BIS Working Papers No 300. The future of public debt: prospects and implications. Monetary and Economic Department

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1 BIS Working Papers No 3 The fuure of public deb: prospecs and implicaions by Sephen G Cecchei, M S Mohany and Fabrizio Zampolli Moneary and Economic Deparmen March 21 JEL classificaion: H5; H6; E6 Keywords: public deb; fiscal defici; age-relaed spending; inflaion; ineres raes; defaul risk

2 BIS Working Papers are wrien by members of he Moneary and Economic Deparmen of he Bank for Inernaional Selemens, and from ime o ime by oher economiss, and are published by he Bank. The papers are on subjecs of opical ineres and are echnical in characer. The views expressed in hem are hose of heir auhors and no necessarily he views of he BIS. Copies of publicaions are available from: Bank for Inernaional Selemens Communicaions CH-42 Basel, Swizerland publicaions@bis.org Fax: and This publicaion is available on he BIS websie ( Bank for Inernaional Selemens 21. All righs reserved. Brief excerps may be reproduced or ranslaed provided he source is saed. ISSN (prin) ISBN (online) 4

3 The fuure of public deb: prospecs and implicaions Sephen G Cecchei, M S Mohany and Fabrizio Zampolli 1 Absrac Since he sar of he financial crisis, indusrial counry public deb levels have increased dramaically. And hey are se o coninue rising for he foreseeable fuure. A number of counries face he prospec of large and rising fuure coss relaed o he ageing of heir populaions. In his paper, we examine wha curren fiscal policy and expeced fuure agerelaed spending imply for he pah of deb/gdp raios over he nex several decades. Our projecions of public deb raios lead us o conclude ha he pah pursued by fiscal auhoriies in a number of indusrial counries is unsusainable. Drasic measures are necessary o check he rapid growh of curren and fuure liabiliies of governmens and reduce heir adverse consequences for long-erm growh and moneary sabiliy. JEL classificaion: H5; H6; E6 Keywords: public deb; fiscal defici; age-relaed spending; inflaion; ineres raes; defaul risk 1 Cecchei is Economic Adviser a he Bank for Inernaional Selemens (BIS) and Head of is Moneary and Economic Deparmen, Research Associae of he Naional Bureau of Economic Research, and Research Fellow a he Cenre for Economic Policy Research; Mohany is Head of he Macroeconomic Analysis Uni a he BIS; and Zampolli is Senior Economis a he BIS. This paper is a revised version of he draf prepared for he Reserve Bank of India s Inernaional Research Conference Challenges o cenral banking in he conex of financial crisis, Mumbai, India, February 21. We are graeful o Eswar S Prasad for his houghful discussion of he paper, o Lars Svensson and Marin Wolf for very useful commens, and o Nahalie Carcenac, Jakub Demski, Magdalena Erdem and Ger Schnabel for he excellen saisical suppor. The views expressed in his paper are hose of he auhors and no necessarily hose of he BIS. iii

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5 1. Inroducion The financial crisis ha eruped in mid-28 led o an explosion of public deb in many advanced economies. Governmens were forced o recapialise banks, ake over a large par of he debs of failing financial insiuions, and inroduce large simulus programmes o revive demand. According o he OECD, oal indusrialised counry public secor deb is now expeced o exceed 1% of GDP in 211 somehing ha has never happened before in peaceime. 2 As bad as hese fiscal problems may appear, relying solely on hese official figures is almos cerainly very misleading. Rapidly ageing populaions presen a number of counries wih he prospec of enormous fuure coss ha are no wholly recognised in curren budge projecions. The size of hese fuure obligaions is anybody s guess. As far as we know, here is no definie and comprehensive accoun of he unfunded, coningen liabiliies ha governmens currenly have accumulaed. Should we be concerned abou high and sharply rising public debs? Several advanced economies have experienced higher levels of public deb han we see oday. In he afermah of World War II, for example, governmen debs in excess of 1% of GDP were common. 3 And none of hese led o defaul. 4 In more recen imes, Japan has been living wih a public deb raio of over 15% wihou any adverse effec on is cos. So i is possible ha invesors will coninue o pu srong faih in indusrial counries abiliy o repay, and ha worries abou excessive public debs are exaggeraed. 5 Indeed, wih only a few excepions, during he crisis, nominal governmen bond yields have fallen and remained low. So far, a leas, invesors have coninued o view governmen bonds as relaively safe. Bu bond raders are nooriously shor-sighed, assuming hey can ge ou before he sorm his: heir ime horizons are days or weeks, no years or decades. We ake a longer and less benign view of curren developmens, arguing ha he afermah of he financial crisis is poised o bring a simmering fiscal problem in indusrial economies o boiling poin. In he face of rapidly ageing populaions, for many counries he pah of pre-crisis fuure revenues was insufficien o finance promised expendiure. The poliics of public deb vary by counry. In some, seared by unpleasan experience, here is a culure of frugaliy. In ohers, however, profligae official spending is commonplace. In recen years, consolidaion has been successful on a number of occasions. Bu fiscal resrain ends o deliver sable deb; rarely does i produce subsanial reducions. And, mos criically, swings from deficis o surpluses have ended o come along wih eiher falling nominal ineres raes, rising real growh, or boh. Today, ineres raes are excepionally low and he growh oulook for advanced economies is modes a bes. This leads us o conclude ha he quesion is when markes will sar puing pressure on governmens, no if. When, in he absence of fiscal acions, will invesors sar demanding a much higher compensaion for he risk of holding he increasingly large amouns of public deb ha auhoriies are going o issue o finance heir exravagan ways? In some counries, unsable deb dynamics, in which Public finances in emerging marke economies are generally in a much beer shape. Wih heir financial sysems and economies remaining relaively immune o he crisis, public deb levels have grown much less rapidly, and are on average around 4% of GDP. One noable excepion is India a counry wih a hisory of fiscal problems where public deb remains high by oday s emerging marke sandards. In he Unied Saes deb/gdp peaked a close o 121%, while in he Unied Kingdom i rose o abou 3%. According o Reinhar and Rogoff (28, Appendix Table 3), he las defaul in he indusrial world was Japan and Germany in he immediae afermah of World War II. There have been no advanced counry defauls for more han half a cenury. As a maer of macroeconomic heory, so long as he deb/income raio is consan, an economy could live wih any level of deb. 1

