Fiscal Space: Special Report

economic & consumer credit AnAly tics
December 13, 2011
sPeciAl rePort
Fiscal Space
Prepared by
Mark Zandi Chief Economist +610.235.5000 Xu Cheng Senior Economist +610.235.5129 Tu Packard Senior Economist +610.235.5216
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Fiscal Space
Mark Zandi, Xu Cheng and Tu PaCkard
ore than two years after the end of the Great Recession, the global economy cannot seem to shake its effects. Advanced economies are still struggling to grow; unemployment in the U.S. and Europe remains near double digits, and Japan is stuck in a 20-year slump.
Chart 1: The Great Recession Was Very Costly sion is expected to ultimately top $2.35 U.S. federal government public debt-to-GDP ratio trillion, equal to more 120 The average federal debt-tothan 15% of GDP.2 The 100 GDP ratio since WWII is 40%. cost to taxpayers was 80 substantial but would Ratio has risen 30 percentage points in the Great Recession. have been measurably 60 greater without the 40 governments aggressive policy response, 20 as the economy would 0 have almost surely 1790 1815 1840 1865 1890 1915 1940 1965 1990 3 suffered a depression. Sources: Treasury, BEA, Moodys Analytics Europes debt problems are even to quantify. Given that governments have the more daunting. While government debt power to raise taxes and cut spending, makloads in Germany, France and Britain are ing timely debt payments is almost always a similar to those in the U.S., many nations on question of political will. Governments generEuropes periphery are having severe difficulally give debt payments a very high priority, ty managing their finances. Greece will not but there are times when debt loads increase repay all it owes, and other nations will have so much that the political will evaporates. In to take extraordinary fiscal steps to avoid democracies, a consensus can develop that reneging on their own obligations. Europes austerity is no longer worth it and people just banking system is inadequately capitalized give up, forcing leaders to give up as well. The to withstand significant losses on its soverultimate economic cost of default is likely eign debt holdings and is thus at grave risk. to be greater than the cost of the austerity The future of the euro zone and the global necessary to avoid it, but enraged voters are economy hangs in the balance. unlikely to see it that way. The risk that a national government will Argentinas sovereign default a decade not meet its full debt obligations is difficult ago was an example. Chafing under the 2 For historical comparison, the savings and loan crisis of the restrictions imposed by the International early 1990s cost some $350 billion in todays dollars: $275 Monetary Fund and other creditors, billion in direct costs plus $75 billion due to the associated recession. That was equal to about 6% of GDP at the time. Argentine leaders decided that default 3 See How the Great Recession Was Brought to an End, was the preferable option. The country Alan Blinder and Mark Zandi, July 27, 2010. http://www. economy.com/mark-zandi/default.asp had the resources to pay its debts, but
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The most serious impediment to stronger growth is arguably fiscal, as governments in advanced economies struggle with record budget deficits and burgeoning debt loads. Policymakers are attempting to strike a balance, imposing enough fiscal austerity to reassure global investors, but not so much or so quickly that they undermine nascent recoveries. This predicament came about as the economic upheavals of recent years brought long-simmering fiscal pressures to a boil. Problems stemming from aging populations and rapidly rising healthcare costs have long been anticipated, but the financial crisis and economic contraction brought the day of reckoning sooner than expected, forcing governments to borrow and spend heavily to avoid even worse outcomes. This is evident in the U.S., where the federal governments debt-to-GDP ratio has surged by some 30 percentage points in just the past four years. The current ratio of publicly traded debt to GDP is close to 65%, the highest since World War II and well above the approximately 40% average of the postwar period (see Chart 1). This reflects the impact of the recession on tax revenues and government spending and also the governments multifaceted response to the crisis.1 The total budgetary cost of the Great Reces1 The recession cost the federal government an estimated $750 billion. The governments responseincluding the TARP bailout fund, the fiscal stimulus, mortgage-related losses at Fannie Mae and Freddie Mac, and other measurescost an additional $1.6 trillion. The fiscal stimulus cost a total of $1.3 trillion.
MOODYS ANALYTICS / Special Report: Mark Zandi, Xu Cheng and Tu Packard / Copyright 2011
ANALYSIS Fiscal Space
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Argentines decided that the pecuniary and nonpecuniary costs of doing so were too great. Recent riots in Athens and other European capitals are a reminder that similar pressures are building today throughout that region. The concept of fiscal space can be used to determine how close a government is to this point of no return.4 Fiscal space is defined as the difference between a nations sovereign debt-to-GDP ratio and the limit beyond which the nation will default unless policymakers take fiscal steps that are outside of anything they have done historically.5 Identifying the debt limit is obviously important for investors in sovereign debt, but it is also important for policymakers working to find an appropriate balance between too much fiscal austerity to allow economic growth and not enough to achieve fiscal sustainability. Fiscal space and the debt limit are estimated using econometric techniques to identify how nations fiscal policies have responded historically to increases in their public debt. Nations that have aggressively managed their budgets when their debt loads have increasedbecause of recessions, financial crises, wars, natural calamities and other shockshave higher debt limits and thus more fiscal space. Canada and South Korea are examples of nations that have shown political will to address their fiscal problems. Others, such as Japan and Portugal, have shown much less resolve in managing their fiscal affairs, and thus have lower limits and less space. Fiscal space and the debt limit are also significantly affected by a countrys economic growth rate and the interest rate it pays on its sovereign debt. Not surprisingly, nations that enjoy stronger GDP growth and lower interest rates have higher limits and more fiscal space than those that do not. Stronger growth lifts tax revenues and reduces demand for government services, making it easier for a nation to escape a fiscal bind. Lower interest rates bring down the cost of financing debt. Countries such
4 The fiscal space analysis presented here is motivated by a methodology presented in Fiscal Space, Ostry et al, IMF Working Paper, September 2010. 5 The debt limit is also known as the fiscal cliff.
