Does fiscal sustainability matter only when there is a fiscal house on fire, as was the case with the Greek sovereign insolvency in 2011–12? Far from it.
Overcoming challenges that hinder inclusive and sustainable growth can only become possible through actionable policies and programmes if there is sufficient public funding in place, with support from the private sector. Public infrastructure, both physical and legal, for example, provides a foundation for progress in society. Further commitments of public resources are needed to ensure that this new world will be secure and stable.
Financial support for public spending (on healthcare, pensions, infrastructure, etc.) must be funded through taxes that are clear, fair, and transparent – which is essential to their political acceptability – and that do not cause avoidable damage to the incentives to save, invest, work, and create wealth. Fairness and efficiency have intertemporal and intergenerational dimensions too, so public debt, which redistributes the burden of funding public spending over time – across generations and between different stakeholders within a generation – plays a critical role in meeting many of today’s financial challenges.
Fiscal crises are just the tip of the public finance/sovereign funding iceberg. Even in normal times, the political and economic choices involved in determining the size and composition of public spending and the structure of the tax system are complex and often deeply divisive.
The most remarkable feature of the fiscal sustainability crises that followed the North Atlantic financial crisis late in 2007 was that they were all advanced-economy crises, including the heartland of modern capitalism – the US, the UK, and the Eurozone. To varying degrees, advanced economies have socialised financial-sector losses caused by the crisis.
Together with revenue losses (and automatic fiscal stabiliser-driven increases in social spending) caused by the North Atlantic financial crisis and the balance-sheet recession that followed it, this has tipped already precarious fiscal positions in many advanced economies into outright dangerous territory. For fiscal sustainability, fairness, and moral hazard reasons – that is, future crisis prevention – it is essential that financial-sector reforms be implemented to avoid a recurrence of the socialisation of financial-sector losses.
Emerging markets and developing countries – historically the usual suspects when it comes to fiscal sustainability crises, sovereign solvency crises, and even public debt restructurings or defaults – were not on the fiscal delinquents list following the most recent financial crisis.
The reason emerging market nations did not find themselves in the fiscal doghouse after 2007 was that the benefits of the reforms and improved macroeconomic management following the Tequila crisis of 1994, the Asian crisis of 1997, and the Russian crisis of 1998 had not been dissipated by 2008. After the painful and humiliating experiences of the Asian and Russian crises, most emerging markets cleaned up their balance sheets in the banking sector and non-financial corporate sector. Government deficits were brought down and the external current account deficits were reduced or turned into surpluses. Structural reforms to enhance the efficiency of their economies were undertaken – especially in the tradable goods sectors. Almost 15 years of export-led growth followed.
When the North Atlantic financial crisis hit in 2007, most emerging markets were, for the first time in their histories, able to counter a recession imported from the US and Europe through effective countercyclical policy. Monetary and fiscal stimuli were applied, and most emerging markets recovered swiftly from the crisis. As advanced economies cut official policy rates to historically unprecedented levels during the period 2008–10 and engaged in rapid and large-scale balance-sheet expansions by their central banks, a ‘wall of money’ driven by a relentless hunger for yield came towards those emerging markets that were open to global capital flows; by now most of them except for China and, to a lesser extent, India.
Attempting to counter the appreciation of their currencies that was warranted by these inflows, emerging markets accumulated foreign-exchange reserves on a huge scale. Attempts to introduce capital controls in a hurry, both administrative and fiscal, to limit inflows were unsuccessful in Brazil and elsewhere. The combination of high emerging market yields and appreciating emerging market currencies was irresistible. Macroprudential tools to stem capital inflows were embryonic, and the accumulation of forex reserves could not be effectively sterilised in most emerging markets, so domestic credit expansion imported from advanced economies resulted.
Many emerging markets objected vociferously to these ‘currency wars’. When ‘currency peace’ broke out in May 2013, however, they did not like it any better. This was in part because after the successful countercyclical policies of 2008 and 2009, emerging markets, instead of ceasing to stoke the fires of domestic demand, continued to fan them. India, Brazil, Turkey, Indonesia, South Africa, and many other emerging market nations permitted purely domestically generated credit booms to reinforce the imported credit booms.
