Definition of Fiscal Space – The difference between the current level of public debt and the level of debt that is sustainable and manageable.
A key issue for many advanced economies is being aware of the level of government borrowing that is sustainable in the long term. Basically, how much can a government borrowing without raising the risk of default / inflation or serious fiscal crisis?
The stakes are high, if government borrowing rises to an unsustainable level, markets will be reluctant to hold government bonds. Interest rates will rise, and there could be capital flight from that country causing a collapse in confidence. To reduce an unsustainable deficit, the government is faced with several unpalatable options.
- Raise taxes and cut spending drastically. This is politically unpopular, and will also reduce Aggregate Demand, economic growth – possibly pushing the economy back into recession (which harms the fiscal position by reducing tax receipts e.t.c)
- Print Money to finance the debt. To inflate away the debt is an option, but, it will cause a loss of wealth to those who have savings, it will discourage people from investing in that country. There will be a sharp fall in the exchange rate, reducing living standards.
- Default. The government could refuse to honour its debt commitments.
What Determines the Sustainable debt level?
- Appetite for buying government debt. E.g. in a liquidity trap, individuals / financial institutions tend to be keener to buy government bonds, even at low interest rates. When the private sector offers many good investment opportunities during a boom, government bonds look relatively less attractive.
- Historical precedent. If a country has a reputation for default or inflation, markets will be less willing to buy debt at a low interest rate.
- Projected growth rates. High rates of economic growth will help reduce debt to GDP ratios. Whearas negative economic growth, can easily push debt to GDP on an ever increasing spiral.
- Are Debt Interest Payments manageable? – As debt to GDP rises, the proportion of income spent on debt interest also rises.
There is no specific figure we can use. E.g. in a recession, a country should be able to borrow a higher debt to GDP ratio than in a period of economic growth. At full employment, there will experience crowding out quicker.
What Happens if We Run Out of Fiscal Space?
- If debt is increasing at a faster rate than the government can manage, we will see a rise in interest payments as a % of GDP. Also net debt to GDP ratios will rise rapidly.
- As a country gets close to its fiscal space, markets will demand higher interest rates to compensate for the growing risk of holding government debt.
- There can be a spiral of negative confidence, and investors may start selling looking for safer investments. It could lead to a run on the currency, if a lot of debt was held by foreign investors.
- Fiscal Space – pdf working document at IMF – tough reading for A Level Students
- How much Can governments Borrow?
- Understanding government debt statistics