as Portugal and Italy are experiencing fiscal strife in large part because their economies have historically had weak growth rates. Of course, a nations fiscal situation can also affect its pace of growth and the interest rates it pays. As a nations debt-to-GDP ratio approaches the debt limit, interest rates will rise, and those higher rates will weigh on growth. There is a so-called survival interest rate, above which a nations debt load spirals out of control as the cost of servicing its debt increases more quickly than its GDP. A nations fiscal space and debt limit are not immutable. Todays policymakers could deal with fiscal problems differently than their predecessors. In a crunch, a nation may respond more aggressively than it did in the past. But the debt limit defines a key juncture beyond which a countrys historical fiscal response to rising debt becomes insufficient to maintain fiscal sustainability. Policymakers must then break with past practice or their nation will default. It is also important to note that the debt limit does not define an optimal level of public debt. Since the debt limit is the point at which a nations fiscal solvency is in jeopardy, a nations debt load should remain well below that level. If it does not, the government risks triggering rapidly rising interest rates, or even a liquidity crisis, as global investors lose faith. How close a country can get to its limit before this happens depends on investors assessments of potential fiscal shocks. These assessments are continually changing; nations that stray too close to their debt limits can quickly find it difficult to even roll over existing debt if investors turn negative, no matter the reason. Our analysis includes the current debt limits and estimated fiscal space for 30 advanced economies. Australia, Korea and Taiwan top the list of countries with the most fiscal space; for nine countries, fiscal space exceeds 200 percentage points (see Table 1). Australias survival interest rate is above 10%; that is, Australias 10-year sovereign yields would have to be consistently above 10% for the nation to be at risk of default. At the other end of the spectrum are Greece, Ireland, Italy, Portugal and Japan.
These nations have already run out of fiscal space, as their current debt loads have risen above their debt limits. This does not mean these nations will default, but it does mean that to avoid default, their policymakers cannot conduct business as usual; they must take extraordinary steps. Japans situation is so severe that it would take a negative interest rate on its debt to solve its fiscal problems. Several other European nations are also flirting with severe fiscal problems. Most notable are Spain and Belgium, but even France is at risk. These nations have close to 125 percentage points of fiscal spacea key thresholdand this is sure to shrink quickly given their already-large deficits and weakening economies. Their survival interest rates have fallen to near 7% or lower. It is no wonder that the European Central Bank has resumed purchasing large volumes of European sovereign debt. The ECB purchases are critical to ensuring that yields remain below survival rates; otherwise, the European debt crisis could quickly spiral out of control. Our analysis suggests that U.S. policymakers have some room to maneuver. With almost 170 percentage points of space and a survival 10-year Treasury yield of nearly 9%, the U.S. is still a meaningful distance away from a significant fiscal problem. This is not to say that U.S. policymakers can be complacent. Given a budget deficit equal to 8.5% of GDP in fiscal 2011 and large deficits likely for a number of years even under the most optimistic assumptions, this space will quickly narrow. Policymakers must therefore follow through on the agreement reached this past summer to increase the Treasury debt ceiling. But our analysis also suggests that while substantial austerity is necessary in the U.S., policymakers have the latitude to wait at least another year before imposing the steps needed to achieve fiscal sustainability. It is neither necessary nor desirable to do too much too quickly. After all, nothing will push the U.S. to its debt limit faster than another recession. The fiscal space methodology and results are presented in detail in this article. The results are compared with sovereign
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Table 1: Who Has Fiscal Space and Who Does Not

Fiscal space Increase in debt-to-GDP ratio, ppts South korea australia Taiwan Luxembourg new Zealand hong kong Singapore Sweden norway denmark israel Switzerland Finland u.S. netherlands Canada germany u.k. austria France Belgium iceland Spain ireland italy Portugal greece Japan
Source: Moodys Analytics
243 232 228 226 221 219 217 213
ratings from Moodys Investors Service and the expected default probabilities from credit default swaps on sovereign debt. The usefulness of the fiscal space approach is also tested by determining how accurately it would have predicted the current sovereign debt problems in the advanced economies. Because of rapidly changing economic and political events, the Moodys Analytics fiscal space analysis will be updated monthly.
