The recent economic crisis inflicted substantial damage on the public finances of many countries around the world. Enormous stimulus programmes, bank bail-outs, increased welfare and unemployment payments, and depressed tax receipts weighed heavily on government balance sheets. To make matters worse, some countries were already running substantial deficits before the crisis hit. When fears of another great depression began to recede, news of another crisis began to emerge.
The aggregate budget deficit for the OECD is expected to be around 7.5%, but some countries have deficits that run well into the double digits. Public debt is forecast to be about 30% of GDP higher in 2011 than it was in 2007, before the crisis. Though some countries appear to be handling the fallout of the crisis better than others, growth remains subdued.
One problem is that, in today's global markets, financial difficulties, whether in large countries or even in relatively small developed countries, can affect the entire financial system. The responses also have to be international.
As in 2008, this truth was again evident in 2009, when rumblings among investors about the size of the Greek budget deficit caused uneasiness in already-fragile financial markets. By the end of 2009 all three major rating agencies had issued downgrades on Greek sovereign debt.
In the months that followed, these rumblings turned into a full-fledged crisis that eventually spread to other European countries. In spiral effect, investors, nervous about the ability of some countries to repay their public debts, charged high premiums to hold government bonds. This in turn provoked downgrades on sovereign debt ratings, which made debt even more expensive. Other European countries, including Ireland, Portugal and Spain, repeatedly found themselves having to reassure the markets that their investments were safe.
But the downgrades continued and the euro area seemed under attack, as did the stability of the euro itself. This prompted unprecedented intervention by the European Commission, the European Central Bank, EU member states and the International Monetary Fund. In the case of Ireland, a contingency loan has been agreed which effectively gives the country shelter from the bond market and a chance to put its affairs in order. Still, many economists argue that the risk of contagion is still high, and structured default should also be considered as an option in some cases.
Nor are euro area countries the only ones with burgeoning deficits. Some of the world's largest economies, including the United States, the United Kingdom and Japan-whose debt level has long been high and is projected to top an astonishing 200% of GDP in 2011-have also seen their public spending skyrocket in recent years. In fact, all OECD countries saw their fiscal positions deteriorate in 2010. The US budget deficit, which stood at 10.5% of GDP in 2010, has focused on stimulus, while also dealing with the fallout of the crisis, including a rise in long-term unemployment.
Market pressures have also prompted several large economies to announce draconian austerity plans, while others have decided to wait, worried that spending cuts in an uncertain economic climate would hurt the economy. Some economists have called for increased stimulus spending to prevent anaemic recoveries from reversing back into recession. To be sure, the recovery, where it is taking place, is fragile. But the OECD believes that governments should start reining in their budget deficits from 2011, otherwise the deficits and debt will become counterproductive. This leaves governments with difficult decisions. How can they restore public finances and promote sound economic growth at the same time? Where should they cut spending? Is it possible to preserve the quality of vital but expensive public services, such as healthcare and education, while restraining expenditure?
The OECD view is clear. What the recovery needs is for governments to restore order to public finances while enacting reforms in the structure of their economies to enable growth to take hold. These include changes to streamline administration, activate labour markets, improve competition and bolster spending on social security. It means targeting taxes that favour greener growth, and focusing spending on education, innovation, healthcare and infrastructure. And it means doing all of this while continuing to support development aid and investment in poor countries.
Striking the right balance will not be easy, and the fiscal challenge is sure to dominate the global public policy agendas in 2011.