6 higher deb levels lead o higher ineres raes, which hen lead o even higher deb levels, are already clearly on he horizon. I follows ha he fiscal problems currenly faced by indusrial counries need o be ackled relaively soon and resoluely. Failure o do so will raise he chance of an unexpeced and abrup rise in governmen bond yields a medium and long mauriies, which would pu he nascen economic recovery a risk. I will also complicae he ask of cenral banks in conrolling inflaion in he immediae fuure and migh ulimaely hreaen he credibiliy of presen moneary policy arrangemens. While fiscal problems need o be ackled soon, how o do ha wihou seriously jeopardising he incipien economic recovery is he curren key challenge for fiscal auhoriies. In his paper, we do no address his issue, bu we noe ha, in our view, an imporan par of any fiscal consolidaion programme is measures o reduce fuure liabiliies such as an increase in he reiremen age. 6 Announcemens of changes in fuure programmes would allow auhoriies o wai unil he recovery from he crisis is assured before reducing discreionary spending and improving he shor-erm fiscal posiion. The remainder of his paper is organised in four secions. In Secion 2, we presen an examinaion of he recen build-up of public deb. Following he facs, we urn, in Secion 3, o a forward-looking examinaion of he public deb rajecories in indusrial counries. In Secion 4, we discuss he challenges hese possible fuure deb levels pose o boh fiscal and moneary auhoriies. The las secion concludes. 2. The facs Afer a large increase during he recen financial crisis and recession, public deb raios are se o coninue o rise over he nex few years. How far depends on several facors: he ulimae coss of he financial crisis, he rae of real growh and he level of ineres raes, as well as poliical decisions abou spending and axes. The fac ha srucural deficis have a endency o linger in indusrial counries, ogeher wih large long-erm age-relaed liabiliies, makes he curren policy in a number of counries unsusainable going forward. In his secion, we summarise he facors influencing long-erm fiscal imbalances and hen go on o presen projecions of he pah of deb/gdp raios in large indusrial counries. Curren and projeced fiscal deficis We sar wih Table 1. A key fac emerging from he able is ha over he pas hree years public deb has grown rapidly in counries where i had remained relaively low before he crisis. This group of counries includes no only he Unied Saes and he Unied Kingdom bu also Spain and Ireland. Alhough he rise in deb levels is comparaively small in counries wih a hisory of deb problems (such as Ialy and Greece), he crisis has, neverheless, added fuel o heir problems. I is imporan o realise ha, while he direc coss of financial crisis on governmens may appear large, hey are in fac relaively small compared o indirec coss arising from losses of ax revenues and increased expendiure o provide demand simulus. Financial rescue programmes, including capial injecion, reasury purchase of asses and lending as well as upfron governmen financing (bu no deb guaranees), amoun o 13.2% of GDP in 6 See Giavazzi (29) for a discussion. Measures o ackle long-erm liabiliies should be such o minimise heir impac on curren saving behaviour. 2

7 Table 1 Fiscal siuaion and prospecs 1 Fiscal balance Srucural balance 2 General governmen deb 3 As a percenage of GDP Ausria France Germany Greece Ireland Ialy Japan Neherlands Porugal Spain Unied Kingdom Unied Saes Asia Cenral Europe Lain America Regional averages calculaed as weighed averages based on 25 GDP and PPP exchange raes. 2 Cyclically adjused balance. 3 For Argenina, he Philippines and Thailand, cenral governmen deb. 4 China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, he Philippines, Singapore and Thailand. 5 The Czech Republic, Hungary and Poland. 6 Argenina, Brazil, Chile and Mexico. Sources: IMF, World Economic Oulook (emerging marke economies); OECD, Economic Oulook (advanced economies). advanced economies so far (see IMF (29)) 7 and a significan par of his is likely o be recovered. By conras, overall fiscal balances have been deerioraing sharply by 2 3 percenage poins of GDP in jus hree years. And, unless acion is aken almos immediaely, here is lile hope ha hese deficis will decline significanly in 211. Even more worrying is he fac ha mos of he projeced deficis are srucural raher han cyclical in naure. So, in he absence of immediae correcive acion, we can expec hese deficis o persis even during he cyclical recovery. 7 This number is comparable wih pas crises. According o Laeven and Valencia (28), in he previous 49 crises he average ne direc resoluion cos borne by he governmen has been 13% of GDP. 3