China created what is probably the largest credit bubble ever without any assistance from the rest of the world. The balance sheets of the banking sectors in all these countries expanded rapidly, indeed recklessly, and the quality of the assets put on the balance sheet became hard to verify, but was undoubtedly deteriorating rapidly as the growth of credit outstripped the banks’ capacity for effective monitoring of credit and counterparty risk.
In China, the counterpart to the explosion of the banking sector’s balance-sheet size was mainly local government special purpose vehicles and corporate credit expansion. India’s credit boom also mainly involved corporates. Unlike China, however, quite a few corporates in India borrowed abroad in hard currencies, mainly US dollars. The same was true in Brazil, Indonesia, and Turkey. Corporate and banking-sector balance sheets expanded rapidly. In Brazil, for example, credit to the household sector was the main driver of balance-sheet expansion. Private-sector balance sheets became vulnerable, while external current account surpluses declined or turned into deficits. Stocks of gross external foreign currency debt, mainly issued by the private sector, also rose rapidly. The vulnerabilities were there. All that was needed for a financial ‘kerfuffle’ was a trigger. US Federal Reserve Chairman Ben Bernanke provided it through the tapering announcement of 22 May 2013.
But even now, the balance sheet positions (or stock positions) and the budget deficit positions of most emerging market sovereigns are less vulnerable than those of the US, the EU, and Japan. There is a risk, of course, that impaired private assets from banks, corporates, or households that are either too big to fail, or too politically sensitive or politically well-connected to fail, will migrate to the public sector balance sheet, turning a private sector balance sheet crisis into a fiscal insolvency crisis.
As noted earlier, the socialisation of financial sector balance sheet losses has indeed been the norm in the banking crises that were at the core of the North Atlantic financial crisis. The impaired assets of banks and other systemically important or politically well-connected entities were de facto implicit contingent sovereign liabilities. These implicit liabilities have since 2008 become explicit liabilities, most spectacularly in Ireland and to a lesser degree in Spain, Greece, the Netherlands, and Belgium. Slovenia’s government appears to be about to socialise at least part of the losses of its state-owned banks. Such intersectoral asset and liability migrations are not always in the same direction – i.e. they do not always involve the socialisation of private losses. In some emerging markets, notably in Argentina, there have been raids by the state on good private sector assets – the socialisation of private profits – in an attempt to restore public finances to sustainability.
There is no doubt that emerging markets are more fiscally vulnerable today than they have been since the legacy of the 1997–98 crises. Complacency about the state of public finances in India, Brazil, Indonesia, South Africa, and even China – where there are likely to be large contingent sovereign liabilities hidden in the balance sheets of the banking and shadow banking sectors – is therefore not warranted.
The gross debt of the US government (federal, state, and local) stands at more than 100% of annual GDP. It is clear that the US federal government, in particular, has a fiscal stock problem. Thanks to a supportive monetary policy and, in 2013, a material dose of fiscal austerity, the immediate government deficit problem or flow problem has been much diminished, with the federal deficit for the current fiscal year coming down to 4% of GDP and likely to fall further. However, unless entitlement reform – especially social security, retirement, Medicare, and disability benefits – is tackled decisively, and unless comprehensive personal and corporate tax reform is pursued in a way that raises revenues (average effective tax rates) without necessarily raising the top notional marginal rates, an unsustainable federal funding gap will materialise again in the next decade.
It remains an open issue to whether the desirable revenue and distributional implications of restricting exemptions, deductions, allowances, etc. will be able to overcome the powerful special interests that created these tax expenditures in the first place. Given the obvious need for additional public spending in the US on infrastructure, education, and other forms of human capital formation, and on fundamental R&D, the medium-term and long-term fiscal challenges facing the US are formidable. Political polarisation and the gridlock in the US Congress create concerns about whether the US political institutions will be able to deliver the necessary reforms.
