In advanced economies, the difference lies in the fact that domestic wealth is more relevant in relation to GDP and is partly composed of domestic debt instruments, including government bonds. A debt restructuring or default thus has an immediate and direct impact on the value of the residents’ wealth and thus on the real economy. The larger the impact of a (partial) default on the financial and real economy of the country, the more costly a (partial) default would be, compared with the alternative of achieving the primary surplus necessary to stabilise and reduce the public debt. What is often forgotten is that the wealth effect does not depend only on the direct effects of a default or restructuring of the public debt, but also on the chain of events that would be triggered throughout the entire banking and financial system. Owing to the role of advanced economies as lenders of last resort to their own financial system, as has been confirmed by this crisis, a debt problem at the level of the state would cripple the economy as a whole. This is often ignored by those who claim that there can be such a thing as an “orderly” debt restructuring mechanism for the public debt of advanced economies. We need better analysis also in this domain. The second issue which deserves more analytical work relates to the functioning of global financial markets in allocating resources and setting relative prices in an environment in which the probability of sovereign default becomes significant and widespread.
At the latest Economic Policy Symposium held in Jackson Hole a couple of weeks ago, in a very stimulating paper, Eric Leeper set out a long list of questions that he felt should be addressed by researchers in order to fill the large knowledge gap in the field of fiscal policy and guide it closer to scientific analysis and away from its current state of alchemy. 1 Tonight I would like to add a couple of issues to that list, which are partly related to the international dimension of fiscal policy (often ignored by US academics). I will try to inspire our academic colleagues to give more thought to some issues which are key to the functioning of the global financial system and about which policy-makers often do not have sufficient understanding to inform their actions. The legacy of the financial crisis One feature of the financial crisis that has become apparent only at a relatively late stage has been the dramatic and widespread increase in public debt, especially in advanced economies. I will focus on this legacy and its implications for both the global financial system and the global economy as a whole. First, regarding the global financial system, high levels of public debt in major advanced economies are likely to have a non-negligible impact on financial market conditions over the next few years. We have seen in some cases how financial markets react to delayed fiscal consolidation, at times in a rather non-linear fashion.