8 Based on a very comprehensive daa se, Reinhar and Rogoff (29a) repor ha hree years afer a ypical banking crisis he absolue level of public deb is on average abou 86% higher han prior o he crisis. In hose counries where he crisis was mos severe, deb almos rebled. This ime around, several counries are beyond his hisorical average: Ireland wih increases in public deb of 98% beween 27 and 29; and he Unied Kingdom wih projeced rises of 111% by 211. Meanwhile, he Unied Saes and Spain wih projeced increases of 75% and 78%, respecively, by 211 are no far behind. We doub ha he curren crisis will be ypical in is impac on deficis and deb. The reason is ha, in many counries, employmen and growh are unlikely o reurn o heir pre-crisis levels in he foreseeable fuure. 8 As a resul, unemploymen and oher benefis will need o be paid for several years, and high levels of public invesmen migh also have o be mainained. Graph 1 Governmen gross deb and primary fiscal balance in indusrial economies 1 As a percenage of GDP Governmen deb (lhs) Primary balance (rhs) Srucural primary balance (rhs) Shaded areas represen forecas. 1 Weighed average based on 25 GDP and PPP exchange raes of economies cied and daa availabiliy; Ausralia, Ausria, Belgium, Canada, Denmark, France, Finland, Germany, Greece, Ireland, Ialy, Japan, he Neherlands, New Zealand, Norway, Porugal, Spain, Sweden, Swizerland, he Unied Kingdom and he Unied Saes. Sources: OECD; auhors calculaions. The permanen loss of poenial oupu caused by he crisis also means ha governmen revenues may have o be permanenly lower in many counries. Beween 27 and 29, he raio of governmen revenue o GDP fell by 2 4 percenage poins in Ireland, Spain, he Unied Saes and he Unied Kingdom. I is difficul o know how much of his will be reversed as he recovery progresses. Experience ells us ha he longer households and firms are unemployed and underemployed, as well as he longer hey are cu off from credi markes, he bigger he shadow economy becomes For insance, based on he experience of he pas banking crisis, Knoek and Terry (29) predic ha he US unemploymen rae may say above 1% up o 211, drifing down only gradually o 8% by 214 and abou 6% in 218. OECD (29a) projecs a similar pah for he euro area unemploymen rae, wih a reurn o below 9% level only in 217. There is some evidence o sugges ha VAT non-compliance among firms ends o worsen during an economic downurn; see Brondolo (29). Schneider (29), for insance, prediced ha he share of he 4

9 These concerns also need o be pu ino hisorical conex. Many counries have a clear defici bias. To see his, noe in Graph 1 he relaionship beween public deb and wo major indicaors of he budgeary sance in advanced economies: he primary balance (he defici excluding ineres paymens on he ousanding deb) and he srucural primary balance (he primary balance adjused for cyclical increases in expendiure and cyclical decreases in revenue). The graph shows ha primary deficis in indusrial counries have a life of heir own, saying high or low for a number of years running. Such persisence is clearly eviden in he 197s and 198s and again, o a lesser exen, in he early 2s. To invesigae his endency, we perform a panel regression of he srucural primary balance on is own lag, he lagged value of he deb/gdp raio and he conemporaneous value of he oupu gap, using he pas 3 years as a sample period. The esimaes in Table 2 confirm ha, on average, he srucural primary balance is highly persisen and, furhermore, allow us o conclude ha i responds posiively o he lagged deb/gdp raio. In paricular, he shor-erm response of he srucural primary balance o a 1 percenage poin increase in he deb/gdp raio is beween 1 and 2 basis poins. Taken a face value, hese resuls imply a long-erm response of approximaely 6 9 basis poins. 1 Furhermore, we find no evidence ha fiscal auhoriies behave opporunisically, aking advanage of improvemens in he oupu gap o ighen he sance of fiscal policy. Taken ogeher, all his suggess o us ha fiscal policy is likely o remain highly expansionary in he near erm. In addiion, if pas behaviour is any guide o he fuure, fiscal auhoriies migh find i difficul o adjus quickly unless, ha is, hey are lef wih no choice. Table 2 Srucural primary balance regressed on a consan, lagged deb/gdp raio, lagged srucural primary balance and conemporaneous oupu gap 1 R 2 Consan Deb/GDP raio ( 1) Srucural primary balance ( 1) Oupu gap Panel esimaion ***.2***.77***.5 Panel esimaion ***.2***.76***.6 Panel esimaion ***.1***.84***.2 *, ** and *** denoe coefficiens significanly differen from zero a he 1%, 5% and 1% level, respecively. 1 Sample period is Counries in he sample: Ausria, Ausralia, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Ialy, Japan, he Neherlands, Norway, New Zealand, Porugal, Spain, Swizerland, Sweden, Unied Kingdom and he Unied Saes. 2 The panel regression has been esimaed by OLS wih Whie cross-secion sandard errors and fixed effecs. 3 The panel regression has been esimaed by GMM wih Whie cross-secion sandard errors and fixed effecs (using as he insrumens regressors and lags of dependen variable (from 1 o 3). 4 The panel regression has been esimaed by GMM wih Whie cross-secion sandard errors (using as he insrumens regressors and lags of dependen variable (from 1 o 3). Sources: OECD; auhors calculaions. 1 shadow economy in OECD counries could rise, on average, by.5 percenage poins of GDP in 29 over he previous year, reversing a declining rend since he early 2s. A shor-erm response of 1 2 basis poins is sufficien o offse he immediae rise in ineres paymens ha he exra deb would generae if he difference beween he ineres rae paid on deb and GDP growh is smaller. Ye, because of he sluggish response, any large negaive values of he srucural primary balance (as brough abou, for example, by a recession) would narrow only slowly over ime. 5

