The Role of Fiscal Policy When Private Debt is High
However, fiscal policy cannot do it alone; it has to be supported by complementary policies within credible frameworks.
Globally, the private sector is trillions in the red
As discussed in the recently released IMF Fiscal Monitor (IMF 2016a), global debt has reached a staggering $152 trillion and is rising. Indeed, the total borrowing of the nonfinancial sector—comprising the general government, households and nonfinancial firms—has substantially outpaced global growth in recent years and it now amounts to 225 percent of world GDP (Figure 1). Two-thirds of this debt are liabilities of the private sector which can carry great risks when they reach excessive levels. Most of the debt is concentrated in the world’s richest economies, although easy financial conditions in the aftermath of the global financial crisis have also led to a private debt boom in some emerging market economies—notably China.
The record-breaking level of private debt could be problematic for two reasons. First, when the balance sheets of household and firms are overstretched, consumption and investment dwindle as debt servicing eats up a large share of the private sector income. Strained balance sheets also tend to impair access to new secured and unsecured credit, reducing aggregate demand, especially when income is stagnant and the value of collateral is low. Second, rapid increases in private debt often end up in financial crises. In turn, financial recessions are typically longer and deeper than normal recessions and tend to bring about painful and drawn-out public debt legacies (see, for example, Jordà, Schularick, and Taylor 2016).
Thus, resolving the private debt overhang faced by many countries should be a priority but progress to-date has been mixed. The main reason is that deleveraging and low nominal growth are interacting in a vicious loop in which the latter makes deleveraging very difficult and the former dampens growth. In the process, the balance sheet of the banking sector—notably in some European countries—has weakened, further compounding these effects and inhibiting credit growth beyond what it would be desirable (IMF 2016b).
What can fiscal policy do to help out?
When households and firms find it difficult to borrow, fiscal policy can facilitate the repair of private balance sheets by expanding the amount of available credit. The purpose is not to prevent private deleveraging from happening but to ensure that it is orderly and the associated drag on output (including from disruptions to the financial system) is minimized. This is analyzed in Batini, Melina and Villa (2016, BMV hereafter), which examines a “crisis-style” event where a highly-indebted private sector undergoes a phase of forced deleveraging following a drop in asset prices. This framework explicitly accounts for the two key links between private and public indebtedness that characterize debt deflation dynamics and have played a central role in the recent financial crisis. First, through the financial accelerator, private deleveraging depresses output and prices, which in turn exacerbates the downturn and reduces government revenues. Second, public debt increases as the government lends to the private sector to meet the demand for credit, and thus mitigate the consequences of private deleveraging on output and prices.
Policy simulations with an initially moderate level of public debt show that:
- Temporary financial assistance by the government to households and firms that are financially constrained (what BMV call ‘targeted fiscal intervention’) can alleviate the recessionary impact of private sector deleveraging. By doing so, the government allows financially-constrained agents to maintain a higher spending level despite the shock to house prices, and therefore dampens the fall in aggregate demand (Figure 2, panel 1).
- In the model, for a given level of expenditure, temporary targeted interventions have larger effects on aggregate demand than alternative forms of public spending (it has larger multiplier effects). The reason is that, by stimulating credit for those private sector agents with the highest propensity to consume and government spending at the same time, this type of intervention avoids the classic crowding out effect. Other expenditures, by contrast, go toward a mix of patient and impatient agents, diluting fiscal multiplication and thus reducing the output benefits of the fiscal stimulus (Figure 2, panel 2).
- Beyond a certain level of fiscal intervention, a trade-off emerges between the output gains offered by the intervention and the future adverse impact of higher taxes from a larger fiscal cost, making targeted intervention still valuable but less effective. Therefore, the optimal level of intervention is a function of fiscal buffers (Figure 2, panel 3). The smaller these are (i.e. the higher the initial stock of public debt), the lower the optimal level of intervention.
- By stimulating aggregate demand, targeted intervention mitigates the severity of deflation, reducing also the real value of debt servicing costs. Thus, under moderate efficiency costs, the targeted intervention is associated with a lower public debt-to-GDP ratio than under no policy action (Figure 2, panel 4).
Summing up, why should the government act?
Current private debt dynamics pose risks for fiscal sustainability because historical experience shows that, when growth is lackluster like today, private debt tends to spur financial stress and, eventually, translate into higher levels of public debt. Accommodative monetary policy could help combat stagnation and stem recessions, but the effective lower bound on policy rates limits conventional monetary stimulus and unconventional tools may cause undesirable macro-financial side effects (Gaspar, Obstfeld, and Sahay 2016). Fiscal policy, on the other hand, can play an active role in reducing stagnation by alleviating the private sector’s credit constraints while allowing private deleveraging to take place. This can be achieved through targeted fiscal interventions, which can take the form, among others, of temporary loans to indebted households and firms that have cut down on consumption and investment to honor their loan obligations. The analysis discussed here shows that, if sized and targeted appropriately, this kind of intervention sustains output and inflation without adding to public debt.
Successful examples of these interventions can be found in various countries including in the aftermath of the global financial crisis, for example the United States. But experience shows their effectiveness depends in practice on their design features across four dimensions (IMF 2016a). First, fiscal targeted interventions should be used only to help viable institutions or individuals for which borrowing constraints are binding, and should include conditionality. Second, direct support measures (such as targeted subsidies, transfers and loans) are preferable over tax incentives. Third, early intervention is desirable as delaying action may make it costlier. Finally, to be effective these interventions should be supported by a strong insolvency framework and prudential and regulatory policies that, among other things, aim at efficient and equitable burden-sharing. More generally, fiscal policy cannot solve the debt problem by itself but it has to be supported by a comprehensive package including monetary, financial and structural policies.
Authors’ note: The views expressed herein are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.