The Covid-19 crisis has led to an extraordinary hit to economic activity and has transformed the fiscal outlook. Fiscal policy has been highlighted as the best available policy response tool (Baldwin and Weder di Mauro 2020a, 2020b). Yet, there is now huge uncertainty about the path of the pandemic, the economy, and the public finances in the years to come.
This column sets out a series of fiscal scenarios to 2025 for a small euro area country based on the recently published Fiscal Assessment Report of the Irish Fiscal Advisory Council. We take a concrete look at what fiscal policy might look like in euro area countries in the years ahead.
Given the uncertainty, a state-contingent approach is warranted. In the first phase, policymakers have the fiscal space to continue emergency support measures. In the second ‘recovery’ phase, most countries would have fiscal space to launch a sizeable temporary fiscal stimulus. In the third ‘new normal’ phase, fiscal adjustment will become the priority. However, it should be possible to avoid a return to austerity — that is, significant increases in unemployment due to severe fiscal adjustments, particularly in a downturn (Wren-Lewis 2017).
Although debt-to-GDP ratios will rise sharply to very high levels, current very low interest rates would create substantial headroom if maintained (Krugman 2020, Lilley and Rogoff 2020, Blanchard et al. 2019). Managing the public finances with such high debt levels creates a new ‘high-altitude’ regime. This remains manageable provided low interest rates are broadly maintained, even if they rise moderately from today’s levels, but could be unstable in other configurations. This is why the ECB’s role and the stability of the monetary union are key. Favourable conditions would make targeting faster reductions in debt-to-GDP ratios more achievable than has been the norm in recent years.
Using scenarios to look ahead
Today’s fiscal policy decisions need to be taken with a view to future outcomes. With debt rising sharply, will there be space for stimulus? What sort of fiscal consolidation could eventually be needed?
Scenario analysis is a useful way of exploring the range of likely outcomes. Given the non-linearity of debt dynamics, the policy implications of a large shock could be disproportionalely severe if it puts the public finances on an unstable path.
The Fiscal Assessment Report looks at three scenarios: (i) a ‘Mild’ scenario, where the pandemic and economic conditions improve rapidly, (ii) a ‘Central’ scenario, where confinement measures ease as planned but with lasting impacts, and (iii) a ‘Severe’ scenario with repeated lockdowns and wider financial distress. The scenarios extend to 2025.
A Mild scenario could see debt ratios in Ireland fall steadily in later years to levels nearer to 90% of national income from a peak of around 119%. The deficit would fall to 3.5% next year, then gradually close.
A Central scenario, with a steep initial downturn and limited recovery would see debt peak at 125% of GNI* in 2020.1 By 2022, the debt ratio would likely still be around 120%.
A Severe scenario could see debt ratios climb to over 140% in 2021 and flattening at that level. Fiscal stimulus would further add to government debt.
Figure 1 Three scenarios
a) Domestic demand (Q4 2019 = 1000)
b) Budget balance (% GNI*)
c) Gross debt ratios (% GNI*)
Source: Fiscal Assessment Report, May 2020: “The Fiscal Impact of Covid-19”.
A state-contingent approach to policy: Three phases
With high uncertainty, fiscal policy will need to adjust to circumstances. State-contingent policy rather than a time-dependent path may be a useful approach.
The economy is likely to move between three phases: (1) the immediate crisis, where activity remains restricted and disrupted by Covid-19, (2) the recovery, in which demand would remain weak, and (3) the new normal when demand has largely recovered.
During the immediate crisis, the priority is on emergency support measures for workers and firms, together with health measures. In the recovery phase, a sizeable fiscal stimulus would be warranted, likely over several years. In the new normal, addressing the remaining structural deficit and putting the debt-to-GDP ratio on a downward path will come to the fore.
Future fiscal adjustment needs
Given the high level of debt, the public finances will be vulnerable to increases in interest rates, shortfalls in growth, and other shocks. A permanent loss in output as a result of Covid-19 (Portes 2020) would also open up a structural budget deficit that would need to be closed. Some fiscal adjustment is likely to be needed eventually to put the debt-to-GDP ratio on a downward path. However, this could be surprisingly limited.
This chart shows the adjustment needs for Ireland to return the debt-to-GNI ratio to a downward path of minus three percentage points per year (similar to its pre-Covid path).
