Economics Department

Governments should target prudent debt levels and fiscal rules will help get there

 

3/7/15-Governments should set prudent debt targets to ensure that public finances serve to promote economic growth and stability, according to new OECD research.

 

Prudent Debt Targets and Fiscal Frameworks assesses the effect of debt on economic activity. Taking into account various criteria, including the effectiveness of fiscal policy in pursuing counter-cyclical policy and the link between debt and the provision of public infrastructure, the OECD suggests that gross debt above about 80% of GDP has detrimental consequences for growth.

 

The report lays out a robust analytical framework for setting prudent debt targets over the medium to long run and analyses the fiscal rules that can ensure that governments meet their objectives.

 

“In large part because of sluggish growth, government debt has risen sharply during the recent crisis, to an OECD-wide average of 111% of GDP in 2013, which is the highest ratio since the aftermath of the Second World War,” OECD Chief Economist Catherine L. Mann said while launching the report during the 15th annual Rencontres Économiques d’Aix-en-Provence. “Our research has shown that such high debt levels have a negative impact on the economy. Prudent debt targets for the medium-term provide the commitment tool that can re-assure markets, diminish risk premia and, most importantly, allow the use of active fiscal policy to stabilise and grow the economy in the short term.”

 

Empirical cross-country evidence presented in the report defines the “danger zone” or turning point at which the negative effects of debt  kick in, for three groups of countries:

  • For higher-income OECD countries, a debt threshold range of 70 to 90% of GDP.
  • For euro area countries, a  debt threshold of 50-70% of GDP, which takes into account their lack of  control over monetary policy,  the no-bail-out clause, the absence of debt pooling, a higher dependency on foreign financing and difficulties in adjusting to shocks.  
  • For emerging economies, the debt threshold is even lower at 30 to 50% debt of GDP as they are exposed to capital flow reversals.

 

The OECD provides guidance on the establishment of prudent debt targets, to avoid an over-shooting of the debt thresholds in the event of large, adverse shocks, while also providing near-term fiscal space. These prudent debt targets take into account uncertainties surrounding macroeconomic variables and are thus country-specific. Prudent debt targets are on average 15 percentage points lower than debt thresholds, but with a wide variation across countries.

 

The report also provides policy recommendations on setting up a fiscal framework that promotes fiscal discipline while allowing stabilisation policies, including to reduce the likelihood of recession in the near-term. In particular, the analysis shows that the combination of a budget balance rule and an expenditure rule seems to suit most countries well.

 

“Well-designed expenditure rules appear decisive to ensure the effectiveness of budget balance rules and can simultaneously foster long-term growth,” Ms. Mann said.

 

Further information on the OECD’s new research on Prudent Debt Targets and Fiscal Frameworks is available from the OECD Media Office (+33 1 4524 9700).

 

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