>Public finances in developed countries: what is the exit strategy?

The increase in public debt registered over the last few years is without precedent (table 1). In each of the main OECD countries, public debt is not on a sustainable path1 (chart 1). This contrasts with past periods, during which emerging markets have appeared more at risk from this perspective (chart 2). The majority of developed countries will have a public debt ratio in excess of 90% in the middle of the decade.

From 2007 to 2014, according to the IMF (2010), the debt ratio in these countries is expected to rise by an average of more than 30 points of GDP, reaching an average of 110% of GDP. Of this increase, 3 points will be related to supporting the financial system (table 2), 4 points to the increased cost of debt, 10 points to automatic stabilisers, 3.5 points to budget stimulus measures and 9 points to losses of tax revenues relating to the decline in asset prices. The widening of deficits is largely structural in nature. The deficit ratio adjusted for cyclical variations is 4.4% in the eurozone out of a total deficit of 6.7 points, with 9.8 points in the UK (out of a total of 13.3 points) and 8.8 points in the US (out of a total of 10.7 points). In the past, this structural deficit has shown a strong tendency to persist.

For the time being, surplus production capacity limits the risk of public debt having a crowding-out effect on private investment. However, the public finance situation calls for credible recovery measures. While budget stimulus measures are intended to boost demand from financially constrained consumers (in their case, the classic system of budgetary multipliers takes full effect), it may for others - the majority - result in the emergence of Ricardian behaviour, i.e. growth in savings in order to cope with the increased cost of future tax increases. While the conventional crowding-out effect does not have an impact, the budget situation - contrary to the situation before the financial crisis - now affects the assessment of risks and may inflate risk premiums (chart 3). This results in a higher cost of debt, making adjustment even more difficult.

This situation could make an end to the until now observed developments characterised by rising debt with no impact on interest payments because of falling interest rates - a kind of "free lunch" (charts 4 and 5).

A high level of debt increases the probability of an interest rate or growth shock resulting in unsustainable debt, with higher debt ratios and a widening gap between the apparent real interest rate and the rate of growth. This configuration makes adjustment even more difficult and in any case presents a number of threats (snowball effect of debt). From this viewpoint, recent data clearly call for a reaction. Furthermore, as a direct consequence of the financial crisis - with an increase in the cost of capital and structural unemployment and a decline in economic activity (Furceri et al, 2009) - the potential level of GDP in the OECD region is around 3.5 points below the pre-crisis level (chart 6).

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