10 Long-erm fiscal imbalances More worryingly, he curren expansionary fiscal policy has coincided wih rising, and largely unfunded, age-relaed spending (pension and healh care coss). Driven by he counries demographic profiles, he raio of old-age populaion o working-age populaion is projeced o rise sharply. Ineresingly, his rise is concenraed in counries such as Japan, Spain, Ialy and Greece, which are already laden wih relaively high debs (Graph 2, lef-hand panel). Added o he effecs of populaion ageing is he problem posed by rising per capia healh care coss. This leads us o he obvious conclusion ha any assessmen of he governmen fiscal siuaion based on a shor-erm perspecive is incomplee and a bes misleading. A key quesion is o wha exen such accrued liabiliies should be refleced in deb esimaes. Concerns abou boh fiscal susainabiliy and inergeneraional equiy demand ha he accumulaed ne discouned value of all fuure revenues and expendiure commimens scheduled in curren laws be added o he curren deb sock. Currenly, however, here is no unique source providing such esimaes. And uncerainy abou fuure policy, demography and produciviy growh raises issues abou how his informaion should be presened and used (see eg Auerbach (28) for a discussion). Tha said, exising sudies repor ha he magniude of he long-erm fiscal imbalance he presen value of unfunded liabiliies arising from ageing is very large. Hauner e al (27) esimae he change in he primary balance required o equae he ne presen discouned value of all fuure revenues and non-ineres expendiures o he deb levels prevailing a he end of 25 for seven major indusrial counries (Canada, France, Germany, Ialy, Japan, he Unied Kingdom and he Unied Saes). The auhors repor ha in order for hese counries o pay off all heir financial liabiliies, hey would require an average improvemen in heir budge balance excluding ineres paymens of 4.5% of GDP. For he Unied Saes and Japan, he esimae is 6.9% and 6.2%, respecively. Graph 2 Projeced populaion srucure and age-relaed spending Old-age populaion (raio o working-age populaion) 1 Unied Saes Japan Unied Kingdom Germany France Ialy Spain Greece.8.6 Esimaed increase in age-relaed governmen expendiure from 211 o US Japan UK Germany France Ialy Spain Greece 1 Working-age populaion is beween 15 and 64 years of age. 2 In percenage poins of GDP. Sources: IMF, World Economic Oulook, April 27; UN Secrearia; European Commission; Congressional Budge Office; auhors calculaions. Oher esimaes are similar in magniude. For example, Gokhale (29) presens a measure of he long-erm fiscal imbalance faced by 23 indusrial counries. His esimaes sugges ha, for financing fuure benefis wihou fuure ax increases, he Unied Saes and major 6

11 European counries would be required o generae an annual presen value surplus of he order of 8 1% of 25 GDP over he period o 25. The US Congressional Budge Office (CBO (29)) provides official projecions of long-erm fiscal gaps associaed wih agerelaed spending. These sugges ha he Unied Saes would need a permanen improvemen in is budge balances of he order of 2.6% of 29 GDP in he nex 5 years and 3.2% in 75 years o sabilise he federal deb/gdp raio a is 29 level. Because of he large uncerainies involved, we do no aemp o make our own projecions of age-relaed liabiliies, bu insead rely on recen projecions of age-relaed expendiure by he European Commission, he CBO and he IMF (Japan). The righ-hand panel of Graph 2 repors he esimaed incremenal age-relaed oulays beween 211 and 25. We noe ha hese numbers sugges ha he disribuion of age-relaed spending is uneven across counries, wih he burden considerably higher in Germany, Greece, Spain, he Unied Kingdom and he Unied Saes han in oher counries. A he level projeced, US healh care expendiures as a percenage of GDP would double from abou 5% oday o 1% by 235 and more han reble o 17% by 28. Ineres rae and growh rae The differenial beween he real ineres rae and real oupu growh is a criical inpu parameer in deermining he fuure evoluion of public deb. 11 When his differenial is posiive, so ha he ineres rae is greaer han he growh rae, he deb raio will explode in he absence of a sufficienly large primary surplus. So far, he build-up of public deb in indusrial counries has aken place agains he backdrop of an exceedingly low ineres rae environmen. Despie low inflaion, he real ineres rae (in effecive erms) a which governmens are able o finance heir deficis and roll over ousanding deb obligaions has been falling since he lae 199s, reaching almos zero in some counries in he wake of he moneary policy response o he financial crisis (Graph 3, lef-hand panel). However, as he graph reveals, he siuaion is changing quickly even wihou a change in moneary policy-conrolled ineres raes. Real borrowing raes rose hrough 29, and are poised o coninue increasing wih he reversal of he curren zero ineres rae policy. Added o his is he fac ha he crisis is likely o reduce he poenial oupu growh rae for some ime o come (Cecchei and Zhu (29)). The righ-hand panel of Graph 3 is indicaive of he severiy of he problems ha governmens face. I plos a measure of he difference beween he real ineres rae and real growh on he horizonal axis and he raio of he primary surplus o oal deb on he verical axis. The higher he differenial beween he real ineres rae and poenial oupu growh, he larger he required srucural primary surplus as a proporion of he previous-period deb level needed o mainain a sable deb/gdp raio. Turning o he graph, for deb/gdp o remain sable, a counry mus be above he 45-degree line on he graph (which appears relaively fla due o he differences in he horizonal and verical scale). The daa show ha he curren fiscal policy is unsusainable in every counry in he graph. Drasic improvemens in he srucural primary balance will be necessary o preven deb raios from exploding in fuure. 11 The appendix conains a brief primer on he arihmeic of deb dynamics and he raionale behind our projecions. 7