Governments are generally responsible Governments are generally responsible in managi where is the change in the debt-to-GDPin managi 7.4 is the change in the where = ( ) , called the debt loadis debt-to-GDP ratio, pbt also callednominal(2) growth. and ) is a cou low and manageable, the also pb is the debtGDP loadis low ( manageable, the countrys the primary balance-to-GDP ratio, t 207 > 10 the and gt is the ratio, pb is the primary where is the change inratio,debt-to-GDPcountrys tnominal GDP balance-to 194 8.3 6 6 Because a sovereign government normally issue Governments) isgenerally responsible in managi Because areisaacountrys growthgovernment normally issue growth. countrys nominal GDP growth. ( asovereigncountrys growth-adjusted in 189 > 10 also called the debt loadis low and manageable, the determining the actual debt-to-GDP ratio movement th determining the actual debt-to-GDP ratio movement adjusted interest payments. 189 6.6 payments divided by total debt. total debt. payments divided bymanaging their fiscal Governments are generally responsible in generally responsible affairs. Wh Governments are 178 7.4 also called the debt loadis6low and manageable, government normally issue in managing their fiscal affairs. When their Because a sovereign they respond sensibly to ris debt-to-GDP ratioalso called the debt 171 8.7 determining the actual debt-to-GDP ratio movement 6 loadis low and manageable, they with different ma 163 6.7 Because a sovereign payments divided by total debt. respond government normally issues bonds sensibly to ratio deficits by should be the determining the actual debt-to-GDP rising movementtightening theireffective in 155 8.5 proverbial belts, stabilizing their debt load payments divided6.5 total debt. by 149 at a reasonable level. The large costs associ142 7.1 ated with wars, natural disasters or even 139 5.4 financial crisis may result in big increases in their debt loads, but as long as they respond 127 5.5 with fiscal discipline, they are able to stabi120 7.2 lize their financial situations. 117 > 10 However, there is a point when a 98 6.1 countrys debt-to-GDP ratio and interest no Space 6.3 payments on that debt rise so high that policymakers are tempted to give up. This no Space 4.3 can happen when the share of national no Space 4.2 income going to paying taxes has become no Space 1.6 so onerous, or cuts in government spendno Space negative interest ing have grown so severe, that further tax hikes or more cost-cutting meet stiff resistance. Governments face a Hobsons Fiscal space in theory choice: They can impose fiscal austerity, Fiscal space is defined as the difference risking unrest and their own jobs; or they between a governments actual debt and the can default and take their chances with theoretical debt limit implied by the historithe nations creditors. cal behavior of its policymakers. To deterThis dynamic is determined by the relamine a countrys debt limit and fiscal space, tionship between the governments primary we begin with a simple fact; namely, that a balance reaction function and growth-adcountry must issue debt equal to the difference between the interest payments on its 6 Because a sovereign government normally issues bonds with different maturity dates, the interest r determining the existing debt and its primary balance. The actual debt-to-GDP ratio movement should be the effective interest rate, or total interest payments divided by total debt. primary balance is the difference between
7.9
t
The fiscal space methodology and results are pr economies. Because of rapidly the U.S. to its debt limit faster than another recession. changing economic a economies. Because of rapidly changing economic a compared with sovereignmonthly.from Moodys Inve analysis will be updated ratings analysis will be updated monthly. from credit default swaps on sovereign debt. The use The fiscal space methodology and results are presented in detail in this a compared with sovereigndetermining how accurately it would have predicted ratings from Moodys Investors Service and the exp www.economy.com Fiscal space in theory economies. Because of Fiscal space in theory rapidly changing economic a from credit default swaps on sovereign debt. The usefulness of the fiscal spac analysis will have predicted the current sovereign deb be updated monthly. determining how accurately it would Fiscal space economic and political events, the a Fiscal space is defined as the difference between a economies. Because of rapidly changingis defined as the difference betweenM implied by in theory analysis will be updated implied by the historical behavior of its policymakers monthly. the historical behavior of its policymakers Fiscal space we begin with a simple fact; namely, that a country m the governments revenues and its non-debt we begin with a simple fact; namely, that a country m interest payments on its existing difference between a payments on its existing debt can servicing expenditures. This relationshipand its primary Fiscal Fiscal space in theory interest space is defined as the debt and its primary the expressed as: revenues and its of its policymakers governments be governments revenues and its non-interest expen the implied by the historical behavior non-interest expen we the difference between a governments country m survivalspace yield Fiscal 10-yr is defined as begin with a simple fact; namely, that a actual deb = (1) (1) = on interest payments , Upper limit on 10-yrthe historical behavior , its existing debt and its (1) implied by bonds, % of its policymakers. To determine a primary country the namely, that a country and issue debt equal to th we begin with a simple fact; governments revenuesmust its non-interest expen > 10 is the change a a countrys debt where is the change in a countrys debt level or d where is the change inin countrys debt level or d where interest payments on its existing debt and its primary balance. The primary bal is the primary time t, r This and PBttdebt issuance atbalance. 6is the can be rewritte PB is the primary balance. 6 This can be rewritte > 10 and or level (1) t the governments revenues and = , expenditures. This relationship its non-interest 8.0 nominal interest rate, and PBt is the primary be , = Thisthe ) , balance. ( ) rewritten in terms debt(2) level where= 6(iscanchangein a countrysof (2) or d (1) = 8.2, shares t GDP: and PBofis the primary balance. 6 This can be rewritte > 10 where is the change in the debt-to-GDP ratio, pb where is the change in the debt-to-GDP ratio, pbtt change in a countrys debt level or debt issuance at timeat, rt where is the 10.0 countrys nominal GDP growth. ( ) is a cou countrys nominal GDP growth. ( ) is cou 6 ( can be , (2) (2) and PBt is the primary balance.=This )rewritten in terms of shares of G
