Is Australia's debt sustainable? How to reduce it, anyway?

Is Australia's debt sustainable? How to reduce it, anyway? Efrem Castelnuovo Melbourne Institute Melbourne Institute Public Economic Forums Canberra, April 29, 2015

Australia: Solid economy... Solid growth rate for more than two decades, resilient to GFC

Real effects of GFC around the World 6 4 2 0-2 -4 GERMANY AUSTRALIA UK US WORLD -6 2007 2008 2009 2010 2011 2012 2013 2014 Yearly GDP growth rate.

Australia: Solid economy... facing tricky challenges Solid growth rate for more than two decades, resilient to GFC Challenges: o Trending house prices o Swings in commodity prices o End of the mining boom o Ageing population o Inequality o Debt sustainability

Debt smaller than in other countries in terms of levels...

... but spectacularly larger in terms of growth rates! 40 35 30 25 20 GERMANY AUSTRALIA UK US OECD 15 10 5 0-5 -10 2008 2009 2010 2011 2012 2013 2014 General Gov't Gross Financial Liabilities over GDP, yearly growth rates.

Debt sustainability: Proposals by economists "Ratings agencies say the Abbott government will need to deliver further spending cuts or tax hikes to ensure Australia maintains its AAA credit rating over the longer term" (Financial Review, February 5, 2015) "Most of the economists surveyed said it would be better to fix the expenditure side of the budget before raising taxes." (The Age, July 12, 2014) "Why cutting spending? Why not raising taxes?" (Max Corden, "The Conversation", December 5, 2014)

Questions My view from the ivory-tower on these questions: Is Australian debt sustainable? o "back-on-the-envelope" computations o academic literature on MDS o macro-financial data What to do to reduce debt, anyway? o academic literature on recessionary effects of G and T o considerations on communication and credibility

Is Australian debt sustainable?

Sustainability: Factors As long as Australia is able to borrow, yes! In other words, as long as Australia is perceived as able to repay When is country perceived as problematic? When debt/gdp ratio "too high" (more on this "too high" later) Factors behind evolution debt/gdp ratio? o real GDP growth o inflation o interest rate(s) o deficit/gdp ratio Law-of-motion of debt/gdp, back-on-the-envelope computations

Back-of-the-envelope computations: Debt/GDP law-of-motion Law-of-motion of the real debt/gdp ratio: b t (1+i t -π t -z t )b t-1 + d t Calibration (Intergenerational Report 2015): o debt/gdp ratio in 2015 d 2015 = 22% o reference inflation rate π t = 2.5% o reference real GDP gr. rate z t = 2.8% o reference interest rate i t = 6% o deficit d t =?

Back-of-the-envelope computations: Scenarios Projections up to 2050 Simulated scenarios: o 2.5% deficit/gdp from 2016 onwards o 2% deficit/gdp from 2016 onwards o 1% deficit/gdp from 2016 onwards o 0% deficit/gdp from 2016 onwards Debt explosion?

2.5% deficit "forever" 180 160 140 2.5% 120 100 80 60 95% Debt/GDP ratio 60% Debt/GDP ratio 40 20 0 2015 2020 2025 2030 2035 2040 2045 2050 Assumption: Deficits in place "forever".

2% deficit "forever" 180 160 140 2.5% 2% 120 100 80 60 95% Debt/GDP ratio 60% Debt/GDP ratio 40 20 0 2015 2020 2025 2030 2035 2040 2045 2050 Assumption: Deficits in place "forever".

1% deficit "forever" 180 160 140 2.5% 2% 1% 120 100 80 60 95% Debt/GDP ratio 60% Debt/GDP ratio 40 20 0 2015 2020 2025 2030 2035 2040 2045 2050 Assumption: Deficits in place "forever".

0% deficit "forever" 180 160 140 120 100 80 60 2.5% 2% 1% 0% 95% Debt/GDP ratio 60% Debt/GDP ratio 40 20 0 2015 2020 2025 2030 2035 2040 2045 2050 Assumption: Deficits in place "forever".

Gains from quick stabilization "0% forever": Quick stabilization of the debt/gdp ratio, costly to implement (zero-deficit plan from 2016 onward) Is "Austeralia" (Austerity in Australia) needed? Alternative scenario: Gradual fiscal adjustment o 0.5% deficit reduction per year in 2016-2020 o 1% surplus in 2021-23 o 0% in 2024-2050 Gains from "quick stabilization"?

Gradual fiscal adjustment 160 140 120 100 0% forever Gradual consolidation plan 95% Debt/GDP ratio 80 60 60% Debt/GDP ratio 40 20 0 2015 2020 2025 2030 2035 2040 2045 2050 Assumpt.: 0.5% reduction per year until 2020, 1% surplus in 2021-23, then 0% "forever".