12 Graph 3 Governmen borrowing and ineres rae growh differenials Real governmen borrowing raes 1 Unied Saes Unied Kingdom Germany Ialy Spain Greece Ineres rae growh differenial and primary balance 5 IE ES CH IT DE AT JP PT SE NL DK FI FR GR US GB AU BE NZ Primary balance/deb Real ineres rae minus poenial growh 3 25 AU = Ausralia; AT = Ausria; BE = Belgium; CH = Swizerland; DE = Germany; DK = Denmark, ES = Spain; FI = Finland; FR = France; GB = Unied Kingdom; GR = Greece; IE = Ireland; IT = Ialy; JP = Japan; NL = Neherlands; NZ = New Zealand; PT = Porugal; SE = Sweden; US = Unied Saes. 1 Effecive real ineres rae on public deb compued from governmen gross ineres paymens a period () divided by governmen gross financial liabiliies a period ( 1) minus inflaion rae; in per cen. 2 Governmen primary balance a period () divided by governmen gross financial liabiliies a period ( 1) in 29; in per cen. 3 Effecive real ineres rae on public deb (average ) minus OECD-esimaed real poenial GDP growh for ; in percenage poins. Sources: OECD; auhors calculaions. 3. The fuure public deb rajecory We now urn o a se of 3-year projecions for he pah of he deb/gdp raio in a dozen major indusrial economies (Ausria, France, Germany, Greece, Ireland, Ialy, Japan, he Neherlands, Porugal, Spain, he Unied Kingdom and he Unied Saes). We choose a 3- year horizon wih a view o capuring he large unfunded liabiliies semming from fuure agerelaed expendiure wihou making overly srong assumpions abou he fuure pah of fiscal policy (which is unlikely o be consan). In our baseline case, we assume ha governmen oal revenue and non-age-relaed primary spending remain a consan percenage of GDP a he 211 level as projeced by he OECD. Using he CBO and European Commission projecions for age-relaed spending, we hen proceed o generae a pah for oal primary governmen spending and he primary balance over he nex 3 years. 12 Throughou he projecion period, he real ineres rae ha deermines he cos of funding is assumed o remain consan a is average, and poenial real GDP growh is se o he OECD-esimaed pos-crisis rae Noe ha he European Commission provides projecions for age-relaed expendiure beween 28 and 26. Using hese projecions, we inerpolaed an annual series for age-relaed expendiure for he nex 3 years. The real ineres rae is compued as he effecive nominal ineres rae on public deb minus CPI inflaion (see definiion in Graph 3). Poenial real GDP growh is aken from OECD (29a). 8

13 Deb projecions From his exercise, we are able o come o a number of conclusions. Firs, in our baseline scenario, convenionally compued deficis will rise precipiously. Unless he sance of fiscal policy changes, or age-relaed spending is cu, by 22 he primary defici/gdp raio will rise o 13% in Ireland; 8 1% in Japan, Spain, he Unied Kingdom and he Unied Saes; and 3 7% in Ausria, Germany, Greece, he Neherlands and Porugal. Only in Ialy do hese policy seings keep he primary deficis relaively well conained a consequence of he fac ha he counry enered he crisis wih a nearly balanced budge and did no implemen any real simulus over he pas several years. Bu he main poin of his exercise is he impac ha his will have on deb. 14 The resuls ploed as he red line in Graph 4 show ha, in he baseline scenario, deb/gdp raios rise rapidly in he nex decade, exceeding 3% of GDP in Japan; 2% in he Unied Kingdom; and 15% in Belgium, France, Ireland, Greece, Ialy and he Unied Saes. And, as is clear from he slope of he line, wihou a change in policy, he pah is unsable. This is confirmed by he projeced ineres rae pahs, again in our baseline scenario. Graph 5 shows he fracion absorbed by ineres paymens in each of hese counries. From around 5% oday, hese numbers rise o over 1% in all cases, and as high as 27% in he Unied Kingdom. Seeing ha he saus quo is unenable, counries are embarking on fiscal consolidaion plans. In he Unied Saes, he aim is o bring he oal federal budge defici down from 11% o 4% of GDP by 215. In he Unied Kingdom, he consolidaion plan envisages reducing budge deficis by 1.3 percenage poins of GDP each year from 21 o 213 (see eg OECD (29a)). To examine he long-run implicaions of a gradual fiscal adjusmen similar o he ones being proposed, we projec he deb raio assuming ha he primary balance improves by 1 percenage poin of GDP in each year for five years saring in 212. The resuls are presened as he green line in Graph 4. Alhough such an adjusmen pah would slow he rae of deb accumulaion compared wih our baseline scenario, i would leave several major indusrial economies wih subsanial deb raios in he nex decade. This suggess ha consolidaions along he lines currenly being discussed will no be sufficien o ensure ha deb levels remain wihin reasonable bounds over he nex several decades. An alernaive o radiional spending cus and revenue increases is o change he promises ha are as ye unme. Here, ha means embarking on he poliically reacherous ask of cuing fuure age-relaed liabiliies. Wih his possibiliy in mind, we consruc a hird scenario ha combines gradual fiscal improvemen wih a freezing of age-relaed spending-o-gdp a he projeced level for 211. The blue line in Graph 4 shows he consequences of his draconian policy. Given is severiy, he resul is no surprise: wha was a rising deb/gdp raio reverses course and sars heading down in Ausria, Germany and he Neherlands. In several ohers, he policy yields a significan slowdown in deb accumulaion. Ineresingly, in 14 In our projecions, we consider gross raher han ne public deb, he laer being gross deb minus financial asses. Our preference for focusing on gross deb hinges on a number of consideraions. Firs, governmen financial asses are more difficul o idenify and accuraely value han governmen liabiliies. Second, he definiion and range of asses included in ne deb vary across counries, making comparisons more difficul. Third, from he poin of view of a credior, i is reasonable o assume ha some or all of he fiscal auhoriies financial asses, such as sof loans graned o firms wih a high probabiliy of defaul, may no be available o repay deb when needed. Fourh, including financial asses in our analysis would require accouning no only for ineres paymens on gross deb bu also for revenue accruing o hose asses. While use of ne deb numbers would have made he absolue levels of he deb/gdp raios somewha lower, i would have complicaed he analysis significanly wihou changing he profile of he projecions. 9

14 Graph 4 Public deb/gdp projecions Ausria France Germany Baseline scenario Small gradual adjusmen Small gradual adjusmen wih age-relaed spending held consan Greece Ireland Ialy Japan Neherlands Porugal Spain Unied Kingdom Unied Saes Sources: OECD; auhors projecions