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Chart 2: Market Revealed Debt Limit
Chart 3: Sovereign Debt Dynamics
PB, Primary balance reaction curve PB curve proverbial belts, stabilizing their debt load at a reasonable level. ThePB, costs associated with wars, natural large disasters or even financial crisis may result in big increases in their debt loads, but as long as they respond (r-g)d (r-g)d with fiscal discipline, they are able to stabilize their belts, stabilizing their debt load at a reasonable level. The large costs associated with wars, na proverbial financial situations. Growth-adjusted Growth-adjusted disasters or even financial crisis may result in big increases in their debt loads, but as long as they respon interest curve interest curve proverbial belts, stabilizing their debtcountrysfiscal discipline, they are able to stabilize their financial natural with reasonable level. The interest payments on that wars, situations. However, there is a point when a load at a debt-to-GDP ratio andlarge costs associated withdebt rise so Fiscal disasters or even financial crisis may result up.big increases in their debt loads, but nationalas they respond space high that policymakers are tempted to give in This can happen when the share of as long income going to Debt limit with fiscal discipline, they are able to or cutsHowever, there spending have grown so severe, that further tax interest payments on that debt rise paying taxes has become so onerous, stabilize their financialis a point when a countrys debt-to-GDP ratio and in government situations. hikes or more cost-cutting meet stiff resistance. Governments face a tempted tochoice: They can impose d high that policymakers are Hobsons give up. This can happen when the share of national income going A B C Debt/GDP Debt limit Debt/GDP However, there is a unrest and a countrys debt-to-GDP ratio and onerous, their chances with the nations have grown so severe, that further fiscal austerity, risking point whentheir own jobs; or they can default and takepayments on that debt rise so paying taxes has become so interest or cuts in government spending high theirpolicymakers are temptedlevel. hikeslarge costshappen when thewars,resistance. Governments face a Hobsons choice: They can impose that debt load at a reasonable to give up. or more cost-cutting meet stiff natural lts, stabilizing Moodys Analytics The This can associated Source: share of national income going to with Moodys Analytics creditors. Source: paying taxes has become so onerous, or cuts in austerity, risking unrestthey respond jobs; or they can default ven financial crisis may result in big increases in their debt loads, but as long as have grown so severe, that further tax and take their chances with the nati fiscal government spending and their own Chart 4: Fiscal Space Can Shrink Suddenly hikes or dynamic is determined stiff resistance. Governments face a Hobsons primary balance impose scipline, theyThisable tocost-cutting meet by the situations. between the governments choice: They can reaction are more stabilize their financial relationship creditors. justed interest payment curve. interest own interest The function and growth-adjusted and theirpayment curve.pay- primary and take their chances with the nations fiscal austerity, risking unrest The primary jobs; or they can defaultbalance reaction function is represented by: 7 when a countrys debt-to-GDP ratio7 and ment curve). is determined debt rise so balance reaction function is represented by: This dynamic 8 there is a creditors. point interest payments on that by the relationship between the governments primary balance reaction PB curve PB, icymakers are tempted to give up. This can happen function and growth-adjusted interest payment curve. The primary balance reaction function is represen whenThis corresponds the share of national income going to (before) 7 by: onerous, ( , in + , (3) (3) have case in This dynamic is determined by the relationship between the governments primary has become so = +or cuts )government spending to the grown so severe,(r-g)d further tax balance reaction that which policymakfunction stiff resistance. Governments face a Hobsons choice: They can impose reaction function e cost-cutting 7meet and growth-adjusted interest payment curve. The primary balance Growth-adjusted is represented by: pbi iistheirprimary balance-to-GDPdefaultof worry their di, is ) +public the nations ratio, xi is a vector of where pb isthe primary balance-to-GDP ratioandcountry i, chances , debt-to-GDP the own jobs; or they can ra- ers take about its with = + ( (3) PB curve ty, risking unrest and (after) fundamental economic factors, which also affect the primary balance, Ai is ainterest curve country-specific constant, and tio of country i, di is its public debt-to-GDP their countrys Fiscal space public debt-to-GDP ratio, xi is a vecto No fiscal space is + ( , + , where pb is linearized to become: is xrandom element.)This reaction functionhighi be the primary balance-to-GDP ratio of country i, di is its ratio,a i = a vector of fundamental economic (3) can debt load (before) left(after) factors, by the relationship between the governments primary factors, reaction and respond by mic is determinedwhich also affect the primary bal- fundamental economic balance which also affect the primary balance, Ai is a country-specific constant, a whereAiinterest payment constant, and (4) aof country i, d functionreaction function can be is a vector of is is + primary