, although there will be significant variations across countries. Analysis carried out by the IMF’s Fiscal Affairs Department – and summarized in the IMF’s new semi-annual Fiscal Monitor publication — highlights that consumption taxes may prove to be an important source of potential revenues.
In particular, the IMF has endorsed earlier plans by the Japanese authorities to reduce the budgetary shortfall in part by increasing the rate on Japan’s Value-Added Tax (VAT). Like many fiscal policy experts, Fund staff also have suggested that a VAT should be considered as a potential innovation for US deficit-reduction efforts, along with targeted income-based safeguard measures to protect low-income groups.
More generally, classic tax reforms – encompassing broadening tax bases while simplifying rules and rates – would be appropriate in most advanced economies. At the same time, it would be important to review the increasingly significant role of tax expenditures. Tax expenditures are special provisions providing tax reductions for specified activities, equivalent in economic effect with regard to the deficit as direct government spending. Rolling back tax expenditures would bring in substantial revenue—they amount to as much as 5 percent of GDP in several of the largest economies—while also improving both the efficiency and fairness of tax systems. One of the key areas where action could be taken includes mortgage deductions. The United Kingdom’s recent experience has demonstrated that this can be done without major dislocations if phased in over time.
Action could also be useful to rein in special incentives in the corporate sector related to depreciation and other credits. These are win-win reforms, in that they could help to reduce deficits while reducing distorting incentives that work via the tax system. At the same time, the broad area of environmental concerns will encourage the opposite, namely the introduction of measures that produce desirable distortions intended to correct specific market imperfections.
To be credible, any advanced economy fiscal consolidation strategy must deal with the cost of entitlements that are a – if not the – key driver of long-term spending pressures. Of course, health care-related spending reforms will have to form a central part of any budget strategy. New projections by IMF staff show that for advanced economies, public spending on health care alone is expected to rise on average by 3 percent of GDP over the next two decades. Thus, for any budget consolidation plan to be credible, it must deal with the reality of rising health care costs. Inevitably, successful reforms in this area will include effective spending controls, but also bottom-up reforms that will improve the efficiency of health care provision.
While old-age pension spending is in somewhat better shape in some countries, others countries still face long-term solvency challenges. After all, public pension spending in advanced economies is projected to increase on average by over 1 percent of GDP by 2030 with the increase exceeding 2 percent in a quarter of the economies. In some instances, however, forecasts may be based on optimistic assumption, including regarding productivity growth.
Another key point: good institutions are needed to underpin good policy. In the fiscal area, institutions such as independent fiscal agencies, using fiscal rules, strong medium-term fiscal frameworks, close monitoring of out-turns, and coordination across levels of government are keys to success. Fiscal transparency should remain a principal policy goal. Unfortunately, this already has been a victim of the crisis as some countries resort to accounting tricks to artificially boost reported revenues or lower to spending.
These include using pension contributions to provide an immediate boost to revenues while the associated pension liability will translate into spending only in the future; or increasing expenditures but keeping the headline deficit in check by guaranteeing loans and running up other contingent liabilities. Such accounting strategies paint a false picture and should be avoided. In this respect, a key role can be played by independent surveillance by international financial institutions, for example with reports on compliance with fiscal standards, such as the IMF’s code of fiscal transparency.
Fiscal adjustment will not be painless, especially on the scale that will be required. With unemployment so high for so long, targeted measures geared towards job creation and alleviating the costs of joblessness make sense in some countries—within the context of an overall adjustment strategy. Such measures could include extensions of unemployment benefits, short-term work schemes, job subsidies targeted at vulnerable groups, or active labor market policies that focus on training and education. Fiscal adjustment can be fair, and it can be done in a way to protect the most vulnerable. Indeed, adjustment will be sustainable only if it is achieved in a way that ensures that costs of adjustment—and the benefits of recovery—are distributed equitably across society.
Emerging market challenges
I will now turn to the emerging economies, where the fiscal situation may appear less worrying. Fiscal deficits in these economies fell last year – to average 3 percent of GDP – and they will decline again this year. Debt ratios are also much lower than in the advanced economies, around 37 percent of GDP.
But the fiscal house might not be as sturdy as it first appears. In some instances, the favorable picture reflects strong capital inflows, low interest rates, buoyant asset prices, and currently high commodity prices. At the same time, inflationary pressures are broadening beyond food and energy prices, especially in Asia. And fiscal buffers need to be rebuilt to protect against sudden reversals in capital flows.
For all these reasons, a tighter fiscal stance than currently envisaged will be needed in the near term in many emerging economies. Underlying fiscal balances should be improving much faster than they in fact are. At a minimum, spending pressures should be resisted and revenue over-performance saved in full. But once again, the poor must be protected—targeted measures to protect the most vulnerable in the face of rising commodity prices are a key element of social solidarity.
Shifting to the medium term, while fiscal challenges vary, increases in government spending are likely. Some countries will need reforms in order to help boost consumption; others need greater investment in infrastructure. Especially in Asia, many countries plan to increase health care spending with the goal of raising access and coverage. Many emerging economies also intend to improve social safety nets in order to support the vulnerable, to increase consumption by reducing precautionary savings, and reduce to reduce inequality.
The main challenge is to improve these safety nets while preserving long-term fiscal sustainability. Many emerging market countries need to manage the required increase in the size of government without adding to risks of overheating in the near term. This will require a skillful combination of both expenditure and tax reforms.
Many of the measures I have been discussing—by both advanced and emerging economies— also would help reduce global imbalances, which are on the rise again, and are expected to continue rising over the medium term. Growth in economies with large external deficits, like the United States, is still being driven by domestic demand. And growth in economies with large external surpluses is still too reliant on exports. For example, we expect China’s current account balance to increase again over the coming years, after bottoming out in 2010. Current account surpluses are expected to decrease only marginally in many other Asian economies. And with the US current account deficit not expected to fall further over the next few years, global imbalances could widen again, putting the sustainability of the recovery at risk.
In the short run, the fiscal adjustment being undertaken or planned in some deficit countries will help to moderate imbalances, although the impact will be somewhat offset by the need to rebuild fiscal buffers in surplus emerging economies. In the medium to long run, however, many of the measures I have outlined would help tackle the distortions at the root of persistent imbalances.
For instance, increasing consumption taxation and eliminating tax exemptions that effectively subsidize debt would help raise national savings and reduce the external deficits. In emerging market economies, the development of social safety nets—particularly pensions and broader healthcare provisions—would weaken incentives for excessive precautionary savings. In addition, eliminating policies that distort exchange rates markets would contribute to an internal rebalancing of the sources of growth, as the wealth and income effects of an appreciating currency boost domestic consumption in surplus countries. This is well known, and widely accepted.
In sum, there is no doubt that given the evolution of the recovery, countries are grappling with increasingly-complex and increasingly-diverse challenges. This is certainly true of fiscal policy. But to move toward a future of strong, sustainable, and balanced growth, these fiscal challenges need to be addressed urgently. The time for action is now.
Thank you for your attention.