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There is a longstanding jibe that IMF stands not for International Monetary Fund, but rather for “it’s mostly fiscal”. That epithet has seemed less generally apposite for a while. Of course, the fund has continued to complain about fiscal incontinence in crisis-hit countries, such as Greece or Argentina. But, in its broader surveillance, it has been relatively relaxed about fiscal policy since the financial crisis. That, however, was the world of “low for long” or even “lower for longer”. This is no longer the world in which we live. The fund has duly changed. Gita Gopinath, first deputy managing director, has sounded the alarm, calling “for a renewed focus on fiscal policy, and with it, a reset in fiscal policy thinking”. The IMF has become “mostly fiscal” again.
It is unquestionable that public debt has reached high levels by past standards. An update of an IMF chart published in 2020 shows the ratio of public debt to gross domestic product of high-income countries at 112 per cent in 2023, down from a recent peak of 124 per cent in 2020. The latter matched the previous peak reached in 1946. What makes this even more remarkable is that the earlier peak occurred after the second world war, while this latest peak occurred in peacetime. Furthermore, the ratio for emerging economies has reached 69 per cent of GDP, a record for these countries. (See charts.)
So, is public debt disaster looming? If so, will there be defaults, inflation, financial repression (forcible attempts to keep debt cheap), or some combination of all three? If none of these is to happen, what must be done?
Olivier Blanchard, former chief economist of the IMF and now at the Peterson Institute for International Economics in Washington DC, has reminded us of the mechanics and risks of debt in a recent blog. On the former, the determinants are, first, the relationship between the rate of interest on debt and the rate of growth of the economy and, second, the ratio of the primary fiscal deficit (the deficit before interest payments) to GDP. On the latter, the most important point is that debt must not grow explosively. While a particular debt ratio cannot be defined as unsustainable, on empirical or theoretical grounds, the higher the initial ratio and the faster it is likely to grow, the less sustainable the debt is likely to be. Blanchard argues that “advanced economies can sustain a higher debt ratio, so long as it is not exploding”. But there is a likelihood (though no certainty) that interest rates will rise with debt levels. If so, debt dynamics will tend to become explosive.
If debt ratios are to remain stable, the rate of economic growth must equal the average rate of interest, when the primary balance is zero. The greater the excess of the interest rate over the growth rate, the larger the primary fiscal surplus must be, and vice versa.
Where are the fiscal debts and deficits of big high-income economies today?
Their net debt ratios are far higher than two decades ago. The IMF forecasts ratios of debt to GDP at close to 100 per cent in the UK, France and US, 133 per cent in Italy and 156 per cent in Japan in 2024. In contrast, in 2001, ratios were below 50 per cent in the UK, France and US, 75 per cent in Japan and 100 per cent in Italy. These jumps happened despite low interest rates. Not surprisingly, then, primary deficits have been large: between 2008 and 2023, they averaged 5.3 per cent of GDP in the US, 5.2 per cent in Japan, 4.1 per cent in the UK and 2.9 per cent in France. Italy ran an average primary deficit of only 0.2 per cent of GDP. But that was not enough to contain the rise in debt altogether, because interest rates were so high in the eurozone crisis. This was punishment for earlier profligacy. But Germany managed to run a small primary surplus averaging 0.3 per cent of GDP.
What, then, are the future prospects for interest rates and prospective economic growth? The former have jumped substantially. Yields on 10-year government nominal bonds are up by between 3 percentage points in Canada and 3.9 points in the UK over the past three years. Japan is, as is well known, the exception. But, strikingly, the rise in real yields in the US and UK, which have offered index-linked bonds for a long time, have almost matched the rise in nominal yields: 3 percentage points on US Treasury inflation-protected securities, against 3.6 percentage points on conventional bonds and 3.4 percentage points on UK index-liked gilts against 3.9 percentage points on conventional gilts. Higher long-term inflation expectations cannot be a large part of the reason for the jump in nominal yields. This leaves an upward shift in equilibrium real rates or tighter monetary policy as the explanations. If the former, real rates might remain rather high. If the latter, they should fall once again when monetary policy normalises (whatever that might mean). In sum, real interest rates might be permanently higher than they used to be, though this is not yet certain.
What, finally, are the prospective rates of economic growth? IMF forecasts for 2024-28 give real growth averaging 1.9 per cent in the US, 1.8 per cent in Canada. 1.6 per cent in the UK and France, 1.4 per cent in Germany, 0.9 per cent in Italy and 0.6 per cent in Japan. These are decidedly low relative to today’s real interest rates.
If governments are going to avoid the risks of a debt explosion and are also not going to resort to surprise inflation or financial repression, they will have to tighten what are mostly still ultra-loose fiscal policies. But will they dare to do so in ageing societies, with slowly growing economies and expanding defence burdens?
Faster growth would help. But, as the Truss government in the UK proved, this will not be achieved by magical means. Painful fiscal choices seem to lie ahead.