(Yicai) Oct. 31 -- The post-Covid era has highlighted some difficult fiscal choices for many countries in high-debt economies. In the aftermath of the financial crisis, we have seen a surge in public debt in many countries. The latest October 2024 IMF Fiscal Monitor highlights the extent of the problem, with global public debt projected to reach 93% of the world’s GDP by the end of 2024. More worryingly still, the sensitivities of this position in adverse scenarios look bad: if there were to be a severely adverse scenario for the world economy in the next three years, the global debt-GDP ratio could reach 115% by the end of that period.

To be clear, not all countries are in the same position. China, for instance, does have the scope and opportunity to engage in short-term fiscal support of its local government as part of tighter supervisory and regulatory controls on local government debt, as well as support of domestic consumption to facilitate adjustment to the recent issues in its property market. These points were all set out clearly by the IMF article IV consultations on China in August 2024.

But many of the OECD economies are experiencing tight constraints to their fiscal policy, especially in Europe (including the UK). This at a time when these countries need to invest to bootstrap economic growth and productivity, or to manage the transition to net zero. The need to invest in public sector R&D and infrastructure is acute. 

In the EU we have seen the publication of the Draghi Report. It sets out the competitiveness challenge for the EU in very stark terms:

“…The EU is entering the first period in its recent history in which growth will not be supported by rising populations. By 2040, the workforce is projected to shrink by close to 2 million workers each year. We will have to lean more on productivity to drive growth. If the EU were to maintain its average productivity growth rate since 2015, it would only be enough to keep GDP constant until 2050 – at a time when the EU is facing a series of new investment needs that will have to be financed through higher growth.

To digitalise and decarbonise the economy and increase our defence capacity, the investment share in Europe will have to rise by around 5 percentage points of GDP to levels last seen in the 1960s and 70s. This is unprecedented: for comparison, the additional investments provided by the Marshall Plan between 1948-51 amounted to around 1-2% of GDP annually…”

Although much of the Draghi Report is not about financing and fiscal policy, it does emphasise the need for common safe assets and joint investment projects at European level. It’s clear that without significant joint public investment it will be difficult to address the challenges highlighted in the report. 

Similarly in the UK there has been a major debate in the run-up to the first major fiscal policy announcement of the new Labour government. The existing debt-GDP fiscal rule in the UK (the need for this debt ratio to fall in the fifth year of the forecast) is seen by many economists as creating a bias against public investment. Together with other economists, I wrote a letter to the Financial Times in September to highlight this problem. 

There are alternatives here. The IMF Fiscal Affairs Department published an interesting paper in July 2024, written by Hua Chai, Jason Harris, Alexander F. Tieman, which asks whether one could move away from simply relying on fiscal rules based solely on debt-GDP ratios when assessing fiscal sustainability.  Instead, the authors argue that using a balance-sheet objective i.e. anchoring fiscal policy in the medium and long-term to a Public Sector Net Worth (PSNW) target may be a more appropriate approach which does not discourage investment, and ultimately may lead to lower debt-GDP ratios. The authors do recognise some issues in operationalising such a fiscal anchor, not least the need for robust ex ante evaluation mechanisms for potential investments, and the danger that this approach may bias against investment in projects with high social returns but lower financial/GDP returns.

My concerns, which I set out in a previous blog, is one of verifiability and ensuring that the fiscal authorities do not “mark their own homework”.  In the UK context, I argued strongly for a more nuanced approach, using both balance sheet (PSNW or Public Sector Net Financial Liabilities, PSNFL) and debt-GDP as indicators, but with the independent regulator, the Office for Budget Responsibility (OBR) being asked to assess whether the UK government is pursuing a sustainable fiscal policy. Using a variety of indicators addresses the issues with balance sheet indicators highlighted by many commentators. 

I would argue strongly that, much as happened with central bank independence to address inflation stability, a way for countries to address the problem of medium to long-term fiscal sustainability is to ensure a division of power between the elected government and an independent fiscal authority that makes the assessment of debt sustainability. This is not without difficulty. Elsewhere I have outlined the sensitivities which exist in constraining governments in their fiscal policy choices, especially amongst politicians. However, there are intergenerational effects from fiscal policy and therefore there are arguments for setting in place ‘checks and balances’ in any long-term fiscal framework. These issues, I would argue, are becoming more important now than they were in the late 20th century when we did not face long-term inter-generational challenges such as the transition to net zero. 

Author: Anton Muscatelli, IFF Academic Committee Co-Chair, and Principal and Vice Chancellor of the University of Glasgow