Figure 2 Potential consolidation requirements in Ireland (€ billions)
Sources: NTMA; Department of Finance; and Irish Fiscal Advisory Council workings.
Note: Unlike the consolidation amounts during the financial crisis, the amounts set out for scenarios are relative to a situation where public sector wages and welfare payments are assumed to rise in line with general wages.They take place at a stage when the economy is assumed to be growing.
This adjustment would be far lower than after the 2008-10 crisis, which hit Ireland hard. If interest rates remain low, the fiscal adjustment could be more gradual and would come against a background of growth and output near capacity. It should be much less disruptive than during the financial crisis. Adjustment dynamics are likely to be similar in other countries.
High-altitude debt dynamics
Managing the public finances with such high debt levels creates a new ‘high-altitude’ regime. This remains manageable provided that interest rates remain low, but could be unstable in other configurations.
Looking at debt dynamics, the sensitivity to the interest-nominal growth differential increases directly with the debt ratio. Where interest costs are less than growth rates, higher debt paradoxically increases the rate at which the debt ratio falls (for the same primary balance, better interest-growth differentials produce larger debt reductions).2 Since Covid-19, the interest rate has also fallen, further accelerating this process, although growth prospects may be lower too.
For euro area countries, Figure 3 shows how the post-Covid-19 debt-stabilising primary balances could differ from the pre-Covid 19 situation. With a few exceptions, the debt-stabilising primary deficit is larger in the post-Covid-19 era, by up to around 2% of GDP. This reflects several effects. First, a higher debt ratio typically magnifies the impact of debt service costs. But these effects are attenuated assuming interest rates converge to 1%. Second, higher debt ratios will magnify the debt-reducing effects of growth assuming medium-term growth rates are not affected by the pandemic. Taken together, the second debt-reducing effect dominates the interest effect, hence lowering the debt-stabilising primary balance. The exceptions are Germany, Finland, and the Netherlands, where the scope for interest rates to fall assumed does not offset the rise in debt.
Figure 3 Pre-Covid-19 and post-Covid-19 fiscal balances (% GDP unless otherwise stated)
Source: Authors’ calculations based on forecasts and data from OECD Economic Outlook database. Post-Covid-19, it is assumed that interest rates in all countries converge to 1% and medium-term growth rates remain at pre-Covid-19 estimates.
Fiscal management at high altitude
The very high debt ratio will complicate fiscal management. As with high-altitude aerodynamics, debt sustainability will be much more sensitive to shocks and to policy decisions.
On the one hand, the debt-to-GDP ratio would fall faster for a given primary balance. With a higher and less stable debt ratio, it would be warranted to reduce the debt-to-GDP ratio faster than has been the norm in recent years. This would help to restore fiscal headroom and manage any future crisis.
On the other hand, unfavourable shifts in the dynamics will require much stronger policy responses. Instability will never be far away. Issuance of government debt at longer maturities helps to mitigate the immediate risk, but it cannot be completely avoided.
With high uncertainty around the Covid-19 crisis, scenario analysis provides insights on fiscal policy over the coming years. A very wide range of fiscal outcomes is possible. On balance, future budgetary consolidation requirements appear sizeable but manageable, with low interest rates central to this outcome.
The new era of high-altitude debt management will amplify risks, but—provided interest rates remain low—the debt stabilising primary balance will generally be lower. Continuing to target budget balances should, for many countries, put debt ratios on the required downward path. Indeed, reducing indebtedness at a faster rate than in recent years would be warranted.
The feasibility and desirability of the low interest rates required to generate this outcome is difficult to assess. The exercise here suggests some scope for rates to rise without destabilising fiscal policy, but stronger feedback between public debt and monetary policies is now a less distant possibility than prior to the Covid-19 crisis.
Wren-Lewis, S (2017), “Austerity as Concept and Practice“, In E Heffernan, J McHale and N Moore-Cherry (eds.), Debating Austerity in Ireland: Crisis, Experience and Recovery, pp. 17-36. Dublin: Royal Irish Academy.
1 GNI* is an indicator designed to exclude globalisation effects that disproportionally impact the size of the Irish economy.
2 This follows the logic of the standard debt snowball equation. Crudely, today’s debt depends on yesterday’s debt times the interest-growth differential. Primary surpluses further subtract from the debt ratio with primary deficits adding to it.