Update on Fiscal Policy—the “Other” Policy to Watch

13 May 2024

3 min read

Eric Winograd| Director—Developed Market Economic Research

Sandra Rhouma| European Economist—Fixed Income

Adriaan du Toit| Director—Emerging Market Economic Research; Senior Economist—Africa

Lasting fiscal deficits can exact a cost. Here’s how the situation is shaping up for the world’s economies.

Investors have seemed transfixed lately by endless news headlines on the path of monetary policy. But fiscal policy outcomes have far-reaching impacts on long-run growth and fundamentals in the world’s economies. On that score, many regions continue to wrestle with the challenges of deficits and debt.

Persistent US Deficit Poses Growth Headwinds

The US economy has exceeded all expectations over the last few years—a global standout, with fiscal policy an unusual driving force. Typically, economic cycles feature large budget deficits in bad economic times, as governments stoke demand to avoid a more sinister outcome than recession. After the recession, fiscal policy retrenches as tax revenues pick up and emergency-support programs expire.

This cycle in the US has played out a bit differently.

Demographic trends are elevating entitlement spending, and higher spending on infrastructure and other pandemic-era priorities has kept overall government outlays above pre-pandemic levels. At the same time, past tax cuts have constrained revenues. The resulting deficit is roughly 6% of gross domestic product (GDP) (Display), and that level seems set to continue for the next decade, as per Congressional Budget Office (CBO) forecasts. That’s a bigger deficit than would be expected outside of a war or recession.

The US Deficit Is Large and (Likely) Persistent

US Fiscal Deficit as Percentage of Gross Domestic Product

Past performance and current estimates do not guarantee future results.
As of March 31, 2024; estimates for 2024 and beyond
Source: Congressional Budget Office

Is the deficit supporting growth? Yes and no.

Incremental deficit change is what influences growth rates, so a stable deficit for the next several years wouldn’t meaningfully impact GDP growth. Still, the absence of a fiscal-spending pullback has played a role in the expected soft landing. The landing would likely have been harder—maybe even a recession—if fiscal policy had tightened as much as is typical post-recession. The average US budget deficit in “normal” times is around 3.5% of GDP—about 2.5% below the current run rate—which would have been a bigger drag on economic growth.

While larger deficits may have helped keep growth stable, they do come with a cost: rising debt. The ratio of Treasury debt to GDP is over 100% today and is set to rise in years ahead barring a major change in fiscal policy. We don’t think this will cause a near-term crisis, but the combination of rising debt and rising interest rates will boost the government’s debt-service ratio—the cost of repaying existing debt. That’s money that can’t be spent on more productive investments, and it may limit fiscal flexibility the next time the US economy stumbles.

Flexible Fiscal Discipline: Europe’s New Normal

European fiscal policy has helped limit the economic downturn from successive shocks, pushing the budget deficit to an average of 5.3% from 2020 to 2022. Discrepancies are sizable: Italy and France still run large deficits, while Spain and Germany are positioned much more sustainably. The overall eurozone debt/GDP ratio, declining before the pandemic, has risen to 88% and is expected to remain high.

As it stands, both the fiscal deficit and debt/GDP levels exceed limits under the Stability and Growth Pact (SGP), which are 3% and 60%, respectively. But the fiscal impulse—the impact of government spending and tax policies on economic growth—turned negative in 2023 and should stay there in 2024, as countries continue to phase out all energy-related support. Also, the SGP, which was suspended in 2020 to enable member countries to deviate from imposed fiscal constraints, has been reactivated for 2024.

Among the implications of the SGP’s reactivation is that countries planning to exceed the 3% deficit limit in 2025 risk an excessive deficit procedure (EDP) that could stoke short-term volatility. That said, the SGP’s aim is to foster fiscal discipline, and countries that trigger an EDP will be forced into steeper fiscal adjustments. However, these adjustments will likely be smoother than under previous SGP versions; they take country-specific characteristics into account, permitting a more flexible path toward fiscal targets.

Ultimately, fiscal consolidation remains the main end goal of the new SGP. The European Commission expects to pare the deficit to 2.8% of GDP in 2025; a similar trend could play out in the UK (Display), despite a potentially challenging election year. As in Europe, the UK fiscal impulse will turn negative and stay there for several years. The government must also meet fiscal rules, namely to bring down debt and deficit ratios in five years; both objectives are expected to be achieved.

So, from our perspective, the big picture for Europe’s economies seems to be a new normal, highlighted by flexible fiscal discipline.