balance-to-GDP ratioincreasingelement. This is debt-to-GDP is random taxes ance, = the + ( curve. , growth-adjustedpbi a country-specific) + The primary balance reactioni is its publicrepresented ratio,dxilinearized to become: Debt/GDP A C fundamental economic factors, which also affect imposing other is a random element. This reaction function or the primary balance, Ai is a country-specific constant, and isbe random element. Thisparameters determining linearized ofeconomic fundamentals on the primary can + where is a vector become: reaction function = bethe impactto become: austerity mea- + ( ) + , (4) can a linearized to of linear Source: Moodys Analytics ) + , + ( , balance. Based on the just-described reaction of policymakers to changes in their debt load and repeated (3) sures. The surplus = experiments, f(d is , (4) where by a cubic regression + + ( )i)+ best approximatedis aprimary of linear parameters determining the in Chartof economic fundamentals on the primar (4) ofthe vector function (see Chart 2). Also shown impact 2 is he primary balance-to-GDP ratio of country i, dcurve (balance over interest paymentais used to pay policymakers to changes thetheir debt load it repeated its public debt-to-GDP ratio, xi is vector of the growth-adjusted interest payment i is balance. Based. on the just-described reaction of But this just postpones in inevitable, for and ) which also linear parameters regression a country-specific constant, and economic where is a vector ofaffect the primary balance,down experiments,debt-to-GDPfundamentals on the primary the (see Chart 2).between factors, is a vector oflinear parameters determining debtimpact off(di) is best approximated by a cubic function future wedge Also shown in Char Ai is the and the economic ratio falls further enlarges m element.balance. Basedfunction of economiccurve and growth-adjusted interest payment curve ra- the repeated interest payments and the priThis reaction impactjust-described reactionthe policymakers to changes in their debt load and required to back to The primary the can be linearized the of growth-adjusted state debt-to-GDP ( determining the onbalance reaction funda- become: B, the steadyinterest payment curve determine the debt ) . regression experiments, f(di) is a countrys debt-to-GDPcubic function (see B and C in Chart 3; itsin Chart 2 is time, the debt-to-GDP limit. Toon the primary balance. best approximatedAs long as a lies between Chart 2). ratio shown primary Over mentals see this, suppose that Based on tio. by a ratio countrys debt-to-GDP Also mary balance. interest policymakers primary ( just-described than + + the ) + is ,greater reaction of payment curve payment) . PBA and C, it will remain interest payment curve). 8 the red arrow in Chart 3 The (the balance lies above the solvent. ratio moves along balance the growth-adjusted(4) the required interest (stays between curve reaction curve and the growth-adjusted interest payment curve determine the d see this, about their countrys high This corresponds to theload and which policymakers worry suppose that debt-to-GDP debt load and respond bound. and the debt limit its primary and ratio without to changes in their debt case in repeated limit. ToHowever, if a countrys a countrys debt-to-GDPgrows lies between B C is C in Chart 3; vector of linearThe primarydetermining bestimpact of economic so high thatthelies of the interest C, determineinterest this country.the interest payment curve parameters balance ireaction approxi- the growth-adjusted it required primary balance (the the debt the curve and ratio is fundamentals on the primary curve by increasing taxes or imposing other austerity measures. The surplus to paymentof payment over PB curve lies above The distance balance is greater than interest or fiscal cliff for regression experiments, f(d ) is right limit. To see reaction of policymakers thechangeson a pathto fallsbetween B the C in Chart 3;worry about their debt-to-GDP ratio load and respo its primary ed on the just-describedthis,function (see Chartand Alsodebt-to-GDP ratio lies case into B,and steady statebetween the currentcountrys high debt(d payment is cubic to pay down debt 2). toThis corresponds debt load and which policymakers debt-to-GDP the insolvency. From mated by a used suppose that a countrys it is in their towardback repeated C balance best approximatedrequired interest paymentChart 2). curvebalanceother austerity payment The and8 periments, f(di) Asis greater than growth-adjustedfunctiononward, thePB or imposing will remainis measures. curve). its debtthe primary balance over intere ratio. is Chartas is countrys debt-to-GDP ratio (see (the primary shown in Chartinterest in Chart 3) surplus of limit is equal to the by stays between A and C, above the 2 shown in long 2 a the the by a cubic in- increasing taxes Also lies it curve is per-solvent. This payment curve ( ) .. djusted interest corresponds to the casein which policymakers worry aboutdown countrys thecurve load and respondspace.to B, the steady state debt-to-GD payment is used to pay their debt and high debt countrys fiscal back 9 terest payment curve manently below the interest payment debt-to-GDP ratio falls by increasing if balanceimposingcurve and ratio ismeasures. a countrys the rightaof C,ratio on a pathvery important featureremain solvent. However, taxes or reaction other austerityAs the government is locked inprimary is stays between A so high that it lies to of the vicious A interest The primary a countrys debt-to-GDP ratio.and long as The surplusdebt-to-GDP itbalance overtoward and C, it will of fiscal space is payment is used and the growth-adjusted interest payment curve determinetotal interest payment curve and debt-to-GDP mary balance reaction curveto pay downthe primary balance curve is permanently belowthe debt statethat it may shrink suddenly when conditions insolvency. From C interest payment curve debt-to-GDP ratiocycle: back to B, the steady the growth-adjusted onward, debt and the debt-financing falls Required the interest ratio. As countryslocked in a vicious debt-financing between A and C, its higher than the so high that it lies