The economic crisis of late 2007 and early 2008 highlighted the growing importance of the role of the world’s financial sectors in ensuring global financial stability. The finance industry, however, is not homogenous. Insurers, in particular, have a distinct profile within the industry. This was the subject of leading speakers at the ‘Role of insurance in global financial stability’ event, held at the Swiss Re Centre for Global Dialogue, 29 June 2010. Among other qualities, insurers receive premiums upfront, so are not subject to a run of withdrawals; and through matching liabilities with assets, are long term stabilising investors. There are also distinct challenges in regulating the insurance industry. Some of these were discussed by John Maroney, of the International Association of Insurance Supervisors.
When and how should fiscal deficits be reduced?
An extract from ‘Report on the European Economy 2010’, European Economic Advisory Group, 20 Sep 2010
Since the European Economic Advisory Group wrote the ‘Report on the European Economy 2010,’ there have been some dramatic events in European sovereign finance. In spring 2010 Europe was plunged into a crisis over the problem of excess sovereign debt. Greece in particular experienced difficulties in financing its government debt and investors demanded high risk premiums on new bond issues. The states of the European Union put together huge rescue packages to counter the sovereign debt crisis. In addition to an EUR 80 billion package arranged for Greece, the countries approved a credit facility of EUR 500 billion for other needy countries. The International Monetary Fund provided an additional EUR 280 billion.
These rescue measures are valid for an initial three years. Before the rescue packages expire, policymakers must develop a viable concept for future fiscal-policy rules in Europe. This concept must contain two elements: more effective political constraints on government deficits and debt and most importantly a quasi-insolvency procedure for member states. In order to enforce government budget discipline in Europe, and ensure the success of the rescue package, capital markets must receive credible signals that in the case of one country’s over-indebtedness, the creditors bear liability before help from EU or other member states can come into play. This sequencing is essential for inducing creditors to be cautious when granting loans. The sovereign debt crisis has also shown how important it is that states now pursue austerity policies. The world economy is in the midst of a strong recovery process. For this reason now is not the time for new economic stimulus measures. Instead, governments must return to sustainable policies and consolidate their budgets. Only by doing so will the recovery in the world economy develop into a sustainable upswing.
The following is an extract from the European Economic Advisory Group’s (EEAG) “Report on the European Economy 2010”. The EEAG met at the Swiss Re Centre for Global Dialogue to discuss the Report in June 2010.
In some parts or the EU at least, the political debate has moved swiftly on from the need for a fiscal stimulus to a recognition that fiscal deficits have grown substantially and need to be reduced. This raises two related questions. First, how quickly should deficits be reduced? Second, how can they be reduced?
The costs of maintaining high fiscal deficits
A first point to note is related to the analysis above. The larger part of the fiscal deficits currently facing EU governments does not result from discretionary policy in response to the financial and economic crisis. It is due to partly to an automatic response, and partly to structural factors which would have created larger deficits in any event. The automatic responses result from lower growth, which is translated into lower than expected tax receipts and higher than expected costs of social transfers.
These automatic factors work in reverse as economies move out of recession: economic growth will raise revenues (and typically, coming out of a recession, revenues rise more quickly than the underlying growth of the economy). And as unemployed and others find work, social transfers are reduced and replaced by higher tax revenues.
It is possible to do some basic calculations to estimate how long it would take for economic growth to lift the EU back to a position of budget balance. Take as a starting point the projections made by the European Commission for revenue and public expenditure as a proportion of GDP in 2010: these a re 44.1 percent and 51 percent respectively, and would result in an overall stock of public debt of 79.4 percent of GDP.
Now suppose that the EU returns to a steady state 2 percent growth from 2011 onwards. Assume also that revenues rise slightly faster than economic growth (so that the elasticity of revenues with respect to GDP is 1.1) and that public expenditure is held constant in real terms. Under this scenario, the EU as a whole would return to fiscal surplus in 2017, reaching a peak debt/GDP ratio in 2016 of approximately 100 percent.
Obviously, the return to a fiscal surplus would be faster if economic growth were higher, and slower if public expenditure rose in real terms. For example, if instead, public expenditure grew at just 0.5 percent per year in real terms, then a fiscal surplus would not be reached until 2019, and the debt/GDP ratio would peak at 106 percent. 0n the other hand, if expenditure were kept constant in real terms, and growth were 2.5 percent per year, a fiscal surplus would be reached in 2016, with debt peaking at 95 percent of GDP.
While there is of course, considerable uncertainty about future growth rates, and about the ability or EU governments to hold down public expenditures relative to the rate of economic growth, these project ions suggest that it will be some years - and possibly a decade or more - before the EU can reach a fiscal surplus and begin to cut the aggregate stock of debt. Of course, this will happen more quickly in some countries than in others.