15 Ausria Belgium Finland France Germany Greece Ireland Graph 5 Projeced ineres paymens as a fracion of GDP In per cen Ialy Japan Neherlands Porugal Spain Unied Kingdom Unied Saes Sources: OECD; auhors projecions. France, Ireland, he Unied Kingdom and he Unied Saes, even his policy is no sufficien o bring rising deb under conrol. 15 All of his leads us o ask: wha level of primary balance would be required o bring he deb/gdp raio in each counry back o is pre-crisis, 27 level? Graned ha counries which sared wih low levels of deb may never need o come back o his poin, he quesion is an ineresing one neverheless. Table 3 presens he average primary surplus arge Table 3 Average primary balance required o sabilise he public deb/gdp raio a he 27 level 1 Over 5 years Over 1 years Over 2 years Memo: Primary balance in 211 (forecas) Ausria France Germany Greece Ireland Ialy Japan Neherlands Porugal Spain Unied Kingdom Unied Saes As a percenage of GDP. Sources: OECD; auhors calculaions. 15 Such a policy pah is unlikely o reduce Japan s deb raio subsanially because of only a small increase in projeced age-relaed spending in fuure. This is largely a consequence of he fac ha Japan s old age populaion is projeced o decline in absolue erms during much of he nex 3 years, alhough i is expeced o coninue o rise as a percenage of he working populaion. 11

16 required o bring deb raios down o heir 27 levels over horizons of 5, 1 and 2 years. An aggressive adjusmen pah o achieve his objecive wihin five years would mean generaing an average annual primary surplus of 8 12% of GDP in he Unied Saes, Japan, he Unied Kingdom and Ireland, and 5 7% in a number of oher counries. A preference for smoohing he adjusmen over a longer horizon (say, 2 years) reduces he annual surplus arge a he cos of leaving governmens exposed o high deb raios in he shor o medium erm. Risks from fiscal imbalances The fuure profile of public deb presens major risks and challenges for boh fiscal and moneary policy. Here we focus on he real implicaions of living wih a higher level of deb, and urn o challenges facing moneary auhoriies in he nex secion. When a counry sars from an already high level of public deb, he probabiliy ha a given shock will rigger unsable deb dynamics is higher. This risk is increased when public deb is already on a seep upward rajecory, as i is now in several counries. Knowing his, we would expec invesors o demand a higher risk premium for holding he bonds issued by a highly indebed counry. Sudies of he impac of deb on risk premia are raher limied for advanced economies. Wha evidence here is suggess ha he impac is relaively small. For each percenage poin of addiional public deb, researchers esimae a risk premium increase of beween 1.2 and 1.6 basis poins. 16 Wih he adven of he marke for credi defaul swaps (CDS), 17 we now have an addiional source of informaion abou invesor aiudes owards highly indebed advanced economies. Daa ploed in he op lef-hand panel of Graph 6 allow he unsurprising conclusion ha CDS spreads, and hence credi risk premia, are posiively correlaed wih deb/gdp raios. Bu we noe ha here is subsanial heerogeneiy, suggesing ha oher facors are imporan as well. For example, he higher he fracion of deb ha is shor-erm, he lower he risk premium (Graph 6, lower lef-hand panel). A higher raio of incremenal deb o privae saving (lower righ-hand panel) is associaed wih a higher risk premium. And risk premia are generally lower for counries wih a high average revenue share in GDP (op righ-hand panel). 18 In addiion o higher risk premia and increased cos, a second risk associaed wih high levels of public deb comes from poenially lower long-erm growh. A higher level of public deb implies ha a larger share of sociey s resources is permanenly being spen servicing he deb. This means ha a governmen inen on mainaining a given level of public services Using he difference beween governmen bond yields and yields on corporae bonds denominaed in he same currency as a proxy for credi risk premia, Alesina e al (1992) find an impac of 1.6 basis poins for each exra percenage poin of public deb. Since hese measures can be affeced by changes in privae secor credi risk, using he spread beween he governmen bond yield and he reurn on ineres rae swaps of corresponding mauriy and currency, Goodhar and Lemmen (1999) find a slighly smaller effec (1.5 bp). However, hese spreads are also affeced by liquidiy premia besides credi risk premia. In a sudy ha aemps o disenangle he wo effecs, Codogno e al (23) find ha deb levels can explain yield differenials vis-à-vis Germany only in Ialy and Spain. A CDS conrac is a credi derivaive ha, for a specified bond issuer, proecs he buyer agains a defaul or deb resrucuring. I is no clear exacly how his should be inerpreed. On he one hand, an already high level of average axaion may indicae ha a counry is close o is fiscal limi ha is, i has less room for increasing axes furher. So, oher hings equal, one could expec risk premia o be lower for hose counries wih lower average ax raes. On he oher hand, counries wih high axaion migh also be counries wih a low level of deb or wih srong social and poliical cohesion, which should reduce risk, all else equal. Furher economeric analysis would be required o uncover parial correlaions. 12

17 Graph 6 Sovereign CDS spreads 1 and fiscal indicaors 2 General governmen deb/gdp 3 General governmen revenue/gdp 3 4 GR GR IE PT IE PT ES ES IT IT AT GB JP 1 JP GB AT NZ AU CH BE SE CA BE FR CH CA NZ SE DK FI DE DE FR US AU NL DK NO NL US FI NO Share of shor-erm deb 4 Change in general governmen deb/savings 5 4 GR GR IE PT ES IT JP 1 AT BE SE GB FR AU CA DK NZ DE US NL FI IE PT ES IT AT JP GB 1 CH BE NZ SE CA AU US FR DK NO NL FI DE AU = Ausralia; AT = Ausria; BE = Belgium; CA = Canada; CH = Swizerland; DE = Germany; DK = Denmark, ES = Spain; FI = Finland; FR = France; GB = Unied Kingdom; GR = Greece; IE = Ireland; IT = Ialy; JP = Japan; NL = Neherlands; NO = Norway; NZ = New Zealand; PT = Porugal; SE = Sweden; US = Unied Saes. 1 Verical axis: spread as of end of January 21; in basis poins. 2 Horizonal axis. 3 Forecas for Domesic governmen deb wih a remaining mauriy of one o hree years as a percenage of oal domesic governmen deb. 5 Average change in general governmen deb as a percenage of average privae savings; forecas average for he period Sources: IMF, World Economic Oulook; OECD; JPMorgan Chase; Marki. and ransfers mus raise axes as deb increases. Taxes disor resource allocaion, and can lead o lower levels of growh. Given he level of axes in some counries, one has o wonder if furher increases will acually raise revenue. 19 The disorionary impac of axes is normally furher compounded by he crowding-ou of producive privae capial. In a closed economy, a higher level of public deb will evenually absorb a larger share of naional wealh, pushing up real ineres raes and causing an 19 Recen esimaes by Traband and Uhlig (29) show ha he EU 14 can increase ax revenue 8% by raising labour axes and 1% by raising capial income axes. By conras, hese figures sand a 3% and 6%, respecively, for he Unied Saes, indicaing a greaer fiscal capaciy o olerae higher public deb levels. 13

