As a result, further fiscal consolidation will be needed to stabilise debt to GDP in all the major economies bar Germany.
Given the growing reluctance to tighten further, this points to more financial repression in the form of ultra-loose monetary policy and, longer term, it also raises the risk of higher inflation. Our analysis suggests that the eurozone debt crisis is not over, with Spain looking particularly vulnerable.
Meanwhile, Japan is probably heading for insolvency unless policy is tightened significantly, exacerbating prime minister Shinzo Abe’s dilemma on whether to press ahead with the consumption tax hike in 2014.
Progress on repairing government finances is painfully slow and there are growing signs that politicians may backtrack on previous commitments. Six of our sample of 10 economies have debt above 100% of GDP, most notably the US, although four of these are in the eurozone (Greece, Ireland, Italy and Portugal). Japan completes the 100 club.
Comparing present growth with government borrowing, Germany is the only country set to reduce its debt-to-GDP ratio. At the other extreme are the peripheral euro economies of Portugal, Ireland and Greece, where deficits remain high and nominal national income is contracting.
The required fiscal consolidation needed over the medium term is about 8% to 10% of GDP. Japan also has a significant gap, given a budget deficit of close to 10% of GDP and weak income growth. The US and UK face gaps of around 3.5% of GDP.
Given current growth rates are depressed, a better metric would be to use long-run trend growth estimates. On this basis the figures improve, particularly for Italy and France, but we are still looking at a significant gap that implies serious fiscal consolidation in other eurozone economies such as Spain, Portugal, Ireland and Greece.
Adjustment in Japan is still massive at just under 8% of GDP. The US and UK are more manageable at between 2% and 3% of GDP.
A third approach would be to take account of the economic slack and assume activity will eventually return to normal levels. All budget deficits are adjusted lower on this basis. Only Japan would now seem to have a significant problem in stabilising its debt-to-GDP ratio, although both Spain and Ireland would still need further fiscal consolidation.
Given the structural headwinds, we base our assessment on the second scenario where we use trend growth to take account of the current weakness in activity but remain sceptical on the ability of economies to make significant inroads into the output gap. This suggests further fiscal consolidation is needed to stabilise debt-to-GDP ratios in the advanced economies.
One conclusion is that monetary policy will have to remain loose to facilitate fiscal consolidation by supporting growth and to keep the cost of debt service down. It is why policy is now moving toward forward guidance, the natural evolution from zero short rates and quantitative easing.
Finally, there are two region-specific conclusions: one is that despite the action of the European Central Bank and a fall in peripheral yields, the eurozone debt crisis is not resolved; second, Japan is probably going bust unless taxes are raised, indicating the dilemma over whether to raise the consumption tax in 2014 and risk weaker economic growth.