What are the costs of maintaining such high levels of debt? The most obvious cost is that of servicing the debt through interest payments. At the end or 2009, the yields on 10 year bonds issued by EU governments lie mostly in a range between 3.2 percent and 3.8 percent, although some countries lie outside this range (for example, Ireland and Greece). Yields on shorter-dated bonds tend to be lower than this. But very roughly, the nominal cost or servicing debt at the 2010 level or around 80 percent of GDP is approximately 3 percent of GDP. For example, the European Commission's current projections of the interest liability in 2010 are: 3 percent of GDP in Germany, 3.1 percent in France, 3.1 percent in the UK, 1.9 percent in Spain, and 4.8 percent in Italy. As the stock of debt inevitably rises, these costs will increase further.
The cost will rise as interest rates rise above their current low levels. And the interest rate for the debt of any country will depend on how risky that debt is perceived by financial markets. The risk of the debt depends on a number of factors. Clearly, it depends on the size of the outstanding debt as a proportion of GDP. But it also depends on the rate at which that debt is increasing, and the state and prospects of the economy.
In addition, some countries have provided guarantees to private sector bank debt which could result in large liabilities but which are not reflected in the measures of the current stock of public debt. Some evidence on the extent of the contingent liabilities taken on by governments through their financial sector interventions has been considerable. These include three forms of intervention: capital injections, guarantees on bank liabilities, specific relief on impaired assets and other direct bank support. As would be expected, these forms of intervention varied considerably across countries. To take one notable example, the UK has injected capital into banks worth around 2.6 percent of GDP: it has provided guarantees for bank liabilities of over 11 percent of GDP, and has injected a further nearly 15 per cent of GDP in supporting banks through relief of impaired assets and other measures. As such, the UK clearly has contingent liabilities that are not revealed in the figures for public debt presented earlier in this chapter. Other countries also have huge contingent liabilities, notably Ireland, and to a lesser extent, Belgium and the Netherlands.
One way of assessing the perceived risk is to look at the spreads of credit default swaps on sovereign debt. Prior to the development of the financial crisis, in early 2008, these spreads were typically less than 0.1 percent. They increased dramatically over the course of the crisis, reaching much higher levels - and in the case of Ireland, around 3.5 percent. Since then, they have declined again, though they remain well above their pre-crisis levels.
The cost to governments in terms of higher interest payments due to the risk reflected in these CDS spreads is, however, modest. Most government debt is issued at a fixed rate of interest. The selling price of a new government bond will reflect the risk which the market attaches to that bond, and this implicitly defines the premium which the government must pay. Also, as a risk rises, the market price of existing debt falls, reflecting the higher rate of return required by the market. But it is the owners of existing bonds that bear this cost through the reduction in the value of their asset: the cash paid by the government on existing debt does not change.
The cost to governments of the risk premia associated with these CDS spreads therefore apply only to new debt and not to the stock of debt. New debt includes both new borrowing and the replacement of debt which matures, and so exceeds the fiscal deficit. (For example, a government with a new debt of say10 percent of GDP and a risk premium of 0.5 percent would need to pay an additional 0.05 percent - ie one twentieth of one percent of GDP - a year to service this debt). While these amounts may still be significant - especially for governments with high current deficits - they are small relative to the overall costs of servicing the stock of debt.
Of course, the longer that these risk premia are maintained, though, the more their cost will build up as more and more of the stock of debt has been issued at relatively high risk premia. To reduce these risk premia in the short, medium and long term, it is necessary for governments to demonstrate that they have credible plans to reduce the deficits in the medium term, thereby reducing the possibility of eventual default.
One option here would be simply to point to the type of calculations set out above: that with economic growth and holding down expenditure rises, then deficits will eventually be closed. But other policies may also be required. We now discuss options for such policies.
Options for reducing deficits
The most obvious problem facing governments that wish to reduce their fiscal deficits is that doing so may generate a negative fiscal stimulus, reducing or even overturning any economic recovery. Given the depth of the recession which faced the EU in 2008 and 2009, governments should be cautious in raising taxes or cutting expenditure to reduce their deficits. The costs associated with a delay in such policies are relatively small compared with the possible costs of restricting economic growth.
But there is an important timing issue. As previously discussed, timing works mostly through intertempural substitution effects. Consider, for example, the possibility that a government may try to develop a credible strategy for reducing its deficit by announcing a rise in income tax. If implemented at an early stage, when the economy is still at the beginning of its recovery path. the rise would be expected to generate some reduction in spending, which would be a negative shock to the economy. Now compare that option with an announcement that the rise in income tax will take effect with sufficient delay - say in one or two years' time. In this case, the government would be delaying the reduction in the deficit, presumably in the hope of allowing the economy to recover further before implementing the change. The problem with this is that individuals who face a future rise in their income tax perceive a reduction in their lifetime wealth immediately. They therefore consider themselves to be worse off now, and consequently would be likely to reduce their spending now. There is of course the possibility that individuals would seek to bring income forward from the following year in order to benefit for the lower tax rate while it lasts. This could provide a stimulus to the economy. But shifting income across years is generally much harder than shifting consumption. So it seems implausible that this effect could outweigh the effects on the economy of the reduced spending.