Europe’s Deficits Converging Back Toward Pre-Pandemic Levels

Public Deficits as Percentage of Gross Domestic Product

Historical performance and current projections do not guarantee future results.
As of March 31, 2024; forecasts for 2024 and beyond
Source: Eurostat and Office for Budget Responsibility

Mixed Fiscal Progress Across Emerging Economies

Debt distress, delays in sovereign-default processes and debt dispersion have driven the narrative in emerging markets (EM) over the past few years. Aggregate government debt, excluding China’s, is projected to stabilize around current levels just below 60% of GDP—roughly 7% above the pre-pandemic level. Africa, Asia and Europe have struggled to regain solid fiscal ground in the wake of the pandemic, while Latin America and the Middle East have been relatively successful in rebuilding fiscal buffers.

Latin America’s fiscal improvements reflect prudent fiscal policy but also strong economic growth—derived in part from US exceptionalism. The Middle East’s debt dynamics improved largely because of higher oil prices. Economies more integrated with the US business cycle (or that derive large shares of revenues from oil) have been relatively successful in consolidating debt; stronger ties to Europe and China have been less helpful during this cycle.

Asia’s rising debt trajectory has been driven largely by China. An expansive view of its government debt that includes activities of local government financing vehicles, government-guided funds and special-construction funds reveals a debt surge to about 120% of GDP from around 50% a decade ago. International Monetary Fund projections call for debt growth in China to outpace debt growth in the US for the foreseeable future.

The lack of fiscal belt-tightening in the world’s two largest economies might limit downside risks to global GDP growth, but it could also crowd out EM financing. Scarcer financing sources amid an upward shift in financing needs would require even more fiscal restraint (Display).

Emerging Economies Face Higher Financing Needs

Public Gross Financing Needs as Percentage of Gross Domestic Product

Past performance and current projections do not guarantee future results.
Data are from debt sustainability analyses for 60 emerging-market economies. The emerging-market (EM) weighted average is weighted by the size of each economy in current dollar values as of 2023. China’s public gross financing needs are calculated based on the augmented debt definition, which expands the parameters of government to include the activity of local government financing vehicles, government-guided funds and special-construction funds.
As of March 31, 2024; estimates for 2023 and beyond
Source: International Monetary Fund

What might help ease the pressure? The speedy resolution of sovereign defaults is important, and the recent financial support and policy signals from multilateral agencies could also help. The use of state-contingent factors for debt restructuring and frontier markets regaining market access—could reduce medium-term financing costs if targets were met.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Eric Winograd

Eric Winograd is a Senior Vice President and Director of Developed Market Economic Research. He joined the firm in 2017. From 2010 to 2016, Winograd was the senior economist at MKP Capital Management, a US-based diversified alternatives manager. From 2008 to 2010, he was the senior macro strategist at HSBC North America. Earlier in his career, Winograd worked at the Federal Reserve Bank of New York and the World Bank. He holds a BA (cum laude) in Asian studies from Dartmouth College and an MA in international studies from the Paul H. Nitze School of Advanced International Studies. Location: New York

Sandra Rhouma

Sandra Rhouma is a Vice President and European economist on the Fixed Income team. Previously, she was a global economist and strategist at Millennium Global Investments, a London-based currency investment manager. From 2019 to 2022, Rhouma worked for the European Central Bank as a banking supervision analyst before moving into a US economist position. She holds a PhD in economics from the University of Surrey and a master’s degree from Paris 1 Panthéon-Sorbonne. Location: London

Adriaan du Toit

Adriaan du Toit is a Senior Vice President and Senior Economist for Africa. He also leads AB's team of emerging-market economists. He joined AB in 2017 as a Sub-Saharan Africa economist. Prior to joining the firm, Du Toit was a Sub-Saharan Africa currency and rates strategist and director at Citigroup in Johannesburg, where he worked from 2013 to 2017. Between 2007 and 2013, he held three roles at Standard Bank in Johannesburg (rates analyst, head of Macro Research and fixed-income strategist). Du Toit started his career in 2004 as an economist at the South African Reserve Bank. He holds a BCom (Hons) in economics and an MCom in econometrics (cum laude), both from the University of Pretoria in South Africa, and an MSc in financial economics from the University of Oxford. Location: London

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Update on Fiscal Policy—the “Other” Policy to Watch

Persistent US Deficit Poses Growth Headwinds

Flexible Fiscal Discipline: Europe’s New Normal

Mixed Fiscal Progress Across Emerging Economies

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