Fiscal Consolidation

As governments fought the Great Recession of 2007-09 with massive spending and bail-outs, the public debts of advanced economies increased from 70 percent of GDP in 2007 to 100 percent – its highest level in 50 years.  Since debt levels above 90 percent of GDP eventually lead to crises[1], debt reduction and fiscal consolidation (FC), through spending cuts and/or tax increases, should become a priority.

A recent IMF paper[2] quantified the contractionary effects of FC, based on 30 year data of 173 episodes during which 17 advanced economies undertook budgetary measures aimed at FC.  As Chart 2 (taken from the same paper) shows, income growth drops sharply for two years and remains sluggish for five, while unemployment increases sharply over the short term and remains high over the long term.


The impact of FC on long-term unemployment (Chart 3) is particularly severe and lasting.

Splitting the economy into wages, profits and rents, the IMF finds that FC reduces the portion going to wage earners while the impact on profit and rental income (Chart 4) is less and only short term.

Politicians who promise deficit reduction, accelerating GDP growth and reduced unemployment will not be able to deliver because FC always results in lower incomes and higher unemployment.  That makes Financial Repression, with negative real interest rates and elevated rates of inflation, the most likely scenario for at least the balance of this decade.

The current correction of stock markets around the world indicates that the second part of the Great Recession is already underway.  Emerging market economies will continue to remain rather immune to these adverse developments, though they will experience more difficult export conditions and more volatile capital flows. 

Output per capita[3] 2010 2011 2012 2016
Advanced Economies 2.5 1.0 1.3 2.1
Emerging and Developing Economies 6.2 5.4 5.1 5.8

In recognition of these output numbers and of the emerging markets’ sound fiscal balances and low debt levels[4], a growing number of the more sophisticated institutional investors are increasing their portfolio exposure to both emerging market debt and equity.

In his recent article in the Globe and Mail[5], Grant Robertson noted:  “that ultra-conservative pension funds and other institutional investors are looking to buy corporate debt in some burgeoning [emerging] markets to provide a more attractive haven – and more dependable returns – than in developed countries.”  The positive feedback to the Cordiant Emerging Loan Fund IV that we are receiving confirms his observation.

 October 2011 

[1] Reinhart & Rogoff, This Time is Different, NBER, March 2008

[2] Painful Medicine, Finance and Development, IMF, September 2011

[3] ‘Slowing Growth, Rising Risks,’ World Economic Outlook, IMF, September 2011, page 178

[4] My September 2011 memo ‘The Case for Emerging Market Debt’

[5] ‘The global economy turns upside down, Globe and Mail, September 16, 2011