The fiscal side of the new normal in advanced economies – 04/01/2024 – Why? Economês in good Portuguese

As of 2021, the change in the macroeconomic policy regimes of the main advanced economies has become clear, in relation to the post-2008 global financial crisis period.

There was a shift from a deflationary trend due to chronic insufficient aggregate demand to frequent shocks from supply restrictions and an increase in inflation. This led to the end of the era of abundant and cheap central bank liquidity, resulting in higher interest rates and “quantitative tightening” by central banks.

As a consequence, concerns about possible multiple financial shocks rose. In addition to seeking to balance reducing inflation with maintaining jobs, central banks and governments are obliged to maintain vigilance over financial stability.

Macroeconomic performance reflected the increase in interest rates by central banks. In the case of the United States, growth and employment have proven resilient, while the inflation rate has fallen from the high levels it reached, more recently showing a slow downward trend.

The excess of household savings, after the extraordinary volume of government transfers associated with the pandemic, as well as the return of immigration flows and the protected situation of families with mortgages with fixed and low rates for 30 years, together with fiscal deficits, explain that resilience.

In the financial area, there was banking turmoil last year. However, not only had a large part of the corporate sector taken advantage of the available liquidity phase to extend debts at lower rates than those in force in the markets, but also the stock markets have more than recovered the sharp drop in prices experienced in 2022.

The result in terms of growth and inflation in Europe was less favorable, but in a similar direction.

In any case, inflation-adjusted interest rates are well above post-global financial crisis lows on both sides of the Atlantic, while medium-term growth remains weak.

The novelty in terms of components of the macroeconomic policy regime in advanced economies comes from the fiscal side.

The sustainability of a public debt depends on four key factors: primary balances (excesses of government revenues over expenditures, excluding interest payments), economic growth in real terms, real interest rates and the debt levels themselves.

Higher primary balances and growth help achieve debt sustainability, while higher interest rates and debt levels play in the opposite direction.

For a long time, debt dynamics remained benign as real interest rates were significantly below growth rates. This reduced the pressure for fiscal consolidation and allowed public deficits and public debt to increase without much concern. Then came the increase during the pandemic, due to large emergency support packages.

As a result, public debt as a fraction of gross domestic product has increased significantly in advanced and emerging economies. IMF estimates suggest that they should reach, respectively, 120% and 80% of GDP by 2028.

Therefore, there is a combination of:

1. lower medium-term growth rates, due to mediocre productivity growth, demographics less favorable to growth, low investments and scars from the pandemic.

2. much higher interest rates increasing the cost of servicing public debt, after the rise in debt levels since the pandemic and tax incentive packages. Even if “natural” interest rates (those at which an economy operates at its potential while inflation remains stable) return to lower levels, the long-term interest rates demanded by buyers of government bonds incorporate a risk premium that tends to rise in new circumstances.

There is a “new normal” with financing costs significantly higher than in the last decade.

If improvements in governments’ primary balances cannot be achieved to offset higher real rates and lower potential growth, sovereign debt will continue to grow.

This could also have implications for the health of the financial sector. Higher interest rates, higher levels of sovereign debt and a greater share of this debt on the banking sector’s balance sheet make the financial sector more vulnerable.

A gradual and credible rebuilding of fiscal buffers that ensure the long-term sustainability of sovereign debt will be appropriate in the “new normal” macroeconomic policy regime.

It will also be worth carrying out stress tests that consider the impacts on banks and non-bank institutions of higher sovereign interest rates, in addition to possible episodes of market illiquidity.

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