IMF: "The Good, the Bad and the Ugly: 100 Years of Dealing with Public Debt Overhangs" (Policy Responses to Debt/GDP Over 100%)

From the International Monetary Fund:

Throughout the past century, numerous advanced economies have faced public debt burdens as high, or higher, than those prevailing today. They responded with a wide variety of policy approaches. We analyze these experiences to draw lessons for today and reach three main conclusions. First, successful debt reduction requires fiscal consolidation and a policy mix that supports growth. Key elements of this policy mix are measures that address structural weaknesses in the economy and supportive monetary policy. Second, fiscal consolidation must emphasize persistent, structural reforms to public finances over temporary or short-lived fiscal measures. In this respect, fiscal institutions can help lock in any gains. Third, reducing public debt takes time, especially in the context of a weak external environment.

Public debt in advanced economies has climbed to its highest level since World War II. In Japan, the United States, and several European countries, it now exceeds 100 percent of GDP (Figure 3.1). Low growth, persistent budget deficits, and high future and contingent liabilities stemming from population-aging-related spending pressure and weak financial sectors have markedly heightened concerns about the sustainability of public finances. These concerns have been reflected in ratings downgrades and higher sovereign borrowing costs, especially for some European countries. Correcting fiscal imbalances and reducing public debt have therefore become high priorities.

There is, however, a widespread and ongoing debate over the most appropriate policy mix for achieving a successful adjustment. According to some, fiscal austerity is essential to resolve the current crisis. Others argue that fiscal austerity is self-defeating, given its contractionary effect on output, and that reinvigorating growth through fiscal stimulus is more important. Still others point to the experience of financial repression after World War II and suggest this as a model for resolving the current debt overhang.

This chapter informs the current policy debate by reviewing the historical experiences of advanced economies that have reached debt-to-GDP ratios as high as today’s. The policy responses differed greatly, as did the outcomes. The richness of this historical experience provides insight into the full spectrum of policy options currently under consideration. In particular, the chapter addresses the following questions:

•• How successful were countries in reducing high
public debt ratios in the past?
•• Which policy mix proved most effective? What
were the contributions of fiscal, monetary, and
financial sector policies?
•• What were the macroeconomic consequences of
the policies pursued?
•• What does historical experience suggest for countries
dealing with high debt today?

To address these points, we do not focus only on large debt reductions, as done in previous studies, but we review more broadly “what happens next?” after debt rises above 100 percent of GDP. This allows us to take in the full range of possible outcomes rather than just the successes, which might paint a distorted picture of debt dynamics....MORE (28 page PDF)

HT: The Conversable Economist