Our Deep Debt Future

TILBURG, NETHERLANDS – The 1980’s was the decade in which high inflation was supposedly consigned to the dustbin of history, while the 1990’s were all about the so-called new economy. Governor Mervyn King of the Bank of England once called it the NICE decade (No Inflation, Continuing Expansion) – a time when the economy reached the promised land of high growth and price stability. The following decade turned out to be one of, first, the war on terror and, later, the worst financial and economic crisis in almost a century – a time when virtually every developed economy experienced a long and deep recession. The war against terror is still raging. But, owing to the financial and economic crisis, the current decade will be remembered as the decade of public debt, and in some countries or regions, maybe even the decade of permanent fiscal derailment if nothing is done. In the European Union, for example, public debt in the most important eurozone and EU countries would rise to 100% of GDP or more in the next ten years alone. Of course, something will be done, but it will most likely not be enough. Doing enough would require reducing annual budget deficits by 0.5% of GDP every year during the coming decade just to improve the sustainability of government debt on average. That effect, however, has to come on top of withdrawing the current fiscal stimulus that all countries have implemented. Fiscal consolidation equivalent to 1% of GDP per year might lower government debt down toward 60% of GDP – the ceiling imposed by the EU’s Stability and Growth Pact – during the next decade. But, for some countries, such as Greece, Ireland, and Spain, this would not be enough to reach sustainable debt levels in 2020. Moreover, low long-term interest rates are a thing of the past. As government deficits and public debt increase in many developed and emerging economies, financial markets will most likely demand higher risk premia, owing to heightened fears of default and inflation down the road. So, not only is public debt set to increase much faster than nominal GDP growth, but governments will have to devote an increasing share of their revenues to interest payments. Of course, governments can slash their expenditure and increase taxes to balance their budgets, or at least to embark on a path leading in that direction, as the hotly debated example of Greece has shown. But chances are that it will not really help, because it trying to reduce deficits in that manner will severely undermine economic performance. Greece must slash its deficit by some 4% of GDP. And that is just a start. In the coming years, total consolidation is set to increase to around 9% of GDP. The same goes for the United States, the United Kingdom, and the eurozone’s five largest economies (Germany, France, Italy, Spain, and the Netherlands). Even if all those deficit reductions are implemented, all the forecasts of economic growth in subsequent years, on which fiscal consolidation depends, are not realistic. Already, the European Commission has stated that various European governments’ forecasts for GDP growth, put forward in their plans for budget austerity in the coming years, are overly optimistic. In other words, economic growth will turn out to be structurally much lower than is the figures used now for estimating deficits and debt. Little wonder, then, that the Commission has issued a warning that crisis-related fiscal expansion and the aging population raise questions about the sustainability of public finances in the EU. Many government behave as if the economic setback is temporary and happy pre-crisis days will return fairly soon. Among economists there is a strong feeling that the world economy is bouncing back from deep recession, and that the current crisis, although severe, is an aberration. But even if the world economy is on course to a firm recovery, the long-term trend has been severely and permanently disrupted. After this crisis, nothing in economics will be the same. Indeed, it would be naïve to believe that the crisis is the only reason that public finances are in bad shape. Change in the global economy, from a decade of high structural growth to a long period of low growth, is playing a major role as well. During the last 20 years, economic growth has been based on rising asset prices and declining borrowing costs for consumers and companies. That mechanism is broken beyond repair. In the absence of some miraculous improvement in productivity growth of the same order as the Internet or globalization, the world can expect a lengthy period of low growth and exceedingly difficult fiscal consolidation. The NICE era is well and truly over. Welcome to the BAD (Big Annual Deficits) decade of public debt. Sylvester Eijffinger is Professor of Financial Economics at Tilburg University in the Netherlands. Edin Mujagic is a monetary economist at ECR Research and Tilburg University. Project Syndicate, 2010. www.project-syndicate.org