The OECD Weighs In

The OECD recently published a great report on possible fiscal scenarios, and the results are exactly as expected: if the advanced countries of the world want to return to a sustainable growth path, they must combine medium-term fiscal consolidation with long-term structural reform. These results are based off econometric modeling the OECD has carried out in the past, extended to simulate fiscal and structural reform.

The OECD divides the world’s possible actions into three categories: inaction, a largely baseline scenario; a fiscal consolidation as soon as economically possible; and fiscal consolidation paired with long-term structural reform.  According to the OECD, a fiscal consolidation would see reduced government spending and possible tax increases with the ultimate goal of lowering the deficit to pre-crisis levels.  In the U.S, this level of sustainable debt is believed to hover somewhere around 3 percent of GDP.  On the other hand, long-term structural reform would address not just the current levels of spending and taxation, but also the long-term drivers of increasing government debt, such as population-wide demographic shifts and distortionary tax policies. The resulting numbers undeniably favor eventual consolidation followed by long-term reform.

While lone fiscal consolidation as the economy recovers over the medium-term (without longer-term strucutural reforms) does bring benefits, it is probable that many advanced nations will begin cutbacks nearly simultaneously as the economy recovers. While this is forecasted to lead to a 2 percentage point growth in medium-term global GDP, a welcome change from the currently sluggish rate, the lack of attention toward longer-term global debt imbalances would scuttle the hope for strong long-term growth. Failure to encourage consumption in surplus nations and savings in debtor nations would lead to an eventual reduction in global demand, negating the medium-term growth brought by fiscal consolidation.

However, when fiscal consolidation is paired with long-term structural reform in advanced countries, global growth and imbalances would largely be alleviated relative to both the baseline and eventual fiscal consolidation scenarios. Lower long-term interest rates paired with actions to reduce distortions in global demand would lead to a reduction of global imbalances and an increase in growth. This is truly the optimal scenario.

Growth Rate and Gross Indebtedness (Percent of GDP, 2021-2025)
  Baseline Fiscal Consolidation Fiscal and Structural Consolidation
U.S. Growth 2.3% 2.6% 2.5%
U.S. Gross Indebtedness 129% 74% 75%
OECD Growth 2.0% 2.2% 2.2%
OECD Gross Indebtedness 117% 86% 83%

Don't let the numbers from 2021-2025 confuse you; over the longer term, fiscal consolidation combined with structural reform actually yields the greatest benefits.  Due to the amount of time it takes to enact true structural reform, the 2021-2025 period doesn't capture the full effects. In the words of the OECD, fiscal consolidation alone would "only have a limited impact on external imbalances," while "concerted efforts in a number of policy domains, including fiscal consolidation... and structural reforms" will "get economies back onto the path of strong, sustainable, and balanced growth."

So how does the U.S. get there? Fiscally, the OECD recommends that governments reduce their debt-to-GDP ratios to pre-crisis levels by 2025. Structurally, the OECD sees the need for stronger market regulation (check!), the “elimination of distortionary tax incentives,” and a system by which emissions and pollution can be taxed. They estimate that undertaking these actions would boost U.S. long-term growth by 0.2 percentage points per year. reduce our deficit by 5.8 percentage points per year, lower our indebtedness by 54 percentage points, and improve our current balance by 0.7 percentage points (all relative to the do-nothing baseline). Seems like a winning plan.