Prudent Debt Targets and fiscal frameworks
Government debt has increased sharply in most OECD countries, raising questions about what government debt level countries should target and how fiscal frameworks should be designed to bring debt down to a prudent level.
Prudent debt targets provide the commitment tool that reassures markets and thereby diminishes risk premia not only for government debt, but also lowers the cost of capital for the whole economy. Net debt, the difference between government gross debt and assets, is relevant for solvency analysis, in particular when governments hold a sizeable amount of liquid assets. Implicit and other off-balance sheet liabilities should also be estimated and monitored to assess fiscal risks.
To define a prudent debt target, it is necessary to establish a threshold beyond which debt has adverse effects on economic activity. Debt sustainability largely depends on economic growth, the interest rate and the capacity of governments to run primary balances that ensure that the government meets its liabilities. At high debt levels, countries can lose market confidence and see their borrowing rates increase steeply.
The anchor of the prudent debt target should therefore be based on the analysis of the impact of debt on the economy. Empirical evidence shows that:
-high government debt levels are associated with lower growth though causality is probably running both ways
-the ability to stabilize the economy decreases at debt ratios beyond around 75% of GDP
-estimations find a positive but limited “optimal” government debt level at 50-80% of GDP
-government debt also provides a safe asset in a very liquid market, thus easing liquidity constraints.
The empirical cross-country evidence suggests different debt thresholds for three groups of countries: for higher-income countries (70 to 90% of GDP), for euro area countries (50 to 70%), for emerging economies (30 to 50%). These debt thresholds are used to anchor prudent debt targets which take into account uncertainties surrounding macroeconomic variables and are thus country-specific.
The fiscal framework should have two objectives: promoting fiscal discipline and permitting stabilization policies. Five complementary components of the fiscal framework are considered: a debt target, a fiscal rule, fiscal councils, budgetary processes and medium-term budgeting.
The prudent debt target should serve as the reference point to define numerical fiscal rules. Fiscal rules should be based on observable variables thus reducing uncertainties, when setting policy. A combination of a budget balance rule and an expenditure rule seems to suit most countries well. A budget balance target encourages hitting the debt target. Well-designed expenditure rules appear decisive to ensure the effectiveness of a budget balance rule and can foster long-term growth. A mandatory minimum debt reduction rule can be introduced to guarantee that measures will be taken to offset unexpected increases in the debt level.
Highly indebted countries have less potential to counteract large adverse shocks. However, stronger growth loosens the constraints on fiscal policy that aims at lowering debt to the prudent debt level.
Fiscal councils can underpin transparency and thereby fiscal discipline and the credibility of fiscal rules. The adoption of fiscal rules increases the need for transparency. The effectiveness of fiscal rules with regard to the stabilization objective is enhanced when rules embedded in a medium-term budgeting framework.