Fiscal policy can help keep the economy stable and protect public funds from danger

Since the start of the pandemic three years ago, fiscal policy has come a long way toward normalcy. Governments have stopped giving extra financial help, and public debt and deficits are going down from record highs. This is happening at a time when inflation is high, borrowing costs are going up, growth prospects are getting worse, and there are more financial risks.

Many countries worry about how they can pay back their debts. Due to a slowing economy and a lot of government help, public debt rose to nearly 100% of the gross domestic product in 2020. Since then, fiscal deficits have gone down as special measures taken in response to the pandemic have ended.

Last year, almost all countries trimmed both their fiscal and monetary policies. So, in the last two years, world debt fell at its fastest rate in 70 years. At the end of last year, it was 92 per cent of GDP, which was still about eight percentage points higher than what was expected before the pandemic. Primary deficits are also going down quickly and are getting close to what they were before the pandemic.

After dropping quickly in 2020, nominal GDP has gone up in many countries over the past two years, which has helped state finances. This is due to both the strong economic recovery and the unexpected rise in inflation, which caused nominal GDP growth and tax revenues to be higher than predicted.

Last year, most advanced and emerging market countries (except China) saw their debt go down by about 2 to 3 per cent of their GDP. This was mostly because inflation surprises were greater than expected. The speed at which deficits and debts were paid off depended on how quickly countries got over the pandemic and how badly they were hit by shocks afterwards. Countries that had worse energy or food crises tightened their rules more slowly. This is because the governments of those countries shared the responsibility of protecting households and companies by taking both targeted and non-targeted steps.

How inflation changes affected debt reduction depended on how much debt each country had and what kind of debt it had. Countries that started out with a lot of debt and had big price surprises and strong growth saw their debt go down by a lot. Some emerging market economies and low-income countries’ debt patterns were shaped more by exchange rate depreciation, primary deficits, and higher borrowing costs than by higher inflation. This meant that higher inflation had less of an effect on debt ratios.

Things look complicated in the short run. In a time of high inflation, tightening of credit, and a lot of debt, it should be a top priority for lawmakers to keep the fiscal policy in line with central bank policy to keep prices and finances stable.

Many countries will need to tighten their budgets to help the process of deflation, especially if high inflation stays high for a long time. If the fiscal policy were tighter, central banks would be able to raise interest rates less than they would otherwise. This would help keep government borrowing costs down and limit financial risks.

Tighter fiscal policies need better-targeted safety nets to protect the most vulnerable households, such as addressing food insecurity, while keeping total spending growth in check because governments are likely to face social pressures to make up for past increases in the cost of living.

But there are a lot of risks, so lawmakers will have to be ready to act quickly. If financial turmoil turns into a systemic disaster, the government may need to act quickly to help solve the problem. If the economy slows down a lot and unemployment goes up, governments should let automatic stabilizers work. For example, if jobless benefits go up or tax revenues go down, deficits should go up. This is especially true if inflation pressures are under control and there is fiscal space.

The most important thing is to reduce debt risks and build up economic buffers over time. Even though governments are planning to tighten their budgets slowly over the next few years, we think that the world’s public debt will rise, driven by some big advanced and emerging market economies. More generally, many countries have become more worried about their ability to pay their debts. Higher borrowing costs are also putting a strain on the public budgets of developing countries with low incomes. At least 39 countries are already in or close to debt distress.