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Special Topic: Fiscal position and the economic downturn

While there is increasing confidence that the global economy is recovering gradually from the financial crisis, risks remain and the costs of supporting economic activity are becoming more apparent as public debt increases in many countries as a result of fiscal stimulus and bail-outs of some industries, combined with a fall in tax revenue from the economic slowdown.

This article reviews the experience of twenty OECD countries for which comparable fiscal and economic data are available. There is a wide range of experience, with different economies exhibiting different combinations of fiscal and economic strength. Governments’ fiscal responses have also varied, as have markets’ assessment of the risks associated with the resultant high levels of public debt.

Wide range of experience among countries

There is no strong relationship evident between countries’ initial fiscal position (budget deficit and central government gross debt) and their recent economic performance (fall in output, increase in unemployment, etc). Factors other than fiscal position also affected economic outcomes and countries’ policy responses were not necessarily limited by their initial fiscal position.

On the basis of a range of criteria, we classified the selected economies into four broad groups according to their fiscal position and the economic impact of the financial crisis (Table 1). There is a wide range of experience within these groups.

Table 1 – Fiscal position and economic impact
Figure 7 - Fiscal position and economic impact.

Severe impact despite strong fiscal position

Ireland is an example of an economy which was in an apparently strong fiscal position but was severely impacted by the downturn in its own property market and the global financial crisis. Ireland ran a budget surplus for all but one year in the decade to 2007, averaging nearly 2% of GDP, but much of this came from the booming property market. Gross debt was reduced over that period from 50% of GDP to less than 20% in 2007.[1]

However, because of the exposure of its banks to the property market, the downturn in that sector hit Ireland hard. The economy is estimated to have contracted by up to 7% in 2009 and the unemployment rate increased from 4.7% prior to the downturn to 13.0% at the end of 2009. As a result of the bail-out of the banks and the fall in tax revenue, the budget deficit rose to 11.7% of GDP in 2009. The government is aiming to cut its budget deficit to less than 3% of GDP by the end of 2014 by reducing spending.

Although Ireland’s position is still precarious, its programme of fiscal consolidation appears to have won the support of financial markets so far. Bond rates have fallen but remain high (Figure 7).

Weak fiscal position and severe downturn

The major developed economies of the United States (US), Japan, Germany, Italy and the United Kingdom (UK) all fall in our category of weak initial fiscal position and severe economic downturn. These economies all recorded budget deficits on average over the previous decade, ranging from around 2% of GDP in the case of the US, UK, Italy and Germany to more than 6% for Japan. Central government gross debt over the decade prior to the crisis averaged 36% of GDP in Germany and the US, 42% in the UK, around 100% in Italy and increased from 90% to 160% in Japan (which conducted a policy of fiscal stimulus for many years in an effort to revitalise its economy).

The impact of the global financial crisis on these economies was severe because of the exposure of their financial sectors to bad debts (US, UK) or the reliance of their export sectors on demand for high-quality consumer and capital goods (Germany, Japan and Italy). Demand for these items fell sharply in the early stages of the global recession; Japan, which is more dependent on emerging Asian markets than European countries, experienced a quick bounce-back with GDP rising 2.4% from a fall of 8.4%, but there are doubts about the sustainability of the recovery because of deflationary pressures and weak internal demand. The fall in output in the other economies in this group was 3.8% for the US (similar to NZ), 6.0% for the UK, 6.5% for Italy and 6.7% for Germany. US unemployment rose from below 5% to 10%.

The recovery from the recession in these economies is expected to be slow because of weak domestic and/or external demand and their fiscal positions have been severely impacted by the fall in revenue and increased spending. Given their weak initial fiscal positions, the outlook for their government finances is not strong. In the US, for example, the budget deficit is expected to be 10.6% of GDP in 2011 and government debt to reach 67% of GDP by 2020. Bond rates have remained relatively stable in these countries, although they have risen in the UK (Figure 7).

Figure 7 – 10-year government bond rates
Figure 7 - 10-year government bond rates.
Source: DataStream, RBNZ

Mild downturn despite weak fiscal position

Some economies have experienced only a small fall in output so far despite a weak prior fiscal position. Greece is an example of a country in this category. Greece’s budget deficit averaged 4.5% of GDP over the past decade and gross debt was consistently greater than GDP. The budget deficit for 2009 is estimated at 12.7% of GDP and debt to reach 130% of GDP by 2011.

So far, the fall in output in Greece has been relatively modest at 2.5%, but the economy is still contracting and previous figures are likely to be revised down. Unemployment has risen from 7.5% in mid-2008 to 9.7% in the third quarter of 2009. Despite the muted economic impact to date, the outlook for Greece’s public finances is weak because of past poor performance. The government has adopted an austerity programme to reduce the budget deficit by 4% of GDP in 2010 and to 3% of GDP by 2012. Financial markets attach considerable risk to Greek debt, with bond rates increasing above 6% (Figure 7). Greece’s membership of the Euro area has precluded economic adjustment via devaluation and created stresses within the monetary union and placed downward pressure on the Euro.

Fiscal strength and a mild downturn

The fourth group of countries had a strong fiscal position prior to the crisis and have suffered only a mild downturn. Australia is the best example in this group, experiencing only one quarter of negative growth (-0.8% in 2008 Q4); its fiscal position prior to the crisis was strong (budget surplus averaged 1% of GDP over the past decade and gross debt had fallen to 5% of GDP), allowing it to respond to the crisis with a large fiscal stimulus without impacting its fiscal position as much as in some other countries. Other factors also helped cushion the impact of the crisis, in particular Australia’s benefit from China’s demand for minerals and energy, and the relative strength of its financial sector.

New Zealand also falls in this group, with a relatively small fall in output (3.3%), including the three quarters of decline which preceded the global financial crisis. The budget was in surplus over the past decade, gross debt was less than 20% of GDP and the net position was positive. However, expenditure was growing rapidly and tax revenue has been reduced by the fall in output, resulting in higher debt projections.

Some tentative conclusions can be drawn

Although the experience of the countries we have reviewed varies widely, some general conclusions can be drawn from this high-level survey.

  • A strong fiscal position provides a buffer against a downturn (e.g. Australia).
  • But a strong fiscal position is not a guarantee of only a mild economic impact (e.g. Ireland).
  • A weak fiscal position and an increase in spending, combined with a large economic impact, can lead to a rapidly deteriorating fiscal position (e.g. US, UK).
  • Even a mild economic downturn can have serious consequences if the initial fiscal position is weak (e.g. Greece).

However, there are a number of other factors which can also influence outcomes. This review has not taken account of the impact of monetary stimulus, exchange rate policy (e.g. membership of the Euro) and risk factors such as current account deficits. In addition, a strong fiscal position is important for promoting growth and avoiding or resolving imbalances between domestic and external demand.

 

Notes

[1]Ireland's fiscal position was not as strong on figures adjusted for factors such as the property boom because of its dependence on tax from that sector.
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