Countries with high public debt must support economic growth, IMF study concludes

Friday, September 28, 2012
IMF's research members at the release of World
Economic Outlook based study [Photo: Unifeed]
Washington: Countries battling high public debt must combine policies that support economic growth with lasting changes in government spending and taxation, a new study by the International Monetary Fund (IMF) concludes.

The report notes that public debt has surpassed 100 percent of GDP in Japan, the United States, and several European countries in recent years. 

This is especially worrying because of the low growth, persistent budget deficits, and looming liabilities due to aging populations in these countries. A result, particularly in Europe, has been ratings downgrades and higher borrowing costs.

The case of the United Kingdom in 1918 offers a cautionary lesson. The U.K. government combined tight monetary policy and severe fiscal austerity to cut the price level and return the pound to prewar parities. The results were disastrous: unemployment increased, growth remained anemic, and debt continued to rise.

"Supportive monetary policy, structural reforms, and fixing structural issues with the economy: These are all good things to be done and I would also suggest that those are just as applicable to peripheral Europe today as they were to the UK in the 1920s," said John Simon of the IMF's Research Department.

Simon said that case studies of successful efforts to cut debt levels over the last hundred years demonstrate that even though it's difficult, it can be done.

"What our research shows is that there is a tricky balance to be forged, but that history does suggest that there is a light at the end of the tunnel in that countries have dealt with debt burdens similar to today. We have dealt with debt burdens in circumstances similar to today and they have successfully dealt with them. The debt has come down. So, what we take from this is that I think there is grounds for optimism that this will pass," Simon said.

Many emerging and developing economies did well over the past decade and through the global financial crisis. A second IMF report suggests this resilience is likely to continue.

The report looked at economic expansions and downturns in more than 100 emerging and developing economies over the past 60 years.

"What we found is that the resilience of these economies is not a recent development, but the result of steady gains in performance over the past two decades. These economies are now spending more time in expansion, and their downturns and recoveries have become shallower and shorter," said Abdul Abiad of the IMF's Research Department.

In fact, the past decade was the first time that emerging and developing economies spent more time in expansion, and had shallower downturns, than advanced economies. This was true not just for emerging markets, but for low-income countries as well.

So if shocks can easily derail expansions in emerging and developing economies, what accounts for their improved performance? Part of the improvement is because some of these shocks are less common now than in past decades, the researchers found. But the bulk of the improvement is due to better policies

"One reason these economies did well in the global downturn in 2009 was that they appropriately used their policy space—many countries increased spending and lowered interest rates to support activity. That policy space needs to be restored, by reducing fiscal deficits and keeping inflation in check," Abiad said.

The researchers found that these economies have built up more room to maneuver, thanks to lower inflation and better fiscal and external positions than in the past. Abiad said better policies and greater policy space account for three-fifths of the increased duration of in these economies' expansion, and less frequent shocks accounts for the remainder.

However, Abiad says that growth in advanced economies is largely beneficial for emerging markets, and monetary policy has its place in supporting growth in advanced economies.

"The Fund's view is that monetary easing in these economies to the extent that they help avoid a downturn in advanced economies is a net plus for the global outlook. One of the key results of our chapter is that recessions in advanced economies double the likelihood that expansions in emerging and developing economies will come to an end," Abiad said.
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