Contingent liability

Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

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China: Deleveraging is Hard to Do

For the first time in nearly three decades, Moody’s recently downgraded the long-term sovereign debt of China, lowering its rating from Aa3 to A1. As is frequently true in such cases, the adjustment was overdue. Since China’s massive fiscal stimulus in 2008, the government has experienced a surge in contingent liabilities, as its (implicit and explicit) guarantees fueled an extraordinary credit boom that continues today.

While the need to foster financial discipline is obvious, the process will be precarious. Ning Zhu, the author of China’s Guaranteed Bubble, has compared the scaling back of state guarantees to defusing a bomb. China’s guarantees have distorted incentives and risk taking for so many years that stepping back and allowing market forces to operate will inevitably impose large, unanticipated losses on many people and businesses. Financial history is replete with failed policy efforts to address credit-fueled asset price booms, such as the current one in China’s real estate. There is no safe mechanism for economy-wide deleveraging.

China’s policymakers are clearly aware of the dangers they face and are making serious efforts to address them. This year, authorities have initiated a new crackdown aimed at reducing the systemic risks that have been stoked by the credit boom. This post focuses on that policy effort, including the background causes and what will be needed (aside from good fortune) to make it work....

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A Primer on Bank Capital

When a financial system is hit by unforeseen, adverse events, bank capital is the first line of defense. Capital, or net worth, is the owners’ stake in the bank. Profits and losses from a bank’s activities alter its net worth, guiding investment and risk-taking. If losses wipe out its capital, the bank becomes insolvent – its assets are inadequate to cover its fixed liabilities – and typically fails...

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