In Japan, markets are willing to hold 10-year government bonds at a yield of 0.6%. Yet the gross general government debt-to-GDP ratio is 235%, and the general government deficit is more than 8% of GDP, with the primary (non-interest) deficit more than 6% of GDP. Japan therefore has a combined fiscal stock and flow problem which is hidden by a hyper-aggressive monetary policy, a large stock of net foreign assets, a continuing current account surplus on the balance of payments and a strong, albeit diminishing, home bias in Japanese portfolio preferences. The timing of the collapse of the market’s confidence in the ability of the Japanese sovereign to do what it takes to restore solvency cannot be predicted, but this situation is not sustainable.
Wealth levies, high inflation (perhaps combined with interest-rate caps – financial repression) or an extended period of demand-destroying fiscal austerity are painful ways of resolving an unsustainable fiscal situation; high growth is the painless way to achieve the same result. Unfortunately, unlike austerity, growth is not a policy (or set of policies), but an outcome you get when you have the right policies, the right institutions, the right political and economic culture, the right initial conditions, a supportive external environment, a bit of luck, and access to funding for the sovereign, banks, and other systemically important institutions on affordable terms. Although Japan is likely to have a reasonable cyclical recovery over the next couple of years, the structural reforms (including policies to increase labour supply and address negative demographics) required to raise its growth rate of potential output above the current level are politically demanding and socially divisive.
The Eurozone continues to have a high and rising public-sector debt burden. Even though austerity in the periphery and in some of the highly indebted core countries (the Netherlands, Belgium) has reduced the deficits of most governments, more austerity will be required to reduce the deficits to sustainable levels in most countries, unless something is done to solve the stock overhang problem.
Growth will not come to the rescue. A cyclical recovery would require a much more expansionary ECB monetary policy, the use of fiscal stimuli in those countries that have excessive external surpluses (especially Germany), and market access for the sovereign on attractive terms.
For political/monetary ideological reasons, a monetary-fiscal stimulus in the Eurozone is highly unlikely, regardless of how desirable it may be from the perspective of economic activity. Potential output growth is now estimated by the ECB to be no more than 0.5%. Although ageing, low investment, and disappointing total factor productivity growth are undoubtedly having a negative impact on potential output growth in the Eurozone, the 0.5% estimate is unduly pessimistic.
Some of the unemployment that is viewed as structural will probably turn out to be cyclical after all, investment rates are likely to bottom out and rise again, and there are masses of low-hanging structural reform ‘fruit’ on the Eurozone total factor productivity growth ‘tree’, including in the second- and third-largest countries, France and Italy.
The Eurozone has suffered from a balance-sheet recession, with excessive bank debt everywhere and excessive sovereign debt almost everywhere, especially in the periphery, and with excessive household and non-financial corporate debt in a number of countries. There is some hope that because of the banking union, which is likely by 2015, the excessive bank debt problem and the associated ‘zombification’ of the banking sector will be addressed effectively during the next couple of years.
The sovereign debt stock problem remains. Although the Eurozone political leadership has gone on record as saying that there will be no more sovereign debt restructuring involving private holders of sovereign debt after Greece (give or take Cyprus), all options to deal with the sovereign debt overhang should remain on the table.
Debt restructuring for highly indebted sovereigns in the Eurozone (through maturity extensions, coupon cuts, interest deferrals, debt exchanges involving present-value haircuts, or through face-value haircuts), should be on a menu that also includes partial public debt mutualisation (burden-sharing by the core). Such public debt mutualisation can be done either through the front door (through explicitly mutualised fiscal facilities such as the European Stability Mechanism) or through the back door (by the ECB purchasing the debt of excessively indebted sovereigns and accepting net-present-value losses or face-value losses on these purchases, up to complete cancellation of the debt involved). Another possible way of addressing a public debt overhang without multi-year demand-destroying fiscal austerity would be a one-off wealth levy.
Continued attention is vital to support policy efforts aimed at achieving fiscal sustainability. The World Economic Forum’s Global Agenda on Fiscal Sustainability has advanced concrete proposals for countries across the world, and especially in the Eurozone, to take on their fiscal challenges.
