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Signs of Fiscal Progress: Will It Be Enough?

Posted on July 18, 2012

By Carlo Cottarelli

We’ve just updated our latest assessment of the state of government finances, debts, and deficits in advanced and emerging economies.

Fiscal adjustment is continuing in the advanced economies at a speed that is broadly appropriate, and roughly what we projected three months ago. In emerging economies there’s a pause in fiscal adjustment this year and next, but this too is generally appropriate, given that many of these countries have low debt and deficits.

The improvement in fiscal conditions in many advanced economies is welcome, but it’s going to take more than lower deficits to get countries under market pressure out of the crosshairs.

Signs of Progress

There are clear signs of fiscal progress in advanced economies. The deficit will decline in about three quarters of advanced economies this year, and in almost 90 percent of them next year. Debt ratios are also starting to come down: we project one-third of advanced economies to have a declining debt ratio this year and half of them to do so next year.

The progress in deficit-cutting in Europe means less fiscal tightening will be needed in the future, reducing the fiscal drag on growth: in 2011–12 the fiscal tightening in the euro area will amount to a cumulative 2½ percentage points of GDP, while in 2013–14 it is projected to be one third of this, which is good news for growth.

On the other hand, in the United States there is a risk that fiscal consolidation will increase dramatically next year, with the economy going over the “fiscal cliff” of expiring tax cuts and of automatic spending cuts. A much more contained deficit decline would be preferable, and should be introduced in the context of a medium-term fiscal adjustment plan.

There has been some weakening in the projected fiscal accounts in emerging economies.  Many countries are now expected to show higher than anticipated deficits this year and next. This weakening in fiscal deficits reflects the deceleration in economic activity in the context of relatively stronger fiscal positions. There are a few countries where a more ambitious fiscal adjustment strategy is called for, but in most cases emerging economies have more fiscal space and some of them are using it wisely to cushion their economies against the impact of developments elsewhere.

Spreads not fully aligned with fundamentals

In spite of the progress in adjusting their fiscal accounts, bond spreads remain very high for some euro area countries—higher than what could be explained by fundamentals like debt and deficits, growth, and inflation. Italy and Spain pay spreads that are some 200–250 basis points above their fundamental level. Even a country like France, where the debt ratio is below the euro area average, faces market rates on longer maturities that are higher than can be explained by debt, deficits and the like.

This doesn’t mean that fiscal fundamentals don’t matter. They do. Countries like Italy, Spain and others with high debt and deficits need to continue making progress in restoring fundamentals so that interest rates—and risks of a financial market crisis—come down. But it does suggest that when it comes to restoring market conditions to normal, fiscal fundamentals cannot do the job alone.

Why are spreads higher than justified by the underlying fiscal situation? There are various reasons, but an important one is the challenges that the euro project is facing. Hence there is a need not only to proceed with completing the process of fiscal adjustment in Europe, but also to reassure markets that the euro project remains viable. On this score, there is some good progress to report. The European leaders agreed at their June summit on some significant steps that, if implanted in full, will help break the links between government and bank balance sheets, so that concerns about weak banks won’t feed back into concerns about the government debt.

There’s also been progress in strengthening fiscal governance, with so far 10 of the 25 European Union member signatories having ratified the Fiscal Compact treaty to strengthen fiscal frameworks and cap structural deficits. The European Parliament has also adopted draft regulations known as the “two-pack” that will further improve fiscal policy coordination.

But more needs to be done. In particular, increased banking and fiscal integration are still needed. Consideration should also be given to actions at the euro area level to stabilize funding conditions in sovereign debt markets, such as a reactivation of the Securities Markets Program, under which public and private debt securities are considered eligible for purchase by euro area central banks, or the issuance of common euro area debt in limited amounts.

Measures like these cannot substitute for further progress in reducing debt and deficits in countries under market pressure. But they can help ensure that countries realize the full market benefits of hard-won improvements in their fiscal fundamentals.