The main lesson here is that, from the vantage point of the effect of changes in taxes on permanent income, the announcement of a future income tax rise may not have specific advantages over the announcement of an immediate income tax rise. The timing of the fiscal adjustment, however, can and does make a large difference through channels other than permanent income.
A clear instance is provided by taxes on consumption, such as VAT and excise duties. Suppose the government announced that the rate of VAT would rise in one year's time. This would also reduce the lifetime wealth of individuals, in the sense that, for a given income, they would be able to afford to buy less goods and services. The higher tax burden would tend to depress the economy, as would be the case with other tax rises.
However, the announcement could provide an important fiscal stimulus, since there would be a clear incentive to bring forward spending to take advantage of the lower VAT rate before it was increased. This would provide an immediate stimulus to current private demand, despite raising additional revenue in the medium term.
In some ways such a policy mirrors the fiscal stimulus measure announced by the UK government in December 2008: to reduce the VAT rate from 17.5 percent to 15 percent for a fixed period of about one year. Arguably the most effective element of this stimulus was its fixed time period. A permanent reduction in the VAT rate may not have had a large effect at the point at which the country entered a recession. But the fact that the rate increased again a year later is likely to have had a more significant impact on consumption in 2009.
A second important instance is the possibility of designing consolidation packages including cuts of government spending below trend. Anticipation of lower public demand in the future tends to contain long-term interest rates (as future short term rates will be lower). Lower real rates in turn stimulate current demand, The effect of anticipated cuts is expansionary because, to the extent that firms set prices subject to nominal rigidities, today's prices will already optimally incorporate expectations of the path of future demand and inflation. With sticky prices, prospective spending cuts (all else equal) lower prices, containing the dynamic of inflation, and thus allowing the central bank to be more expansionary.
For the above mechanism to work, however, the central bank must be able to control policy rates, ie the economy cannot be in a situation in which the central bank would like to lower policy rates, but it cannot, because these are already at zero. In these circumstances, as shown by Corsetti et al (2010), the timing of fiscal adjustment is crucial.
With a near-zero nominal interest rate, implementing spending cuts too soon would add to the deflationary pressure of the ongoing recession. These pressures may end up raising inefficiently the interest rates in real terms, and may possibly exacerbate the zero lower- bound problem. In contras, a delayed implementation of spending cuts can be quite beneficial, as it would help the central bank maintain an expansionary monetary stance after the economy exits from the zero-lower-bound constraint (and it may shorten the period of the zero lower bound episode).
These considerations are important in light of the fact that the large rise in public debt requires fiscal consolidation to be substantial. Households reasonably expect adjustment to take place exclusively via increases in taxes but also via some cut in spending. With interest rates still close to zero, anticipation of early spending cuts may actually harm the effectiveness of current fiscal stimulus, as their deflationary impact materialises when the economy is still struggling with the aftermath of the recessionary shock. A credible plan gradually phasing in spending cuts over a two year horizon not only can reduce this risk: it can also enhance the expansionary impact of the ongoing fiscal stimulus.
A final point to note here concerns the need for coordination across countries. As noted in the introduction, in 2008 there was general agreement that enacting a fiscal stimulus would be more effective if all (or at least many) countries followed a similar policy, increasing demand everywhere. By contrast, a single country enacting a stimulus on its own would see much of the stimulus flowing abroad through the purchase of imports.
But in light of the need to consolidate debt, measures to reduce public deficits across the world sum up to a global recessionary impulse. In this case, international policy coordination may still be beneficial insofar as it would be a way to internalise the negative demand spillovers on foreign output created by fiscal adjustment in a country. To wit: the same way in which coordination leads to stronger global stimulus at the start of a recession, coordination would lead to gradualism in fiscal consolidation once the initial stimulus is withdrawn. If all countries simultaneously reduced their deficits by increasing taxes and reducing spending ignoring spillovers, aggregate demand would fall everywhere too much, and adjustment would create a much greater recessionary impulse, possibly harming the nascent world recovery.
However, coordination is not necessarily desirable The risk is that gradualism in the name of coordination could provide an excuse to delay the adoption of the necessary measures to preserve stability. Appealing to the need for a coordinated fiscal consolidation, for instance, incumbent governments may leave unpopular decisions for future governments to make.
