Servicing Debt While Seeking Economic Growth

Across the world, governments are struggling with fiscal frugality. Government deficits are increasing at the same rate as during the second world war. The public debt is projected to rise to an estimated 110% of GDP by 2014, a rise of almost 40 percentage points from just 3 years ago. Without drastic changes by policy makers to curb and reallocate public spending, the financial trajectory for big powers looks bleak. But how can countries focus on economic growth while servicing their massive debts?

Some countries being forced to face their financial shortcomings before others. Portugal has plans to pay down its deficit from 9% to 3% over the next 3 years. Greece must cut its deficit from 12.7% of GDP in 2009 to3% by 2013. Britain’s upcoming election will be won based on economic growth and financial austerity. But the majority of the OECD members have no detailed strategy to service their debts while hitting their growth targets. The policy prescription they choose will have a huge impact on the stability and structure of their economy across all sectors.

Today’s deficits are leading to debt burdens that are simply unsustainable. A general rule of thumb regarding a reasonable level of public debt is 60% of GDP. That limit is outlined in the Maastrich Treaty, the guidelines for the euro. It is the figure that the IMF recommends as well. It asserts that the 35 percentage point raise in rich countries debt could raise borrowing costs by two percent. Sixty percent was also the average debt to GDP ratio among rich economies prior to the financial crisis.

If the world’s debt burdens are reduced to pre-crisis levels, the costs of the crisis will not be passed on to future generations. It would allow governments more fiscal leeway to deal with future recessions and would ensure that higher public debt does not hurt private investment, lowing future growth.

While reducing debt burdens to pre-crisis levels makes sense, it will not be easy. A recent report in the Economist suggests that governments will need to improve their budget balances by an average of 8% by 2020 in order to reduce their debt ratios to 60% by 2030. Each strategy to balance the budget has its own pros and cons. Raising taxes, for example, may hurt growth more than living with a higher debt ratio. Most economists agree that fiscal adjustments via spending cuts are more sustainable and growth friendly than those that rely on tax hikes. Cutting public-sector wages is more effective than cutting public investment. Some cuts, like slashing farm subsidies or raising pension ages, have multiple benefits. They promote growth both by improving public finances and by augmenting efficient allocation of resources. The taxes that hurt growth the least are those on consumption or immobile assets like property. With the current global warming and pollution problems, green taxes are also an effective mechanism that will clean our economies and our environment. Only time will tell if governments will be able to fend off political pressures and take action to pay down their debts.

Photo Credit: Creative Commons