scenario in Chart 4 as an stays if countrys total interest this, suppose that a long debt countrys debt-to-GDP ratiopayments, aC Required3; it will remain solvent. which Take theto the right of C, it is on a path toward the government is limit. To see this, sup- between B cycle: in Chartdebt-to-GDP ratio is change. are determine the as a debt-to-GDP ratio lies However,andwhich are already primary payments, eater than the required interestthe primary balance, insolvency. From interest rise the primary balance curve is permanently below the interest payment curve already higher than payment (theratiocurve lies abovebalance, will payment curve). because of public Suppose before the deterioration of will rise further if C onward,is issued. But 8debt example: pose that a countrys debt-to-GDP PB primary the new debt further if new However, austerity Chart worry aboutfatigue,so highBut because in canright debt-financing may even start a countrys debt-to-GDP theiris issued. is it debt load no respondgo path toward onds to theresistance to Bif policymakers3; its primarythe government highbalancetheand resistance isup and countrys economic fundamentals, the pri- which are case in whichand C in measures or fiscal ratio iscountrysthatlocked to a viciousof C, it toon aa cycle: Required total interest payments, the primary lies of public longer lies between insolvency. To avoidonward, the default,surplusausterity measures primaryfatigue, the pri-uppayment if new and is issued. But because of public Fromthan the required inter- the governmentis permanentlyover interest rise the gap in debtdebt C immediate primary already higher than the or fiscal balance,make balance curve must balance below the interest further curve g taxes or imposing other austerity measures. The of the primary issue more debt to will to decline.greater balance is sed to pay the paymentand thislocked lies above the resistance B,cycle: can measures go fiscalwedge between theare live in were as no longer in Chart 3, may even down debt (the PB curve in a vicious falls back forbalance Required debt-to-GDP may servicing. But the debt-to-GDP ratio debt-financing itthe steady state total interestfatigue, the which balance can certain as that go up and further no longer or up and est government is just postpones the inevitable,to to austerityenlarges the future payments, primary we mary 9 If the world already higher than the stays between A and C, it furthertotime, theTois issued. But because of then only the redof more debt to if the sign is the will rise will remain solvent.avoid immediate public sign g as a countrys debt-to-GDP ratioprimarythe primary decline.start avoid immediate default, ratio moves along the issue fiscal space matters:make up posi- gap in deb must required interest payments and balance, to balance. To if decline. debt-to-GDP the government the sovereign debt-to-GDP ratio will move toward the even Over new debt tive, resistance to austeritygrows without bound. C default, thelimit or postpones issue more up andit further B even if it were literally just a percentage point the may even arrow in Chart 3 and measures or fiscal fatigue,the But this just fiscal cliff the inevitable, for steady state enlarges the future wedge between is the primary balance must longer go servicing. debt government can nofor this country. The distancestart away 7 decline. To avoid which inspired our model the to A debt-to-GDP ratio is so highdefault,lies government must the gap path toward if a countrysfew other empirical studiesimmediateBehavior itshare to the right of C, itissue morethe primary balance. Overin debtmatter as long as it words,ratio moves along the re that of U.S. required interest payments a in debt servicing. up the gap from the debt limit. In other is positive. valuemore time, the debt-to-GDP the In a of fiscal debt to make up is on and debt to make space does not this assumption, including Bohn, 1998, The servicing. and Deficits, Quarterly curve Economics, arrow infor it the and grows without bound. C is the debt limit or world, cliff for this reaction curve From C onward, the primary balanceJournal of isthe inevitable,below further enlarges the future wedge between theuncertainfiscalthe primary balancecountry. The distance Chart 3 interest payment curve and realistic, 7 Public Debt But this just postpones permanently A few other empirical studies which inspired our model share this assumption, including Bohn, 1998, is shifting up red because of stochastic movements of Mendoza is a required interest payments and the primary 8 Chart Over time, the phase which dynamic analysis ent is locked113(3), 949-63; anddebt-financing2008, International balance.interest payments, diagram inare ratio moves along the and downadditive random error term, and less in a viciousSolvency: Isand Ostry, cycle: Required total 3fromversion of the debt-to-GDP economic fundamentals and Evidence on Fiscal Fiscal Policy Debt and derived equations (2) and of Economics, The Behavior of U.S. Public Responsible? Deficits, Quarterly Journal (4) by holding the 113(3), 949-63; and the the debt and interest rate constant for er than thearrow in Monetary3 and grows 1081-93. if new 7 C is fundamentalslimit or fiscal cliff over time. country. The distance higher risk. primary Chart Economics, 55(6), without bound. debt issued. But because of public this fiscal space means Journal of balance, will rise further Mendoza and Ostry, 2008, International Evidence on empirical studies Is Fiscal Policyour model share this assumption, including Bohn, 1998, A few other Fiscal Solvency: which inspired Responsible? austerity measuresof Monetary Economics, 55(6), 1081-93. no longer go up and may even start Journal or fiscal fatigue, the primary balance can The Behavior of U.S. Public Debt and Deficits, Quarterly Journal of Economics, 113(3), 949-63; and 8 o avoid immediateANALYTICS theSpecial Report: Mark Zandi, Xu in dynamicPackard / Copyright fromdebtand (4) by holding the 7 Chart 3 default, / government must issueCheng and Tu Ostry, 2008, International Evidence on Fiscal Solvency: Is Fiscal Policy Responsible? MOODYS is a version of the phase diagram more debt to make up the gap in (2) 4 Mendoza model share this assumption, including Bohn, 1998, A few other empirical studies which inspired ourand analysis derived 2011 ut this justeconomic fundamentals and interest rateJournal ofover time. Economics, the postpones the inevitable, for it further enlarges the future wedge between 55(6), 1081-93. constant Quarterly Journal of Economics, 113(3), 949-63; and The Behavior of U.S. Public Debt and Deficits, Monetary 8 rest payments and the primary balance. Over time, the debt-to-GDP ratioSolvency: Is Fiscal Policy Responsible?derived from (2) and (4) by holding the Chart 3 is a Fiscal moves along the red Mendoza and Ostry, 2008, International Evidence onversion of the phase diagram in dynamic analysis