Debt sustainability... Need to reduce deficit No "Austeralia" needed, stabilization feasible with gradual deficit reduction Sustainability in line with recent academic literature, financial markets' expectations

Debt sustainability: Maximum Sust. Debt, long term rates Recent academic literature I: Collard, Habib, and Rochet (2014) o Maximum Sustainable Debt (MSD) in a model considering lenders' expectations over max. primary surplus, growth uncertainty, country's attitude to repayment, new debt to service existing one, default probability, growth disasters... o Australia's MSD: 120%! Conditional on catastrophes, 95% Recent academic literature II: Gosh et al. (2013) o Fiscal space, i.e., difference between current debt ratios and estimated debt limits, in a model where fiscal fatigue o Australia's debt limit: 193.2%! Data on long-term interest rates, spreads: No signs of worsening in the past few years...

Australia-U.S. spread 10-year Australia-U.S. Government Bond spread.

Long-Term Government Bond Yields 10-year Australian Government Bond Yield.

How to reduce debt, anyway?

Fiscal consolidation: Why and how? Debt sustainability does not imply debt desirability! Constant monitoring on public spending via spending review Careful decisions concerning taxation schemes, inequality/distributional issues should be carefully considered and fiscal plans designed accordingly Considerations on different fiscal multipliers must be factored in

Improvement in fiscal stance, impact on output? Fiscal consolidations: Lower spending vs. higher taxation - impact on output? Difficult to assess fiscal plans because of their nature (effects of a combination of unanticipated current adjustments, anticipated current adjustments, future anticipated adjustments on agents' decisions) IMF: Recently developed database at the OECD level to assess the overall relevance of these components (DeVries et al., 2011) Fiscal consolidations via reduction in G less costly than via increases in T! (Guajardo, Leight, and Pescatori, 2014; Alesina, Favero, Giavazzi, 2015 on fiscal plans) Spending cuts more recessionary during downturns (Caggiano, Castelnuovo, Colombo, Nodari, 2015)

Fiscal plans in OECD countries: G vs. T 17 OECD countries, sample: 1978-2009 Source: Guajardo, Leigh, and Pescatori (2014).

Fiscal plans in Australia: G vs. T T-based adjustments in red, G-based adjustments in blue. Sample: 1978-2009. Source: Alesina, Giavazzi, and Favero (2015).

Role of communication and credibility Clear and detailed communication of the fiscal plan to the public to reduce fiscal policy-related uncertainty o Increase in policy uncertainty from 2006 to 2011 foreshadows U.S. GDP declines of up to 2.3% (Bloom, Baker, Davis, 2013) o 1.8% U.S. unemployment rate due to spikes in uncertainty in 2008-09 (Caggiano, Castelnuovo, Groshenny, 2014) Clear communication + ex-post actions in line with ex-ante statement = credibility => lower risk-premium => 5% interest rate on debt... consequences for a gradual fiscal adjustment?

Gradual consolidation plan: Role of credibility 50 45 40 0% forever Gradual consolidation plan with 6% debt int. rate Gradual consolidation plan with 5% debt int. rate 35 30 25 20 15 2015 2020 2025 2030 2035 2040 2045 2050

Wrap up "It's hard to make predictions, especially about the future." (Yogi Berra, Niels Bohr) Australia's debt/gdp ratio quite low by international standards, likely to be sustainable with needed, gradual adjustments Spending cuts possibly less recessionary than tax increases Fiscal plans should be clearly communicated to maximize credibility - pay-off could be large!

Thank you very much!

Academic literature Alesina, A., C. Favero, and F. Giavazzi, 2015, The output effect of fiscal consolidation, Journal of International Economics, forthcoming. Baker, S.R., N. Bloom, and S.J. Davis, 2013, Measuring Economic Policy Uncertainty, Chicago Booth Research Paper No. 13-02. Caggiano, G, E. Castelnuovo, V. Colombo, and G. Nodari, 2015, Estimating Fiscal Multipliers: News from a Nonlinear World, Economic Journal, forthcoming. Caggiano, G., E. Castelnuovo, and N. Groshenny, 2014, Uncertainty Shocks and Unemployment Dynamics in U.S. Recessions, Journal of Monetary Economics, 67, 78-92. Collard, F., M.A. Habib, and J.C. Rochet, 2014, Sovereign Debt Sustainability in Advanced Economies, Universities of Bern, Zurich, and Toulouse School of Economics, mimeo. DeVries, P., J. Guajardo, D. Leigh, and A. Pescatori, 2011, A new action-based dataset of fiscal consolidation, IMF Working Paper No. 11/128. Guajardo, J., D. Leigh, and A. Pescatori, 2014, Expansionary Austerity? International Evidence, Journal of the European Economic Association, 12(4), 949-968. Ghosh A.R., J.I. Kim, E.G. Mendoza, J.D. Ostry, and M.S. Qureshi, 2013, Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies, Economic Journal, 123(February), F4-F30.

Data sources OECD Statistics. https://data.oecd.org/. All data but where otherwise specified. Federal Reserve Bank of St. Louis. Data on 10-year Government bond yields. Rehinart and Rogoff's "This Time is Different" webpage. http://www.reinhartandrogoff.com/data/. Long-time series on debt/gdp ratio in Australia.

Debt/GDP in Australia, historical perspective Australia's Total Gross Central Government Debt/GDP ratio.