18 offseing fall in he sock of privae capial. 2 This no only lowers he level of oupu bu, since new capial is invariably more producive han old capial, a reduced rae of capial accumulaion can also lead o a persisen slowdown in he rae of economic growh. In an open economy, inernaional financial markes can moderae hese effecs so long as invesors remain confiden in a counry s abiliy o repay. Bu, even when privae capial is no crowded ou, larger borrowing from abroad means ha domesic income is reduced by ineres paid o foreigners, increasing he gap beween GDP and GNP. Las bu no leas, he exisence of a higher level of public deb is likely o reduce boh he size and he effeciveness of any fuure fiscal response o an adverse shock. Since policy canno play is sabilising role, a more indebed economy will be more volaile. This was eviden during he laes crisis. Counries saddled wih very high levels of public deb did no expand fiscal policy as much as oher counries. And, alhough hese counries benefied somewha from he effecs of foreign fiscal expansion, a larger domesic fiscal simulus could have helped o reduce he severiy of he recession acually experienced. 4. The challenge for cenral banks Seeply rising public deb levels and he uncerainy associaed wih fuure fiscal consolidaion plans pose a leas wo imporan challenges for moneary policymakers. Firs, deerioraing public finances can rigger a sudden increase in long-erm inflaion expecaions. Second, uncerainy abou he iming and exen of fiscal consolidaion plans complicaes he forecasing needed o se policy ineres raes a heir appropriae level. In he following, we focus on he inflaion risks. Is here currenly a risk ha inflaion expecaions may rise? And wha can moneary policymakers do o reduce his risk? To answer hese quesions, i is helpful o review he mechanisms by which persisenly high fiscal deficis could lead o inflaion. 21 A firs mechanism sresses he ulimae impossibiliy of coninuing o roll over ever increasing levels of public deb when moneary and fiscal auhoriies are pursuing inconsisen objecives. When he public reaches is limi and is no longer willing o hold public deb, he governmen would have o resor o moneisaion. The resul, consisen wih he quaniy heory of money, is inflaion. And anicipaion ha his will happen may also lead o an increase in inflaion oday as invesors reassess he risk from holding money and governmen bonds. In such an environmen, fighing rising inflaion by ighening moneary policy would no work, as an increase in ineres raes would lead o higher ineres paymens on public deb, leading o higher deb, bringing he likely ime of moneisaion even closer Esimaes of he impac of public deb levels on real ineres raes vary subsanially. For he Unied Saes, Chinn and Frankel (25) find an impac as low as 2 basis poins per percenage poin of he deb/gdp raio. For Europe, EC (24) provides a range esimae rising o 16 basis poins. A main disincion in he lieraure is wheher he quaniaive heory of money holds (in which case inflaion is always and everywhere a moneary phenomenon) or wheher fiscal variables have a direc influence on he price level in addiion o money (fiscal heory of he price level). This paradox of igh money is he sriking finding of Sargen and Wallace s analysis (1981). Noe ha in heir example deb is perfecly indexed in real erms. This rules ou he case ha inflaion arises from he moneary auhoriies aemp o reduce is real value. Inflaion, insead, arises because a a cerain poin bond invesors refuse o hold deb and he governmen is herefore forced o issue money, shor of an ourigh defaul. 14

