Tuesday, March 29, 2011

Fiscal Space and Fiscal Path - How long before sovereign debt reaches crisis levels?

The Comeback America Initiative (CAI), a non-partisan, non-profit organization that is dedicated to fostering discussions around fiscal challenges and solutions.  CAI recently released the findings of its Sovereign Fiscal Responsibility Index (SFRI), a "new fiscal indicator that incorporates a wide range of fiscal, economic and political factors into ranking a country’s fiscal responsibility and sustainability."  This Index provides an insight into the fiscal sustainability of countries around the world by incorporating a wide range of important factors.  The SFRI is the result of a Master's Thesis completed by a team of Stanford University graduate students under the guidance of David Walker, former Comptroller General of the United States.  The index was created to illustrate the current fiscal standing of the United States, where it is headed and how the United States compares to other nations around the world in the area of fiscal responsibility and sustainability.

Here's a quote from one of the team members:

"For many years, people have argued that U.S. government debt is the safest investment out there. Similar arguments were used until 2008 for AAA companies and home prices. We need to understand as a country that while one cannot predict a fiscal crisis, it could be just a few years away if we do not act soon. I was stunned as our team conducted our analysis to find that in only two to three years, the U.S. overall fiscal score will be the same as Ireland or Portugal today.

On the other hand, to see the progress of Australia, New Zealand and emerging markets like Brazil and Mexico was great. Through disciplined spending and legal reforms, these countries have put themselves on solid ground. It shows that countries can change their future through political will. I hope that the United States acts before we hit a painful crisis, rather than after."

The SFRI was constructed by defining each country's sovereign debt level and how much debt that particular country could safely manage by incorporating both qualitative and quantitative metrics.  The results of the SFRI show how countries compare in fiscal responsibility and sustainability.

The SFRI defines fiscal responsibility as a measure of government controls on spending and debt level management.  Three factors are considered; a government's current debt level, the sustainability of that debt over time and the degree of transparency and accountability for their fiscal decisions.  The SFRI also considers the existence of institutions, regulations, procedures and enforcement that regulate the budget process.

Once the SFRI is derived from this information, it has three major components; fiscal space, fiscal path and fiscal governance.  For the purpose of this posting, I'm just going to look at two of these components, fiscal space since it is a really fascinating concept that I've not seen before and fiscal path.  I may post on the overall rankings of each country in the future but including that data in this posting made for a very long read.

Let’s deal with fiscal space first.  Fiscal space is basically answering the question "how much debt is too much?".  It represents the amount of additional debt that a given nation can issue before the level of debt creates a crisis, in other words, the difference between the current debt and the debt crisis level which is termed the "debt ceiling".  The concept of fiscal space is an estimate rather than a hard number since each nation's economy has varied ability to sustain high levels of debt.  The researchers used a term "weighted-average debt level" which consists of gross sovereign debt, intra-governmental debt holdings such as social security, sub-national government debt and public debt held by foreigners to level the playing field between nations so they could get a more complete look at the total amount of a country's debt.  Their overall analysis of the nations in the study show that nations should maintain a space of at least 50 percent of GDP between their debt level and their debt ceiling to reduce the risk of a fiscal crisis.  Nations such as Japan, Ireland, Portugal and Greece all have current fiscal space that is less than 50 percent of GDP.

Here is a bar graph showing the fiscal space for the nations involved in the study highlighting the 50 percent of GDP danger point:

The nations with the greatest fiscal strength in terms of fiscal space are Chile and China with space of 193.3 percent and 184.9 percent of GDP respectively.  Australia and New Zealand are also in very good shape with space of 168.2 percent and 163.6 percent of GDP respectively.  Canada comes in right in the middle of the pack with fiscal space of 106 percent of GDP.  The United Kingdom is in the bottom third with fiscal space of 90.8 percent of GDP and the United States is in the bottom quartile with fiscal space of 62.4 percent of GDP.  Nations in danger of being overwhelmed by their debt include Japan, Belgium, Ireland, Portugal, Italy, Iceland and Greece.  Many of these nations have been in the news lately because they have or will require restructuring of their sovereign debt. 

Fiscal path is simply a projection of future levels of sovereign debt for a given nation.  Nations with relatively low overall debt today but rapidly rising debt levels may be on a poorer future footing than countries that have high but very slowly rising debt.  By using projections for future government spending from the IMF, the study projects sovereign debt for each year into the future up to the year 2050 and then estimates how many years it will be before a country reaches its debt ceiling.

Here is a bar graph showing the fiscal path for the nations involved in the study:

Many nations have over 40 years of time before they hit their debt ceiling once again noting that the study only projected out to the year 2050.  The nations with the longest fiscal path are those developing nations with the fastest growing economies and those nations that have already implemented fiscal reform that limits government spending.  These include Chile, China, Sweden, Australia, India, Korea and Canada among others.  New Zealand is near the top with 38 years, the United Kingdom comes in at 27 years and the United States comes in at 16 years before these countries reach their debt ceiling.  Several nations hit their debt ceilings very soon, among them Greece (already there), Portugal and Japan both at 5 years, Ireland at 6 years, Italy at 7 years and Belgium at 8 years.

What I find particularly interesting about this study is that so much hinges on GDP growth.  Should the world hit another major economic speed bump (i.e. The Great Recession Part 2), all of these countries will have to take on additional debt in an attempt to stimulate their local economies.  The addition of debt and the coincident shrinking of national economies will work together to shorten the time before many of these nations reach their debt ceilings.

The authors of the study feel that time is of the essence, particularly for the United States.  Their analysis suggests that the United States could well be only three to five years away from a debt crisis like the one that is currently facing the PIIGS nations.  They note that tax levels within the most fiscally secure countries varies widely with Sweden having high rates and Chile having low rates meaning that national fiscal responsibility is not related to a given country's level of tax revenue, a lesson which could be learned by Washington.  Nations, particularly in Europe, where demographic changes are anticipated as baby boomers pass into their expensive years should be reducing deficits sooner rather than later to prevent long term fiscal pain.

Let's hope that at least someone in government reads this report and decides to make positive changes now before we read about additional and even more massive sovereign debt near defaults in the future.


  1. APJ:
    where do you find such interesting and relevant material?
    According to Modern Monetary Theory, the U.S. can never go broke. One of the ways to help ensure out solvency is that we have the ability to tax our citizens.
    Do you know if MMT or any other theory states a certain percentage that taxes must be to expenses?
    For example, I think, today, for every $1 of revenue, we spend $1.50. And the debt to that,and, of course, the figure is even higher (unless one discounts debt principal entirely).
    Don Levit

  2. I'm not really certain where the idea comes from that the United States cannot go broke. I've hear the theory that taxation prevents insolvency but I would think that at some point, taxation would reach the point where it would prevent economic growth and probably cause the economy to actually shrink. I think that at some level there is a breaking point - ask the Irish and the Greeks. As for your question, I don't know.

    I find this stuff on page 16 (or thereabouts) in obscure newspapers. It's funny how the mainstream media all covers the same thing and no one gets to see what's behind the news!

    Thanks Don.