2 3 4
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mary balance reaction curve is the solid line, and the debt limit is at C. Given the country has a debt-to-GDP ratio at d, then it still has positive fiscal space. But what if there is a deterioration in economic fundamentals that pulls down the primary balance reaction curve? The country suddenly finds that it has no fiscal space left! The new primary balance curve is now below the interest payment curve everywhere and the debt-to-GDP ratio rises out of control.
regression analysis, the following variables were ultimately determined to be most helpful in explaining changes in the primary balance-to-GDP ratio:
estimating fiscal space

The primary balance reaction function is estimated for 30 countries using a panel regression with data over the period 1985 to 2007. After testing a large number of economic and demographic variables in the
lagged values of the debt-to-GDP ratio in linear, quadratic and cubic forms; real output gap defined as the percent difference between Log real GDP and Log potential GDP. For a number of countries, potential GDP was defined as trend GDP calculated using a Hodrick-Prescott filter; real government expenditure gap defined as the difference in actual expenditures-to-GDP ratio and trend calculated using a HodrickPrescott filter;
lagged moving average of the ratio of the sum of exports and imports to GDP; projected future dependent-population ratios; and real oil price (for oil-exporting countries only).
The results of the fixed-effect regression are shown in Table 2. The R2 is 0.90, which pedagogically means that the model can explain 90% of the fluctuations in the countrys primary balances. Almost all of the coefficients reject the zero null hypothesis at a 5% significance level. The regression results are intuitive. The relationship between the primary balance and the output gap is positive. The output gap represents the difference between actual
table 2: Fixed effect regression of Primary Balance on economic Fundamentals

dependent variable: primary balance - gdP ratio Sample: 1985 to 2007 included observations: 23 Cross-sections included: 30 iMF-defined advanced economies Total pool (unbalanced) observations: 391 coefficient Lagged debt-gdP ratio Square of lagged debt-gdP ratio Cube of lagged debt-gdP ratio Output gap expenditure gap Oil-exporting country dummy * log of real oil price Lagged trade-openness index dependent-population ratio 20-year forward dependent-population ratio r-squared adjusted r-squared S.e. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Mean dependent var S.d. dependent var akaike info criterion Schwarz criterion hannan-Quinn criterion durbin-Watson statistic -0.047 0.001 0.000 0.565 -0.368 2.901 0.023 -0.929 -0.436 0.90 0.89 1.14 459.97 -586.57 82.55 0.00 1.25 3.46 3.20 3.61 3.37 1.67 std. error 0.062 0.001 0.000 0.046 0.024 0.897 0.013 0.319 0.225 t-statistic -0.755 1.912 -2.017 12.350 -15.317 3.233 1.818 -2.910 -1.943 P-value 0.451 0.057 0.045 0.000 0.000 0.001 0.070 0.004 0.053
note: due to lack of data, San Marino is the only iMF-defined advanced economy excluded from the regression. Sources: Moodys MiS, Moodys analytics, iMF economic Outlook, World Bank, Census Bureau
MOODYS ANALYTICS / Special Report: Mark Zandi, Xu Cheng and Tu Packard / Copyright 2011 5
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Chart 5: Propensity for Fiscal Prudence

Estimated fixed effect, deviation from the cross-country mean
Japan Ireland Greece Portugal Spain Italy Belgium U.K. Australia France U.S. Sweden Germany Canada Korea
Chart 6: In-Sample and Out-of-Sample Validation

Primary balance-to-GDP ratio, all developed economies, %
4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 Actual group mean Forecasted group mean 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
5 6
(Out-ofsample) (In-sample)
-10
-8
-6
-4
-2
GDP and the economys potential GDP GDP consistent with a fully employed economy and stable and low inflation. During periods of economic prosperity, when the output gap is positive and the economy is operating at or above its potential, the government will collect more in tax revenues, and government spending on unemployment insurance and other countercyclical programs will decline. The primary balance improves. In recessions, when the output gap is negative, the primary balance deteriorates. The government expenditure gap has a negative relationship with the primary balance. The expenditure gap measures actual government spending-to-GDP relative to its cyclically adjusted trend. The expenditure gap will increase because of temporary spending to finance wars and cleanup from natural disasters and man-made calamities. A higher expenditure gap results in a deterioration in the primary balance. The more open a country is to the global economy, the more likely it is that the country will be fiscally disciplined and operate with a larger primary balance. Policymakers in open economies recognize their dependence on global investors and trade, and as such have more incentive to maintain a strong balance sheet. A countrys openness is measured by the ratio of the sum of its exports and imports to GDP. Most oil-exporting countries rely heavily on revenues generated from levies on their oil industry to fund government operations. Higher oil prices thus quickly result in a better primary balance.
