24 Nov 2009 | Economy

World Economy - Hey, Big Spender 

Governments and taxpayers in heavily indebted countries face some hard choices for the foreseeable future, warns Nigel Dudley.
 

Governments have responded to the global recession by pumping money into their economies, through quantitative easing, bringing forward the capital spending and reducing both direct and indirect taxes.

They argue that by doing so they have prevented their economies from going from recession to the sort of depression that brought the world to its knees in the early 1930s.

For those in employment and not dependent on bank lending there have been clear short-term benefits. Their tax bills are lower, mortgage payments have been cut and interest rates are at all-time lows in most of the Western world - and all this has so far had no effect on inflation.
 

Levels of deficits

There will be a price to pay for these policies. The measures to support financial institutions and other industrial sectors and the economic stimuli are, according to an International Monetary Fund report earlier this year, "having a dramatic impact on fiscal positions around the world."

Generally, those countries that entered the recession with the biggest deficits will face the biggest challenges when the global economy starts to recover. Gabriel Stein, a director at Lombard Street Research, expects the US, UK, Italy, Belgium and Greece to have the highest deficits, while Australia, Sweden, China, Taiwan and South Korea will have relatively small deficits.

Australian Treasurer Wayne Swan says that Australia has delivered a decade of strong economic performance and will have a fiscal deficit of A$53.1bn in the year to 30 June 2010. This is equivalent to 4.5 per cent of gross domestic product, the largest in Australia's history, but is less than half the level of deficits in the United States and Great Britain. Australia is also expected to deliver 0.5 per cent growth in the final quarter of this year when other economies may be struggling out of recession.
 

Mounting Debt

The contrast with the US and UK could not be more acute. "Among the G20 leading industrial and emerging market economies, the UK is seeing the biggest increase in debt. It was the 10th largest and by 2014 it is likely to be the fourth largest", says Carl Emmerson, a deputy director for the Institute for Fiscal Studies.

In the US, the Office of Management and Budget says that the US national debt will almost double over the next decade to reach almost 82 per cent of gross domestic product by 2019 - levels not seen since the Second World War.

Mounting concern over the economic (and even national security) implications of exploding US national debt is also likely to complicate any attempts by the Obama administration to embark on a second fiscal stimulus, which many economists say may prove necessary by 2011 as the effects of this year's $787bn stimulus begin to wane.

The American position encapsulates the policy dilemma facing many Western governments - that is how to balance the need for short-term stimulus and the concern about the size of the deficit that has to be repaid in the medium-term. According to the IMF, "The positive growth impact of fiscal expansion would be enhanced by the identification of clear strategies to ensure that fiscal solvency is preserved over the medium term."

The challenge is made even greater because of the increase in health care and pension costs caused by ageing populations. According to the European Commission's Ageing Report (2009), if there are no policy changes, pension, health and long-term care spending will grow by 0.5 per cent of GDP by 2015 and then by a further 1.9 per cent in total over the next 15 years across the EU.
 

Future Strategies

A return to positive growth in the next few years will help reduce some of the deficits caused by these long and short-term problems, but there is a broad consensus that these will not be enough. The IMF points out that few countries though have spelt out their medium-term strategies for dealing with these problems in adequate detail.

Stein has no doubt that once economies start to grow, tax rises are inevitable particularly in the US and UK. "Some countries like the UK have dabbled with the direct tax rates, but it is likely that VAT - or in the US, sales taxes, unless they bite the bullet and shift to a value-added tax - will have to rise. These taxes are regressive but this can be minimised, (through, for example, zero-rating of necessities) and they are an effective way of raising money. A 2.5 per cent rise in UK rates would yield up to a possible £13 to 14bn extra revenue a year," says Stein.

Failure to address the problem will mean that governments will have to pay more for their borrowings, domestic interest rates will have to rise and provision in politically sensitive areas like health care will have to be reduced. Taxpayers face either paying more taxes or receiving considerably less, particularly for areas like health care where demand is going up very fast.

Investors too, will be affected by the readiness of governments to reduce deficits. Global stock markets have boomed in recent months in anticipation of a recovery but long-term strength depends on evidence that deficits are being addressed. In the immediate future, it is difficult to escape the conclusion that countries facing high deficits and growing demands for government-funded services will enjoy considerably less fiscal freedom and flexibility than those who have borrowed less.
 

Nigel Dudley is a writer and broadcaster covering international banking, business and politics. He has written for The Daily Telegraph, Daily Mail, The European, Financial Weekly, BBC and Sky News. His specialisations are emerging markets, including the Middle East and Eastern Europe.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

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