"Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy" (Mervyn King, 1995). If Mervyn King’s somewhat provocative observation contained some wisdom in the 1990s, this wisdom has been brought to the fore with almost brutal force over the past two years.
As we have been painfully reminded by recent events, unsustainable public finances, bringing with them the spectre of a sovereign default, jeopardise the functioning of the economy. With the threat of a government default, large parts of banks’ asset portfolios lose value, putting the stability of the entire financial system at risk.
And in today’s global economy, both direct financial exposures and more indirect confidence effects mean that such shocks are easily and immediately transmitted on a global scale.
With the threat of a government default, large parts of banks' asset portfolios lose value
But even well short of such dramatic events, unsound public finances are liable to inflict damage on the economy. As the need for the government to finance its rising debt absorbs available funds and enterprises fear future economic disruptions, private investment tends to suffer. In addition, governments will be constrained to support the macroeconomy or the financial sector should this become necessary so that the risks of deeper crises increase.
And if the public expects the real debt load to be reduced by inflation, then inflation expectations are liable to become unanchored. This then requires the central bank to keep policy interest rates higher than would otherwise be necessary, again to the detriment of financing conditions in the economy.
While crucial for economic stability, the sustainability of public finances is not easy to assess in practice. Unlike corporations, states are assumed to live on indefinitely. Dissolving the state and disposing of its assets to cover outstanding liabilities is generally not an option to deal with sovereign obligations. As a consequence, the economic concept of public finance sustainability is derived from assessing a government’s income stream and obligations into the indefinite future. If the government’s infinite discounted income stream covers its obligations, the government fulfills the so-called ‘present value budget constraint’ and is solvent in the economic sense.
In practical terms, this concept may be of limited value. For investors it is crucial to know if a government will be able to roll over its outstanding debt in the foreseeable future. But this depends on other investors’ willingness to continue to provide financing.
There is, therefore, a risk of self-fulfilling prophecies: once some investors start to doubt that other investors will provide funding for a government and consequently reduce their own supply of funds, this can very quickly trigger precisely the event – a government default – that these same investors had feared.
What does this imply for fiscal policy today? It needs to be recognised that the risks arising from today’s already very high levels of explicit government debt are aggravated by the existence of considerable, additional implicit and contingent liabilities. First, there are the contingent fiscal liabilities stemming from the possible need to devote further funds either to international rescue packages or to prop up the domestic financial sector. Second, there are the implicit liabilities related to population ageing and – also related to this – uncertainty regarding the outlook for economic growth over the longer term. For these reasons it has been suggested – and indeed seems logical – that so-called ‘debt tolerance’ (ie, the level of debt that market participants view as safe for an individual country) has fallen for some industrial economies to levels previously considered more relevant for emerging markets.
What can governments do about this in the short run? The obvious answer is to build confidence by developing and communicating credible fiscal consolidation plans, based on prudent economic forecasts and well-defined structural measures. In this regard, governments must not hide from the fact that the scale of today’s problems in many cases will require sizeable adjustments to be maintained over several years.
The ongoing strengthening of the EU’s rules based fiscal framework will help in this endeavour.
Philipp Rother is head of fiscal policies division, Directorate General Economics, European Central Bank
This article was originally published in Sustainable Public Finances: Global Views. Previous articles include Carlo Cottarelli, IMF director of fiscal affairs, Ian Ball, chief executive officer at IFAC, and Ken Beeton, former Treasury director