The public sector, in most advanced economies, is highly indebted, with debt reaching levels that had never been reached before, except during major wars. While this is a direct consequence of the global credit crisis, debt levels have actually been rising for more than 35 years, having been used as the ultimate shock absorber. In other words, government debt has risen during bad times but not declined significantly in good times.
The average public debt burden in the G7 countries fell rapidly during the 1950s and 1960s, helped by strong growth in the countries that won the war (public debt was eroded by inflation in the countries that lost the war). In 1974, the trough was reached with an average gross public debt-to-GDP ratio of 35%. By 2007, one year ahead of the credit crisis, the average debt ratio had more than doubled to over 80% of GDP. Thus, G7 countries entered the credit crisis with a historically high level of public debt. As a result of the crisis, largely reflecting revenue losses as well as the drop in output, public debt is projected to rise to nearly 110% of GDP by the end of 2010.
It is often argued that the increase in G7 government debt reflects a change in the nature of the state, from a state providing "core functions" such as security services as well as large public works to a state that is providing a much wider range of social services. This is true, but with one important caveat. The bulk of the increase in public spending (over 80%) is due to two items; health care and pensions. Health care and pension reform will be the fiscal challenge of the 21st century.
In contrast, the public debt ratio of emerging economies (including South Africa), which increased only modestly as a result of the credit crisis, is expected to have stabilised in 2010 and to have resumed a downward trend in 2011.
In all G7 economies, overall fiscal balances have widened, on average, by more than 7% between 2007 and 2010 to about 9.25% of GDP. This means that large fiscal adjustments are needed simply to keep the debt-to-GDP ratio constant. An even larger adjustment is needed to lower public debt to below 60% of GDP by 2030. In the absence of fiscal adjustment, the high level of public debt would likely have adverse macroeconomic effects. A very recent IMF analysis suggests that an increase in public debt by 40% could raise real interest rates by almost 2% in the medium term, and lower potential growth by over 0.5%.
Importantly, under unchanged policies, the net debt-to-GDP ratio of the G7 economies would reach 200% by 2030 and exceed 440% by 2050. This scenario assumes that fiscal stimulus measures expire but otherwise the cyclically adjusted primary balance remains constant at the 2010 level (in percent of GDP).
Decisive action is needed in the G7 countries to turn deteriorating public finances around without hampering near-term growth prospects. Clearly there needs to be a fiscal adjustment, but it cannot be too abrupt. In other worlds there should be a downsizing of government, but without preventing it from playing a key role in the provision of basic services (sometimes called improved efficiency). The current environment of low interest rates, which has so far kept debt service payments under control in G7 economies despite surging deficits and debt levels, is obviously at odds with the overall trend in public sector finances. But at least it provides a window of opportunity to undertake the fiscal adjustment process. Once interest rates start to rise, this adjustment will become extremely difficult.
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