The Good, the Bad, and the Ugly: 100 Years of Public Debt Overhang

By Don Alexander, MBA
Associate, RSD Solutions Inc.
(Mr. Alexander also lectures at NYU and SunySB

Throughout the past century, numerous economies have faced public debt burdens (debt/GDP) as high, or higher, than those prevailing today.  History offers lessons for countries struggling with high public debt levels.  Already, a number of countries are approaching a debt to GDP ratio of 100%, which is especially worrying because of the low growth that usually follows, persistent budget deficits, and rising liabilities due to ageing populations.  This can result in a downgrade of debt ratings and higher borrowing costs.

The IMF reviews 100 years of historical experiences of countries with high sovereign debt levels and the policies they used to make the necessary adjustments.  This is done in the third chapter of the World Economic Outlook (WEO) chapter 3 entitled The Good, the Bad, and the Ugly: 100 Years of Dealing with Public Debt Overhang (Sept. 2012).

There is widespread debate about the best way to reduce public debt. Some advocate strict budgets or fiscal austerity; others suggest growth through spending, or fiscal stimulus; and others cite the post–World War II U.S. strategy of “financial repression”—governments channeling funds to themselves.  The IMF research looks at the policy responses and outcomes in each case, and draws three lessons for countries battling high public debt today.

The first lesson is that fiscal consolidation efforts need to be complemented by measures that support growth: structural issues need to be addressed and with supportive monetary conditions.  The implications vary for countries dealing with high debt levels today. For some, such as the United States, where financial sector weakness has been addressed and monetary policy is supportive, it would suggest conditions are in place for fiscal consolidation. In others, such as the European periphery, where financial sectors remain weak and fundamental issues relating to monetary union remain unresolved, progress is limited.  Financial repression may not work for countries facing high debt burdens today. The consequences of historically low sovereign interest rates are unknown, but the inflationary consequences of financial repression could threaten the structures that have been in place in recent decades to prevent inflation.

A second lesson is that consolidation plans should emphasize persistent, structural reforms over temporary or short-lived measures. Belgium and Canada were ultimately much more successful than Italy in reducing debt, and a key difference between these cases is the relative weight placed on structural improvements versus temporary efforts. Moreover, both Belgium and Canada put in place fiscal frameworks in the 1990s that preserved the improvement in the fiscal balance and mitigated consolidation fatigue.

A third lesson is that fiscal repair and debt reduction take time—with the exception of postwar episodes, primary deficits are not quickly reversed. A corollary is that this increases the vulnerability to significant setbacks when shocks hit. The sharp increases in public debt since the Great Recession— including in the relatively successful cases of Belgium and Canada—exemplify such vulnerability.  Furthermore, the external environment has been an important contributor to past outcomes. The implications are sobering—widespread fiscal consolidation efforts, deleveraging pressures from the private sector, adverse demographic trends, and the aftermath of the financial crisis are unlikely to provide a favorable environment present in previous episodes of debt reduction. Expectations about what can be achieved need to be set realistically.

Based on these lessons, a road map for successful resolution of the current public debt overhangs is possible. First, support for growth is essential to cope with the contractionary effects of fiscal consolidation.  Policies must emphasize the resolution of underlying structural problems within the economy, and monetary policy must be supportive. Policy support is particularly important since all major economies must address public debt overhangs, and cannot always rely on favorable external conditions. Second, because debt reduction takes time, fiscal consolidation should focus on enduring structural change. In this respect, fiscal institutions can help. Third, while realism is needed when it comes to expectations about future debt trajectories and setting debt targets in a relatively weaker global growth environment, the case of Italy in the 1990s suggests that debt reduction is still possible even without strong growth.  The failure to control public debt growth can have costly consequences.

www.imf.org/external/np/tr/2012/tr092712.htm