Committee for a Responsible Federal Budget

The Need for Reducing Sovereign Debt Risk, according to the IMF

Apr 21, 2010

With global recovery underway but still fragile, reducing government (sovereign) debt risk is important, so that global economic recovery can be sustained. The IMF elaborates on this fiscal theme in its stage-setting documents released on the eve of the spring meetings of the Fund and World Bank:

- The policy agenda for countries should include, the IMF says,

“• Reducing sovereign risk. The key task ahead is to reduce sovereign vulnerabilities. In many advanced economies, there is a pressing need to design and communicate credible medium-term fiscal consolidation strategies. These should include clear time frames to bring down gross debt-to-GDP ratios over the medium term as well as contingency measures if the deterioration in public finances is greater than expected. If macroeconomic developments proceed as expected, most advanced economies should embark on fiscal consolidation in 2011.

• Unwinding the stimulus. Given the large amount of public debt that has been accumulated during this recession, in many advanced economies stimulus exit policies need to emphasize fiscal consolidation and financial sector repair. This will allow monetary policy to remain accommodative without leading to inflation pressure or financial market instabilities. In emerging and developing economies, priorities depend on the room for maneuver on fiscal policy and on current account positions.”

- For the United States specifically, the IMF comments that fiscal policy faces a balancing act of “the need to support growth now and to secure fiscal stability over the medium term.”

“Given the present weaknesses and risks in the labor and housing markets, a case can be made for additional, targeted support to those sectors. However, given the size of U.S. fiscal imbalances, a credible plan for fiscal sustainability will need to accompany any such measures to limit the risk of rising long-term interest rates, which would dampen growth. Such a plan would also allow fiscal room to maneuver in 2011 if downside risks materialize.

When the recovery is solidly under way, fiscal consolidation should be a top priority. The medium-term fiscal outlook is daunting—under conservative assumptions about growth and interest rates and absent action, the deficit would rise to 8 percent of GDP in 2020, with the federal debt exceeding 100 percent of GDP—and significant additional adjustment would be needed to put public debt on a sustainable path. Furthermore, health care reform will be essential to bring medical costs under control. The recent progress toward reform is welcome, including signs that it may contribute modestly to medium-term deficit reduction, although the yield in terms of cost control remains uncertain. Accompanying headway in social security reform could help address entitlement spending (yielding smaller, but more predictable, gains compared with health care reform).”