Conversely, in the current circumstances it makes sense that the worst hit countries or the countries with the most fragile public finances should adjust upfront and most deeply so as to prevent the spreading of concerns about fiscal sustainability. The benefits from coordination, which may be small initially, can quickly turn largely negative if this ends up interfering with the most efficient path of debt consolidation.
In this Chapter we have discussed a number or issues surrounding the large rises in fiscal deficits in Europe. The key points raised are as follows:
- There have been large increases in budget deficits throughout the EU, leading to considerable rises in the stock of public debt as a percentage of GDP. In 2009, the total deficit in the EU was around 6 percent of GDP, and it is expected to rise further in 2010. There has been a corresponding increase in outstanding debt, rising to 72 percent of GDP in 2009 and to nearly 80 percent of GDP in 2010.
- There are also wide variations across countries. The UK, Ireland and Latvia have particularly high deficits, though in all three cases their outstanding debt is moderate. Italy, Greece and Belgium have much higher outstanding debt, though all three have had high debt for some years.
- These high deficits have generally not reflected discretionary changes by EU governments. While most governments introduced a discretionary fiscal stimulus in 2008 and 2009, these were small relative to the overall deficits. The form of these discretionary changes (and even their sign) has varied considerably between countries.
- There is considerable empirical evidence that a fiscal stimulus has a positive effect on out put, although there are many problems in measuring the effect, so that the size of the fiscal multiplier is not known with any certainty. In any case there is little reason to suppose that effects estimated on historic data are likely to be valid in the midst of a recession. This is particularly the case when interest rates are effectively at zero and the economy is shaken by an ongoing financial and economic crisis, when there may be very large multipliers for government spending. There is also little reason to suppose that different forms of fiscal intervention have similar effects.
- The scope for reducing deficits depends crucially on the rate of economic growth achieved over the next few years, and the degree to which real public spending can be curtailed, for example, a simple calculation suggests that if spending is kept constant in real terms throughout the EU, then economic growth of around 2 percent would see the aggregate EU deficit reduced to zero by 2017, with outstanding debt reaching a peak of around 100 percent of GDP. Of course, some countries would need a higher growth rate to achieve fiscal balance within this period.
- There are costs or maintaining high levels of debt, though these should not be exaggerated. Especially at low interest rates, the cost of servicing debt is of the order of 3 percent of GDP, though again there is considerable variation across member states. Two factors could increase this cost in the short to medium term. First, interest rates are likely to rise. Second, public debt appears increasingly risky to the market, which implies that higher risk premia could be charged.
- Although these risk premia are currently not large, they could be lowered - or at least prevented from growing - if governments announced credible strategies to reduce deficits over the medium term. A downside of such a strategy is that announcements of future tax rises may hamper the economy immediately as individuals perceive their lifetime income to be lower.
- One way of reconciling the need for a credible deficit-reduction strategy with the need to avoid harming a fragile economy is to announce rises in taxes on spending - such as VAT - to take effect from some future period, say in one year's time. This would induce individuals to bring spending forward, which would provide temporary stimulus to the economy.
- Another way consists of announcing well-designed measures bringing government spending on goods and services below trend, to be implemented sufficiently far in the future as to avoid the risk of exposing the economy to additional deflationary pressures when policy interest rates are still close to zero. Provided that they arc not implemented too early, future spending cuts are beneficial to recovery, as they contain the rise in long-term interest rates (as well as attenuating concerns about debt sustainability).
- A final point concerns co-ordination. In attempting to stimulate the economy there were gains from coordination. For an individual country, a stimulus to spending might be largely reflected in increased imports, creating demand for goods and services produced elsewhere. A coordinated policy reduces this risk. In principle, the same argument also applies (with a different sign) to fiscal adjustment. If all countries implemented a contractionary fiscal adjustment simultaneously and independently, without internalising negative output spillovers abroad, then this would be likely to hamper the economic recovery. This adverse effect would be reduced if such policies were introduced in a coordinated way, possibly leading 10 more gradualism.
- However, coordinated gradualism should not interfere with the adoption of measures necessary to preserve stability. The worst hit countries or the countries with the most fragile public finances should adjust upfront and most deeply, to prevent the spreading of concerns about fiscal sustainability. If gradualism in the name of coordination feeds doubts about debt consolidation, then no coordination is a much better option.
The 2010 EEAG Report, the ninth in the series, provides an authoritative analysis of the most salient aspects of the financial crisis that wiped trillions of dollars around the world and, in particular, explores what needs to be done to nurture the incipient recovery: there are still several chronic ailments in the financial market that need to be addressed and which pose significant challenges for economists and policymakers. The Members of the European Economic Advisory Group at CESifo: Giancarlo Corsetti; Michael P. Devereux; Luigi Guiso; John Hassler; Gilles Saint-Paul; Hans-Werner Sinn; Jan-Egbert Sturm; Xavier Vives. www.cesifo-group.de