“Public and private debt should decrease to rebuild fiscal buffers”

SAFE Policy Lecture with Ludger Schuknecht from the OECD: A risk-map for fiscal-financial vulnerabilities

After the financial crisis that started in 2007, almost all industrial countries in the world increased their public debt. On average, debt was higher in 2017 than in 2007, with Germany being an exception. These fiscal developments reflected important financial sector linkages to public finances and many observers pointed to the loop between the banking crisis and public finance. For Ludger Schuknecht, Deputy Secretary-General at the Organisation for Economic Cooperation and Development (OECD), this is only the tip of the iceberg of fiscal-financial vulnerabilities. At a SAFE Policy Lecture on 4 July at the House of Finance, he talked about the linkages between the financial sector and public finance.

Schuknecht argued that there is too little knowledge about transmission and elasticities of fiscal financial risks and not much experience with market-based finance in advanced economies. His goal is, therefore, to provide a “risk map” for fiscal-financial vulnerabilities and to discuss their channels. Since the financial crisis, financial buffers were built up in the international economy and especially in the financial sector; however, at the same time, fiscal buffers declined. Risks may be underestimated and in a severe, global crisis, the buffers may not be sufficient, he warned.

Elements of transmission and risks

Schuknecht discussed five transmission channels that link the fiscal and the financial sphere.  The first transmission channel are the effects of asset prices and financing costs. Schuknecht stressed that there are important fiscal risks for government budgets from changes in financing costs and asset prices that can significantly impinge on the deficit and debt dynamics. With a very low interest rate, debt is not much of a problem, as is often argued. Schuknecht, however, showed that even a slight rise in interest rate would raise the financing needs of countries like Italy significantly. “Things can change quickly”, he said. Further, asset price effects can cause fiscal imbalances. This was the case in the financial crisis for Spain, via channels such as transaction taxes for stocks and houses, as Schuknecht explained. For example, if housing and stock markets boom, a government will get more revenue from transaction taxes because tax revenue benefits from high valuations and higher turnover. When markets plunge, these effects reverse. However, public finance is not taking asset prices into account, he said.

Indirect effects via the real economy represent the second channel, through automatic stabilizers, guarantees and growth effects. Automatic stabilizers mean that a changing economic environment affects fiscal balances, via broadly stable expenditure and rising or falling revenue. “We had a much stronger effect in the financial crisis on growth as the financial conditions would suggest,” Schuknecht said.

Countries can also experience increases in fiscal imbalances due to guarantees falling due, for example for failing Private-Public Partnerships (PPPs). This was a problem especially for Spain and Portugal which guaranteed many PPPs “These were not peanuts”, he said. Further, crises and booms can undermine long-term growth: During a boom, much capital goes into specific industries such as construction. When the boom ends, much capital and labor become redundant, affecting the potential growth negatively after the crisis.

Schuknecht also addressed a third transmission channel, which are financial obligations from bank and non-bank sector difficulties. “The costs can be huge,” Schuknecht said. In the financial crisis, buffers were very low. Until now, these buffers have increased substantially: Schuknecht pointed out that the level of Tier 1 capital has risen and also that international regulation and implementation has progressed.

According to him, non-performing loans and corporate debt are still a problem. Schuknecht showed that corporate debt is higher in several countries in 2017 compared to 2007. “From that angle, there is more risk than ten years ago”, he said. Government debt with banks also is problematic: In many countries, banks hold 20 percent or even 40 percent of government debt on their balance sheets, Schuknecht stated. He said that for some countries, the risk of a bank-government doom-loop would be significant.

The risk of central bank losses

Schuknecht also talked about the non-banking sector: He said that its size had grown enormously and disproportionately in recent decades. Of the total global debt of 200 trillion Dollar in 2017, about 100 trillion were part of the broader shadow-banking sector, Schuknecht said. According to him, after the financial crisis, the G20 countries decided to strengthen regulation of the non-bank financial sector to increase buffers and make the industry more resilient. However, progress was mostly slower than in the banking area, except for life insurances, he said. Failing asset managers, corporates, pension funds and central counterparties (CCPs) could constitute significant implicit fiscal liabilities.

The fourth channel is the risk of central bank losses. For asset purchases, the risk is with central banks, and the most important asset category is government debt. Schuknecht pointed out that in some countries, central banks hold over 20 percent of government debt. According to him, these vulnerabilities may be important and compromise central bank independence and objectives.

International linkages represent the fifth channel. According to Schuknecht, there are more interdependencies because banks and non-banks holding more international assets and because international financial support programs have become much larger over time. Through these linkages, financial problems can transmit across borders and undermine financial stability.

Schuknecht named four types of action to counter these fiscal financial vulnerabilities. First, public and private debt should decrease to rebuild fiscal buffers. Higher buffers should reduce the risk of an adverse fiscal-financial spiral with a fiscal crisis at its end. Second, financial buffers in the financial system should augment in line with the continued implementation of the G20 and national financial regulation and supervision agendas. Also, the regulatory privileges of government debt warrant change, Schuknecht said. Further, he addressed the “circuit breakers” which are national and international insurance, such as national blanket guarantees of deposits or fiscal stimulus. He argued that there are good reasons to rethink the role of these measures because they can have unintended effects and cause higher economic and fiscal costs. Another type of circuit breakers are capital controls or trading stops which, according to him, may be part of a broader public debt restructuring regime.

Ultimately, he urged for more analytical work on fiscal financial vulnerabilities. “Still, there is too little understanding of these issues,” he said.