IMF Reports On The Fiscal Implications Of The Crisis

by Mike Godfrey, Tax-News.com, Washington

18 June 2009

The IMF Fiscal Affairs Department has published a study entitled 'Fiscal Implications of the Global Economic and Financial Crisis', which outlines the scale of government debt growth shown in perspective with historic precedents and points to a strategy to maintain fiscal solvency, including the 'elephant in the room', being the consequences of an ageing population.

The IMF is working with figures that project a growth of government debt in the 10 richest G20 countries from 78% of GDP in 2007 to 114% of GDP in 2014. In a worst case scenario it could be as high as 150% by 2014. In actual terms, with the rise in debt reaching a plateau in 2009, it forecasts an increase in government debt from 2007-2010 by USD9 trillion. Such an actual increase in government debt is unprecedented. However in a Harvard University paper referred to in the study, 14 severe but localized economic and banking crises of the 20th century were studied and the aftermath of the crises led to government debt increasing on average by 86% of GDP in order to bring the economy back on course. Historically, according to the study, large debts have accumulated, reaching 100-200% of GDP, as a result of war, prolonged recession or protracted fiscal problems. Furthermore it has been periods of steady growth that have allowed debt levels to reduce the fastest. By the end of the second World War the UK government debt to GDP ratio was approaching 300% and in the US it was almost 140%, but with the 50s and 60s growth, the US ratio was reduced to a manageable 70% by 1963, and the UK reduction to the same level was achieved by the early 1970s. A more recent example of this, referred to in the study, is Ireland, which succeeded in reducing its debt/GDP ratio from 109% in 1987 to 25% in 2007 as it benefited from Europe's single market.

The IMF study's worst case scenario was considerably influenced by the loss of confidence in fiscal solvency. Although no advanced economy has 'defaulted' on debt since the 1940s, prior to that, even the US failed to maintain the gold convertibility of its debt according to its terms in the 1930s, such 'defaults' being euphemistically described as 'highly disruptive ways of reducing debt/GDP ratios' in the IMF study. The UK unilaterally restructured its First War debt between the wars and German and Japanese government debts became worthless through hyperinflation, the former in the 1920s and the latter after World War Two. The IMF study refers to some early indicators of market fears of such 'Disruptions': although actual interest rates have fallen since 2007, interest rates in real terms on long term bonds have not declined, a result that might be expected from the downturn. Also the market is sensitive to highly indebted countries such as Greece and Italy where long term bond yields can be up to 2% higher than similar German bonds although they are all euro-zone countries. Thirdly, according to the study, credit default swap spreads are widening, although the 'implied perceived default risk remains relatively small'. According to the study, it would not be surprising for markets to reflect suspicions that governments prefer to use inflation as a tool to reduce debt in real terms, especially if the increasing application of quantitative easing is not restrained.

The IMF study states that the crisis rise in government debt levels does not of itself imply a major solvency problem, but fiscal solvency requires that government debt is not on an 'explosive path'. 'A rise in debt ratios is not likely to cause rises in interest rates .... a 10% debt/GDP ratio increase would raise interest rates only by a few basis points (at least where debt ratios are less than 100%)'. The study outlines a strategy to ensure fiscal solvency, which should be based on four pillars:

• Fiscal stimulus should consist, as much as possible, of temporary measures.
• Policies should be medium term fiscal frameworks with gradual corrections once economic conditions improve.
• Governments should pursue growth enhancing structural reforms.
• There should be a firm commitment and a clear strategy to contain the trend increase in aging-related spending in countries exposed to unsustainable demographic shocks.

This latter item is the 'elephant in the room'. However damaging we perceive this crisis is to government finances, it is paltry compared with the future problems for the richest G20 countries arising from the 'demographic shock' - the future costs of pensions and healthcare for the aging populations. The study has calculated these costs for each country as a net present value and compared it with the net present value of the deficits forecast from this economic crisis. On average the 'demographic shock' weighed nine times more heavily on government finances, according to the IMF calculations.

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