For the Eurozone, creating a sovereign debt restructuring mechanism – that complements market-based or contractual mechanisms for sovereign debt restructuring (like the collective action clauses attached to newly issued sovereign debt since the beginning of 2013) with a statutory framework that provides conditional liquidity assistance to fiscally challenged sovereigns – should be a priority.
Central to this conditionality is a rigorous, independent review of the sustainability of the fiscal financial programme of the sovereign requesting liquidity assistance, with sovereign debt restructuring a precondition for funding if the public finances are deemed not to be sustainable. The sovereign debt restructuring mechanism could be attached to the European Stability Mechanism, or be a new institution. Liquidity support could, in principle, be provided by the ECB rather than through a mutualised fiscal support mechanism like the European Stability Mechanism, but because of the peculiar constraints on ECB (and national central bank) funding of governments imposed by the existing Treaty on European Union, this would require a politically challenging treaty change, which is probably best avoided for the time being.
A narrow banking union – a single supervisory mechanism, a single rule book, and an effective resolution mechanism for insolvent systemically important banks – is likely a necessary condition for the survival of the euro, and certainly a necessary condition for ending the fragmentation of Eurozone financial markets and the impaired transmission of monetary policies in countries where weak banks and weak sovereigns prop each other up. The comprehensive assessment of the 130 largest Eurozone banks that is getting underway now, especially the asset quality review (AQR) that is expected to be completed under the guidance of the ECB by the end of the summer of 2014 – and the stress tests that will follow towards the end of 2014 – could provide the information base to recapitalise the Eurozone’s banks and make them fit for purpose again as lenders to the real economy.
The institutional mechanism for bank recovery and resolution should combine the bail-in of unsecured creditors other than protected depositors with a Single Resolution Mechanism (SRM) that has a resolution authority that is independent of national governments and supervisors, and a final mutualised fiscal backstop, the Single Resolution Fund (SRF). Unfortunately, the bank creditor bail-in mechanism just agreed to (as part of the Bank Recovery and Resolution Directive) does not mandate the bailing-in of senior unsecured bondholders until 2016. This is at least one year too late, as the results of the AQR and the stress test will be known by the end of 2014, and will have to be acted upon during 2015.
The complexity, indeed impenetrability, of the SRM and SRF blueprints tentatively agreed by the Eurogroup early in December is astounding, even by EU standards. As currently conceived, both the SRM and SRF are completely unworkable. Unless this is remedied urgently, the Eurozone will have to choose between fudging the AQR and the stress test by overstating asset quality and underestimating capital needs, or having an honest AQR and stress test followed by possible financial chaos, as banks cannot be resolved at the speed of crises and no mutualised fiscal backstop with sufficiently deep pockets will be in place.
To sever the perverse feedback loops between fiscally weak sovereigns and (near) insolvent banks, financial repression – governments stuffing the banks in their jurisdiction with sovereign debt they have trouble selling in the market at sustainable interest rates – has to end. The same holds for the implicit guarantees provided by these same sovereigns to their banks and to bank creditors. To this end, sovereign debt should be treated according to the same principles as commercial debt.
Concentration limits applied to sovereign debt can be used to keep the exposure of banks to their sovereigns at prudent levels. If risk-weighting assets for capital adequacy purposes makes sense for bank holdings of risky private debt, it also makes sense for bank holdings of risky sovereign debt. Clearly, the introduction of such measures – from an initial condition with often high exposure of banks to their sovereigns – has to be gradual, and should be timed properly to avoid unnecessary procyclical tightening of financial conditions.
The urgent need is to make progress at the governmental level, and in the case of the Eurozone at the intergovernmental and supranational levels. Only then can there be confidence in the availability of adequate public resources to take on the many challenges that the financial sector continues to face. Fiscal sustainability is a foundation for moving forward on the global agenda.
By Willem Buiter
Willem Buiter is Chief Economist of Citigroup and a CEPR Research Fellow. Prior to his appointment at Citigroup, he was professor of European Political Economy at the European Institute of the London School of Economics and Political Science.