It’s a four-letter word that makes capital markets quake and governments quiver: debt. Witness last summer’s quarrels in the US Senate over raising the debt ceiling and the ongoing drama in the European Union over bank capital ratios and potential sovereign defaults.
But, according to Philip Gerson, senior advisor to the International Monetary Fund’s fiscal affairs department, all the fuss may be an overreaction. “Despite the drumbeat that the fiscal world is falling apart, debt is about where we thought it would be three years ago,” he said in October event sponsored by the Chazen Institute of International Business at Columbia Business School. In introducing the IMF’s latest “Fiscal Monitor,” a twice-yearly report that takes the world’s financial temperature, he added, “We need a more nuanced view to avoid getting carried away by the tidal wave of bad news.”
What the numbers say
As evidence, Gerson reviewed the IMF’s 2009 predictions of debt ratios as a percentage of GDP. In six nations — Canada, Finland, France, Japan, New Zealand, and the United States — “debt levels are about where we thought they’d be,” he said. And while three countries (Greece, Ireland, and Portugal) have significantly higher ratios than we expected, debt is in fact lower than anticipated in European markets from Austria to the United Kingdom — including Spain and Italy, two of the more troubled economies.
Based on the report’s findings, Gerson divided his recommendations into three broad categories.
The Euro area, which has a head start in laying out medium-term targets for economic adjustment, must still act immediately to “ring a fence around the poorest countries so they don’t infect others,” he said. But “Europe can’t do a piecemeal solution,” he warned. A long-term, comprehensive plan should include growth-promoting structural reforms, institutional reforms, and continued fiscal adjustment, especially in markets in which pressures are particularly intense.
On the other hand, Japan and the United States are anomalies, with high debt levels but low interest rates. Relatively strong banking sectors partially explain the low rates, but the bigger driver of low rates is the goodwill factor: simply put, the United States and Japan enjoy greater fiscal credibility than other countries.
Gerson warned that this trust could evaporate. “European events should be a cautionary tale. We have a window of opportunity to get our houses in order rather than a blank check to keep doing what we’ve been doing.” Both countries need medium-term plans to stabilize and bring down debt, he said. To do that, the United States needs entitlement and institutional reforms as well as increased revenues. Japan, on the other hand, does have a medium-term plan in place to increase its consumption tax from 5 percent to 10 percent. But under that plan, debt won't decline until 2021. “Japan needs to be more ambitious by increasing the tax to 15 percent to speed fiscal recovery,” he said.
Emerging markets, meanwhile, largely came through the recent financial crisis unscathed. But Gerson said that the cautionary note should apply to them as well. “Many low-income countries were able to offset the downturn with countercyclical policies,” he said. Now, as they move forward on expensive growth plans, “they need to rebuild their buffers, do a better job of collecting revenue, and move from more general subsidies to targeted policies that help those most in need.”
The bottom line? “All economies face significant challenges,” concluded Gerson. “Markets display little tolerance for delay or unclear policies. The results could be further market turmoil, with potentially heavy economic and social costs.”