19 Thus, in he absence of fiscal ighening, moneary policy may ulimaely become impoen o conrol inflaion, regardless of he fighing credenials of he cenral bank. 23 Conflics beween he goals of fiscal and moneary auhoriies can explain a number of inflaionary ouburss in emerging marke economies. Noable examples of his are: he Brazilian inflaionary boom in he early 198s when moneary policy, in he face of persisen fiscal deficis, sared o ac more aggressively agains inflaion (Loyo (1999)); he large jump in Israeli inflaion in Ocober 1983 (Sargen and Zeira (28)); and he Indian inflaion of he 197s and 198s in which fiscal deficis were moneised (Rangarajan and Mohany (1997)). A second mechanism by which public deb can lead o inflaion focuses on he poliical and economic pressures ha a moneary policymaker may face o inflae away he real value of deb. The payoff o doing his rises he bigger he deb, he longer is average mauriy, he larger he fracion denominaed in domesic currency, and he bigger he fracion held by foreigners. Moreover, he incenives o olerae emporarily high inflaion rise if he ax and ransfer sysem is mainly based on nominal cash flows and if policymakers see a social benefi o helping households and firms o reduce heir leverage in real erms. I is, however, worh emphasising ha he coss of creaing an unexpeced inflaion would almos surely be very high in he form of permanenly high fuure real ineres raes (and any oher disorions caused by persisenly higher inflaion). 24 While discussions of inflaion risks in he financial press abound, here is lile evidence ha fiscal prospecs are maerially affecing inflaion expecaions. While US and euro area marke-based inflaion expecaions became volaile immediaely before and afer he recen financial crisis, Graph 7 shows ha hey have revered o he average levels of he pas five years or so. Meanwhile, survey-based measures of inflaion expecaions in boh areas have been more sable han marke-based ones. Alhough he chance of a governmen being forced or emped o olerae higher inflaion is raher remoe in he shor run, he chance ha i could do so in he fuure is no insignifican. 25 Therefore, he risk ha long-erm inflaion expecaions could suddenly become unanchored oday is a possibiliy ha should no be discouned. The mos likely manifesaion of his risk is an unexpeced and abrup rise in governmen bond yields a medium and long mauriies as negaive news abou he sae of he economy and public finances leads invesors o reassess he risks of fiscal unsusainabiliy and fuure inflaion The mechanism emphasised here requires ha, when he fiscal auhoriy does no resore fiscal susainabiliy hrough changes in is fiscal insrumens, he ineremporal budge consrain of he governmen will evenually be me hrough he issuance of money. By conras, he fiscal heory of he price level sresses ha he ineremporal budge consrain may also be me by a change in he marke value of deb. In is more sylised form, he heory predics ha he general price level will adjus o bring abou he required reducion in he value of bonds (eg Sims (1994), Woodford (1995) and Cochrane (1998)). In realiy, how his change in he price level should occur in he presence of a wide array of asses, nominal rigidiies and raional expecaions is unclear. The heory is sill unesed and conroversial (for a criicism, see eg Buier (22)). Persson e al (1996) esimae ha, given he sae of public finances and he economy in Sweden in he early 199s, he benefi of an increase of 1 percenage poins in he inflaion rae could have been subsanial (an annual real flow of 3 4% of GDP). Mos of his benefi would have arisen no from seigniorage or he devaluaion of ousanding deb bu from he nominal characer of he ax and ransfer sysem in Sweden. Mos imporanly, he auhors also found ha he coss of he increase in inflaion, including hose arising from permanen real ineres raes, would have been even higher. Hisory shows ha counries ha ran high public debs evenually ended up wih high inflaion because governmens were unwilling o pay high ineres raes. Makinen and Woodward (199) provide an accoun of he experience of he European counries during he inerwar period. Following funding crises, governmens in many counries (Belgium, Spain and Ialy) pegged ineres raes and resored o deb moneisaion. Germany s hyperinflaion is also an imporan reminder of his risk. 15

20 Graph 7 Inflaion expecaions In per cen Break-even inflaion raes (five-year-ahead five-year) Mid-erm inflaion expecaions (1-year-ahead) 1 Unied Saes Euro area Unied Saes: Euro area: Japan: Consensus SPF Consensus SPF Consensus For Survey of Professional Forecasers (SPF); euro area, five-year-ahead. Sources: ECB, Survey of Professional Forecasers; Federal Reserve Bank of Philadelphia, Survey of Professional Forecasers; Consensus Economics; naional daa; auhors calculaions. 5. Conclusion Our examinaion of he fuure of public deb leads us o several imporan conclusions. Firs, fiscal problems confroning indusrial economies are bigger han suggesed by official deb figures ha show he implicaions of he financial crisis and recession for fiscal balances. As frighening as i is o consider public deb increasing o more han 1% of GDP, an even greaer danger arises from a rapidly ageing populaion. The relaed unfunded liabiliies are large and growing, and should be a cenral par of oday s long-erm fiscal planning. I is essenial ha governmens no be lulled ino complacency by he ease wih which hey have financed heir deficis hus far. In he afermah of he financial crisis, he pah of fuure oupu is likely o be permanenly below where we hough i would be jus several years ago. As a resul, governmen revenues will be lower and expendiures higher, making consolidaion even more difficul. Bu, unless acion is aken o place fiscal policy on a susainable fooing, hese coss could easily rise sharply and suddenly. Second, large public debs have significan financial and real consequences. The recen sharp rise in risk premia on long-erm bonds issued by several indusrial counries suggess ha markes no longer consider sovereign deb low-risk. The limied evidence we have suggess defaul risk premia move up wih deb levels and down wih he revenue share of GDP as well as he availabiliy of privae saving. Counries wih a relaively weak fiscal sysem and a high degree of dependence on foreign invesors o finance heir deficis generally face larger spreads on heir debs. This marke differeniaion is a posiive feaure of he financial sysem, bu i could force governmens wih weak fiscal sysems o reurn o fiscal reciude sooner han hey migh like or hope. Third, we noe he risk ha persisenly high levels of public deb will drive down capial accumulaion, produciviy growh and long-erm poenial growh. Alhough we do no provide direc evidence of his, a recen sudy suggess ha here may be non-linear effecs of public deb on growh, wih adverse oupu effecs ending o rise as he deb/gdp raio approaches he 1% limi (Reinhar and Rogoff (29b)). 16

21 Finally, looming long-erm fiscal imbalances pose significan risk o he prospecs for fuure moneary sabiliy. We describe wo channels hrough which unsable deb dynamics could lead o higher inflaion: direc deb moneisaion, and he empaion o reduce he real value of governmen deb hrough higher inflaion. Given he curren insiuional seing of moneary policy, boh risks are clearly limied, a leas for now. How o ackle hese fiscal dangers wihou seriously jeopardising he incipien recovery is he key challenge facing policymakers oday. Alhough we do no offer advice on how o go abou his, we believe ha any fiscal consolidaion plan should include credible measures o reduce fuure unfunded liabiliies. Announcemens of changes in hese programmes would allow auhoriies o wai unil he recovery from he crisis is assured before reducing discreionary spending and improving he shor-erm fiscal posiion. An imporan aspec of measures o ackle fuure liabiliies is ha any poenial adverse impac on oday s saving behaviour be minimised. From his poin of view, a decision o raise he reiremen age appears a beer measure han a fuure cu in benefis or an increase in axes. Indeed, i may even lead o an increase in consumpion (see eg Barrell e al (29) for an analysis applied o he Unied Kingdom). 17