Just when markets wanted to take a breather, a new crisis appeared on the horizon. The bank crisis is largely a thing of the past (except for ongoing risks here and there), but the aftermath includes a fiscal crisis. The common factor is that an unchecked building up of debt levels, whether in the private or the public sector, is not sustainable. The day of reckoning can be postponed, but cannot be avoided.

At the moment all eyes are on Greece, as well as other European countries such as Portugal, Spain, Ireland and Italy, whose public debt or budget deficit could potentially put them in the same position as Greece. The Greek dilemma clearly illustrates that the so-called moral hazard problem is not limited to the private sector – Greece should actually be left to its own devices to bear the consequences of its past actions, but its membership of the Eurozone means it is systemically more important than the size of its economy implies.

Just like European policy makers were reluctant to admit that the global financial crisis required action on their part, they were also slow to address the Greek problem. Even if Greece is rescued on strict terms from its dilemma (and it is by no means a foregone conclusion that the recently announced bail-out will resolve the issue), the crisis has revealed the Eurozone’s institutional weakness.

In fact, there is renewed doubt about the merits of the Eurozone as an optimal currency area. It is hard to believe that the possibility of the euro as an alternative to the American dollar as international reserve currency was still being discussed a few months ago.

The fiscal challenge extends beyond the European periphery and is actually of a global nature. Although it is mainly the developed countries that are currently in the firing line, the East European countries, Turkey, India and Brazil must also tread carefully. For example, India’s public debt amounts to 81% of GDP, which is similar to Portugal’s 83%. However, the difference is that India’s primary budget deficit amounts to 3,7% of GDP compared with 5,2% in Portugal. What is even more important is that India is expected to grow by more than 8% per annum in the near future, whereas the Portuguese economy will struggle to achieve growth of 1%. In the case of India the chances of tax revenue increasing at a healthy rate are therefore much better, which will make it much easier for the country to reduce its public debt in an orderly manner.

Consequently the public debt situation in several countries is not sustainable. Although this does not necessarily imply a default, a drastic consolidation of their fiscal positions is unavoidable.

Risk premiums are already increasing following downward adjustments in credit ratings. It is ironic that the same credit-rating agencies discredited by the global financial crisis are still being taken so seriously by the markets. The adjustments in credit ratings are once again pro-cyclical, in other words ratings are adjusted upwards in good times and downwards only once conditions have already worsened significantly.

Even the UK and the US have been mentioned as candidates for a lower credit rating. As the interest rate on long-term American government bonds is used as the global risk-free rate in determining the prices of other bonds, any action that affects it will spill over into the international capital market as a whole. But one should bear in mind that risk ratings are relative and that currently there is no viable alternative to the US. 

Nevertheless, it is a fact that major and sustained improvements in structural primary balances are essential to bring the public debt situation under control. The vulnerability of the economic recovery means that countries will still be excused this year, but if there are no transparent and credible plans by 2011 to reduce public debt levels investors could demand higher interest rates to take up government bonds.

The extent of the fiscal adjustments depends on the initial level of a country’s government debt, the level to which it has to be reduced, and the rate at which this must occur. Most countries will have to reduce their government debt to at least the level that prevailed prior to the financial crisis in order to have room to overcome possible future challenges. 

 Source: IMF

The column on the extreme right shows the required adjustment in the structural primary budget balance between 2010 and 2030 to lower the level of public debt to not more than 60% for the developed countries and not more than 40% for the emerging countries.

The required consolidation is therefore huge and politically difficult to achieve, especially in those countries that are facing an increase in government spending as a result of a rapidly aging population. Also, the lower the economic growth rate, the slower the increase in government revenue. However, research has shown that a high level of public debt could put upward pressure on real long-term interest rates, which would be detrimental to the potential growth rate – a typical catch-22 situation. Other policy measures will therefore be essential to boost economic growth in times of restrictive fiscal policy.

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