The large increase in government debt that we are witnessing across many countries have raised questions about the adjustment that will be necessary to bring those levels back to normal.
As much as the projected increases in debt are large for many governments, we have seen these high levels in the past and in some cases adjustments towards lower levels of debt have been fairly smooth and have taken place over a relatively short period of time. One of these examples is Ireland in the 1996 to 2006 period. During those years government debt was reduced from over 100% of GDP to about 20%. Fiscal discipline during those years helped, but what was more important was to have a fast-growing economy that made the level of debt shrink in relation to GDP. None of the advanced economies (the US, the Euro area) will be able to replicate the growth rates of Ireland in those 10 years but the message is clear: without healthy growth, bringing down debt to GDP ratios will be impossible (and Japan is a good example of what to expect if growth does not return).
The Irish example is also a reminder of how important is to have a proper framework for long-term sustainability of public finances. While the reduction of the debt levels was very impressive, some of the contributing factors were of a cyclical nature but they were judged to be structural by the policy makers. Once the cycle changed and the surpluses turned into large deficits, debt levels increased and, in the case of Ireland, we are witnessing a return to the high levels of the early 90s.
As an example of how cyclical factors helped during those years, the chart below - from the Public Finances 2009 publication of the European Commission - shows how dependent the increase in taxes was on the boom in property taxes. At the peak in the real estate boom, property-related taxes accounted for close to 20% of all tax revenues. In 2008 they have gone down to 10%, a loss of about 3 percentage points of GDP. Ireland is not the only country that is suffering from this problem. Overoptimistic scenarios used during the expansion phase did not produce the necessary fiscal discipline that could have created the necessary space for the current fiscal expansion. Let's hope we get this right in the next expansion (whenever it starts).
Antonio Fatás
