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History Offers Tips for Getting a Handle on Public Debt.

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.

A chapter in the IMF's World Economic Outlook 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.

There is widespread debate about the best way to reduce public debt. Some advocate strict budgets or fiscal austerity; others, reinvigorating growth through spending, or fiscal stimulus; and still others cite the successful post-World War II U.S. strategy of "financial repression"- governments channeling funds to themselves.

Debt since 1875

The study uses an IMF database dating back to 1875 that identifies 26 episodes of debt exceeding 100 percent in the past. The research looks at the policy responses and outcomes in each case, and draws lessons for countries battling high public debt today.

"Indeed, some of the most instructive episodes were those in which public debt increased," say the study's authors.

The report offers three lessons for today, after close examination of six case studies of advanced economies in which public debt exceeded the threshold of 100 percent of GDP, spanning a century of experience.

The cases-the United Kingdom (1918), the United States (1946), Belgium (1983), Canada (1995), Italy (1992), and Japan (1997)- cover the two postwar eras and the most recent era of peacetime debt buildup.

Growth-supporting policy complements fiscal consolidation

Lesson 1: Fiscal consolidation must be complemented by policy measures that support growth.

In Japan, weak growth prevented fiscal consolidation. Debt continued to climb until the authorities addressed weaknesses in the banking system and corporate sector that limited the efficacy of monetary policy.

And in Belgium, Canada, and Italy, debt did not fall until monetary conditions were supportive. These countries all implemented large fiscal adjustments.

But it was only after real interest rates fell that all three countries were able to reduce their debt. In some cases, reforms to wage-setting mechanisms broke a wage-price spiral. And exchange rate depreciation supported external demand and growth.

The case of the United Kingdom offers a cautionary lesson for countries contemplating internal devaluation today.

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.

This shows that a reduction in the price level, a necessary part of internal devaluation, comes at a high cost. But determining whether the cost from internal devaluation is greater than the benefit to competitiveness requires further research.

The U.S. experience in the immediate postwar years confirmed the importance of supportive monetary policy.

Limits on nominal interest rates and bursts of inflation quickly reduced the debt ratio, while growth remained strong. But it is unclear whether such financial repression would work for countries facing high debt burdens today.

Not only are advanced economies benefiting from historically low sovereign interest rates, but the inflationary consequences of financial repression could threaten the structures that have been in place in recent decades to prevent inflation.

Lasting reforms trump temporary measures

Lesson 2: Debt reduction is larger and more lasting when fiscal measures are permanent.

While Belgium, Canada, and Italy all implemented large fiscal adjustment when low inflation was seen as necessary for economy stability, their success in reducing public debt varied.

The greater success of Belgium and Canada was partly attributable to the former countries putting more weight on permanent rather than temporary improvements that were Italy's preference.

And both Belgium and Canada implemented fiscal frameworks in the 1990s that locked in the improvements achieved earlier.

Deficits not easily reversed

Lesson 3: Fiscal repair and debt reduction take time.

Only in postwar periods were deficits quickly reversed. And countries that still have high debt remain vulnerable to subsequent shocks, the study warns. For example, Belgium took 10 years to move from a deficit of 7 percent to a surplus of 4 percent.

But even after relative successes, Belgium and Canada suffered sharp increases in public debt after the global financial crisis. And the supportive external environment that facilitated the earlier debt reduction success stories is absent today.

Widespread fiscal cutbacks, retreat by the private sector, population aging, and the aftermath of the financial crisis mean even countries that follow the guidebook will have to moderate their expectations for reducing debt.

Emerging, Developing Economies Now More Resilient

Many emerging and developing economies did well over the past decade and through the global financial crisis. Analysis in the IMF's latest World Economic Outlook (WEO) suggests this resilience is likely to continue.

Optimists have pointed to improved policymaking in these economies, and to their increased "policy space"-room to respond to shocks without undermining sustainability.

But skeptics note that these economies' recent good performance has been supported by factors that are prone to reversal, such as strong capital inflows, rapid credit growth, and high commodity prices.

The IMF study suggests some of the optimism is warranted. It studied economic expansions and downturns in more than 100 emerging and developing economies over the past 60 years.

Steady gains

The researchers found that the resilience of emerging and developing 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.

Action Now to Secure Global Recovery

Christine Lagarde, Managing Director of the International Monetary Fund, has urged policymakers to use the window of opportunity offered by recent policy decisions-and to take the actions needed to achieve a decisive turn in the global crisis.

"This time, we need a sustained rebound, not a bounce. If this time is to be different, we need certainty, not uncertainty. We need decision makers to be real action takers. We need delivery," she said in a speech at the Peterson Institute for International Economics.

She described recent initiatives by major central banks as "big policy signals in the right direction"-the European Central Bank's OMT bond- purchasing program, QE3 by the U.S. Federal Reserve, and the Bank of Japan's expanded Asset Purchase Program.

At the same time, Ms. Lagarde warned that the global economy is still fraught with risks and policy uncertainty is weighing growth down. The IMF continues to project a gradual recovery, but global growth will likely be a bit weaker than anticipated even in July, she said.

Speaking ahead of the joint Annual Meetings of the IMF and World Bank Boards of Governors in Tokyo, Ms. Lagarde focused on three key sets of policy challenges: the unfinished agenda for Europe and the United States; increased pressures in the rest of the world; and commitments on which the IMF also must deliver.

"Europe obviously remains the epicenter of the crisis and where the most urgent action is needed," she said, calling on European policymakers to deliver on their commitments-including by establishing a single supervisory banking mechanism and enabling the direct recapitalization of banks. Other actions include implementing the European financial firewall-notably the European Stability Mechanism; the agreed plan for fiscal union; and, at the country level, the reforms that are essential for growth, jobs, and competitiveness.

Ms. Lagarde said that another major risk to the global economy is in the United States, where "current law implies a dramatic tightening of the deficit by about 4 per cent of GDP next year... Failure to reach a deal on raising the debt ceiling could also force a dramatic tightening." She called for action to avoid this so- called "fiscal cliff" and a concrete plan "to bring down debt gradually over the medium term."

Ms. Lagarde also noted how, after leading the global economy in the current recovery, the major emerging markets are now slowing; she urged them to focus on countering vulnerabilities, whether domestic or external. She added that she is pushing hard to ensure adequate financing for low-income countries, including through the IMF's concessional lending via the Poverty Reduction and Growth Trust (PRGT). She also called for increased support from the international community so that successful transformation in the Middle East can be based on a "foundation of inclusive growth and employment."

Finally, Ms. Lagarde said that the IMF is striving to be even more effective by improving its economic analysis and strengthening the global financial safety. The Fund is also making good progress in reaching final agreement on "the most significant governance changes in IMF history." She said that the IMF was pushing to pass these reforms, aimed at giving greater representation to emerging market and developing economies, "if not by October, then as soon as possible thereafter."
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Publication:Cambodian Business Review
Geographic Code:1CANA
Date:Nov 30, 2012
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