Current fiscal consolidation plans in advanced G20 countries imply, on average, a reduction in the cyclically adjusted deficit of some 1.25 percentage points of GDP in 2011, with significant dispersion around this according to country circumstances. This seems broadly adequate, and consistent with commandment I, at least based on current projections on the recovery of aggregate demand. This said, while front-loading fiscal tightening is, in general, inappropriate, front-loading the approval of policy measures (which would become effective at a later date) will enhance the credibility of the adjustment.
- Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilisation at post-crisis levels.
High public debt tends to raise interest rates, lower potential growth, and impede fiscal flexibility. Since the early 1970s, public debt in most advanced countries has been the ultimate absorber of negative shocks, going up in bad times and not coming down in good times. In the G7, average gross debt was 82% of GDP in 2007, a level never reached before without a major war. The current fiscal doldrums are due not only to the crisis, but also to how fiscal policy was mismanaged during the good times. This time, it must be different: the final goal must be to lower public debt ratios, gradually but steadily.
- Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth.
This will require a bias towards (current) spending cuts, as spending ratios are high in advanced countries and require highly distortionary tax levels. Some cuts should be no brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages – which have risen faster than GDP in several advanced countries in the last decade – will be necessary.
This said, nothing should be ruled out. Countries with low revenue ratios and large adjustment needs – like the US and Japan – will also have to act on the revenue side. Promising “no new taxes,” in all countries and circumstances, is unrealistic.
- Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable.
Increases in pension and health care spending represented over 80% of the increase in primary public spending to GDP ratio observed in the G7 countries in the last decades. The net present value of future increases in health care and pension spending is more than ten times larger than the increase in public debt due to the crisis.
Any fiscal consolidation strategy must involve reforms in both these areas. This includes Europe, where official projections largely underestimate health care spending trends. Given the magnitude of the spending increases involved, early action in these areas will be much more conducive to increased credibility than fiscal front-loading. And will not risk undermining the recovery. Indeed, some measures in this area – while politically difficult – could have positive effects on both demand and supply (for example, committing to an increase in the retirement age over time).
