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The Future of Public Debt: Prospects and Implications

Stephen Cecchetti*

Economic Adviser and Head Monetary and Economic Department Bank for International Settlements

First International Research Conference, Reserve Bank of India12-13 February 2010

*Views expressed here are those of the author and do not necessarily reflect those of the BIS.

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The problem

Public debt is rising sharply in advanced countries Debt-to-GDP ratios of 100% is becoming common Should we care?

• Post-WWII debts above 100% of GDP were common (examples: US 120%, UK 300%)

• Japan has been living with high debt for years• The last industrial countries to default were WWII losers

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Things are not as they seem

Consolidation is difficult when • Interest rates are poised to increase• Growth rates are unlikely to rise• Even when consolidation occurs, it stabilises debt to GDP

The long run is much worse• Populations are aging.• Unless policy changes debt will rise to 3+ times

its current levels Problem needs to be addressed now.

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Outline

Current facts The trajectory Challenges for policymakers

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Table 1

Fiscal situation and prospects1

Fiscal balance Structural balance5 General government debt6

As a percentage of GDP

2007 2010 2011 2007 2010 2011 2007 2010 2011

Austria –0.7 –5.5 –5.8 –1.4 –3.3 –3.6 62 78 82 Germany 0.2 –5.3 –4.6 –0.8 –4.0 –3.7 65 82 85 Greece –4.0 –9.8 –10.0 –4.5 –6.9 –6.8 104 123 130 France –2.7 –8.6 –8.0 –3.5 –6.8 –6.3 70 92 99 Ireland 0.2 –12.2 –11.6 –1.3 –9.0 –9.0 28 81 93 Italy –1.5 –5.4 –5.1 –2.2 –2.6 –2.8 112 127 130 Japan –2.5 –8.2 –9.4 –3.4 –7.4 –9.0 167 197 204 Netherlands 0.2 –5.9 –5.3 –0.6 –3.6 –3.1 52 77 82 Portugal –2.7 –7.6 –7.8 –2.8 –6.1 –6.8 71 91 97 Spain 1.9 –8.5 –7.7 1.6 –5.2 –4.5 42 68 74 United Kingdom –2.7 –13.3 –12.5 –3.4 –10.5 –9.9 47 83 94 United States –2.8 –10.7 –9.4 –3.1 –9.2 –8.2 62 92 100

China 0.9 –2.0 –2.9 20 22 23 India –4.4 –10.0 –8.7 81 86 86 Other Asia2 2.1 –1.2 –1.0 31 37 38 Central Europe3 3.7 –4.4 –3.9 23 28 29 Latin America4 –1.5 –2.4 –2.0 41 37 35 1 Regional averages calculated as weighted averages based on 2005 GDP and PPP exchange rates. 2 Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand. 3 The Czech Republic, Hungary and Poland. 4 Argentina, Brazil, Chile and Mexico. 5 Cyclically adjusted balance. 6 For Argentina, the Philippines and Thailand, central government debt.

Sources: IMF, World Economic Outlook; OECD, Economic Outlook.

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Graph 1

Government gross public debt and primary fiscal balance in industrial economies1, 2

As a percentage of GDP

Shaded areas represent forecast. 1 Weighted average based on 2005 GDP and PPP exchange rates of economies cited and data availability. 2 Australia, Austria, Belgium, Canada, Denmark, France, Finland, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom and the United States.

Sources: OECD; BIS calculations.

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Graph 2

Projected population structure and age-related spending

Old-age population (ratio to working-age population)1 Estimated increase in age-related government expenditure from 2011 to 20502

1 Working-age population is between 15-64. 2 As a percentage point of GDP.

Sources: IMF April 2007 WEO; United Nations Secretariat European Commission; Congressional Budget Office.

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Long-term fiscal imbalances

Age-related spending is exploding Focus on short-term is incomplete and misleading Concerns about fiscal sustainability & intergeneration equity:

present value of unfunded commitments should be reflected

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Graph 2

Projected population structure and age-related spending

Old-age population (ratio to working-age population)1 Estimated increase in age-related government expenditure from 2011 to 20502

1 Working-age population is between 15-64. 2 As a percentage point of GDP.

Sources: IMF April 2007 WEO; United Nations Secretariat European Commission; Congressional Budget Office.

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Debt-to-GDP Projections

30 years and 12 countries Baseline:

• Revenue and non-age related expenditure constant at 2011percentage of GDP

• Real interest rate at 1998-2007 average• Potential growth at OECD post-crisis level

Gradual adjustment:Primary deficit improves 1pp of GDP per yr for 5 yrs

Gradual adjustment + freezing age-related spending to GDP at 2011 level

Results Graph 4

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Graph 5

Projected interest payments as a fraction of GDP1

In per cent

Source: Author’s projections.

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Table 3 Required average primary balance

to stabilize public debt to GDP ratio at 2007 level1

over 5 years over 10 years over 20 years

Austria 4.7 2.6 1.6 France 7.3 4.3 2.8 Germany 5.5 3.5 2.4 Greece 5.4 2.8 1.5 Ireland 11.8 5.4 2.2 Italy 5.1 3.4 2.5 Japan 10.1 6.4 4.5 Netherlands 6.7 3.7 2.3 Portugal 2.2 -0.3 -1.6 Spain 6.1 2.9 1.3 United Kingdom 10.6 5.8 3.5 United States 8.1 4.3 2.4

1 As a percentage of GDP.

Sources: IMF, World Economic Outlook; OECD, Economic Outlook; author’s calculations.

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Risks and risk premia

Higher debt increases the possibility unstable dynamics So, higher debt means a bigger risk premium We plot CDS spreads against

• Debt to GDP• Government revenue to GDP• Share of short-term debt• Incremental debt to private saving

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Graph 6

Sovereign CDS spreads1 and fiscal indicators2

General government debt/GDP3 General government revenue/GDP3

Share of short-term debt 4 Change in general government debt/savings 5

1 Vertical axis: average spread over the last 20 working days; in basis points. 2 Horizontal axis. 3 Forecast for 2011. 4 Domestic government debt with a remaining maturity of 1-3 years as per cent of total domestic government debt. 5 Average change in general government debt in per cent of average private savings; forecast average for the period 2009-11.

Sources: IMF; OECD; JPMorgan Chase; Markit.

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Debt and fiscal policy

Higher taxes create greater distortions Higher debt can mean higher real interest rates Reduced effectiveness in responding to shocks All of this can lower the long-run growth path

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Debt and monetary policy

Inflation expectations Forecast uncertainty

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Conclusions

Current estimates of public debt ignore the big problem:age-related expenditure

High debts have significant real and financial consequence

Action is needed now.