The age dependency ratiothe share of the population above 65 and under 15 years oldis a good proxy for the contingent liabilities that many countries are struggling with. Developed economies with aging populations need to devote an increasing amount of public resources to medical care, while emerging economies with younger populations need to invest more in education: The higher the dependency ratio the more negative the primary balance. All other national features affecting fiscal prudence such as the political structure of the country, the ideological tint of the major parties, and so on are captured by the fixed-effect term in the panel regression. The fixed effects can be loosely thought of as a measure of a countrys fiscal prudence. Not surprisingly, those countries currently experiencing sovereign debt crises are those determined by this measure to be less fiscally prudent (see Chart 5). The most fiscally prudent are also no surprise: They include South Korea, Canada, Germany and Sweden. Perhaps somewhat surprising in light of recent political acrimony, U.S. policymakers are also deemed fiscally prudent. The primary balance model performs well in both in-sample and out-of-sample validation tests (see Chart 6). The in-sample mean of fitted values of the primary balance-to-GDP ratios of all developed economies closely tracks the actual historical mean between 1997 and 2007. In the outof-sample test for the period from 2008 to 2011, the mean of the fitted values correctly reflects the sharp drop of the actual mean
during the Great Recession. When the actual mean bottoms out in 2011, the fitted mean also moves up.10
market and endogenous interest rates

A significant complication in implementing the fiscal space model is the choice of interest rate to use in calculating a countrys future interest payments. Using forecasts of market interest rates will likely overestimate a countrys fiscal space.11 That is because interest rates will rise modestly with a rising debt-to-GDP ratio when the debt-to-GDP ratio is low. But as it becomes clearer that a countrys debt-to-GDP ratio is approaching its debt limit, interest rates will increase more quickly as investors demand higher yields to compensate for increased risk of default. If it becomes clear that the country will default, interest rates spike. Using market interest rate forecasts to calculate a relatively safe countrys fiscal space thus likely overstates the countrys actual space. For instance in Chart 7, if the market interest rate is used to determine the risk of default when default risk is thought to be low (the blue curve), then the calculated debt limit is at C while the actual limit is at point A. The fiscal space is overstated by the distance between A and C. The fiscal space model deals with this problem by providing estimates of
10 In general, test results from out-of-sample validation should always be worse than that from an in-sample validation. 11 The current and future market interest rates and sovereign debt structure affect the future effective interest rates that determine a countrys future interest payments.
thoseAll other national features affecting fiscal prudence such as the political structure ofmeasure to be less countries currently experiencing sovereign debt crises are those determined by this the country, the fiscally prudent (seethe major The most fiscally prudent are also the surprise: They include South Korea, ideological tint of Chart 5). parties, and so on are captured by no fixed-effect term in the panel regression. Canada, Germany and Sweden. Perhaps somewhat surprisinga countrys recent prudence. Not surprisingly, The fixed effects can be loosely thought of as a measure of in light of fiscal political acrimony, U.S. policymakers are Fiscal Space prudent. those countries also deemed fiscally ANALYSIS currently experiencing sovereign debt crises are those determined by this measure to be less www.economy.com fiscally prudent (see Chart 5). The most fiscally prudent are also no surprise: They include South Korea, The primary balance Sweden. Perhaps somewhat in-sample in light of recent political acrimony, U.S. Canada, Germany and model performs well in both surprising and out-of-sample validation tests (see Chart 6). The in-sample mean of fitted fiscallyof the primary balance-to-GDP ratios of all developed economies policymakers are also deemed values prudent. closely tracks the actualRate Rises When End Isand 2007. In the out-of-sample test for the period Chart 7: Interest historical mean between 1997 Near Chart 8: Finding the Survival Interest Rate from The primary balance modelthe fitted valuesin both in-sample and sharp drop of the actual mean during 2008 to 2011, theActual interest mean of performs well correctly reflects the out-of-sample validation tests (see Chart Interest curve under 10 curve fitted values of the primary balance-to-GDP ratios of all moves up. economies the Great in-sample mean ofwithactual mean bottoms out in 2011, the fitted mean also developedinterest rate 6). The Recession. When the survival changing yield closely tracks the actual historical mean between 1997 and 2007. In the out-of-sample test for the period PB, PB, Interest curve from 2008 endogenous interest rates 2011, the Market and to fixed yield mean of the fitted values correctly reflects the sharp drop of the actual mean during with (r-g)d (r-g)d the Great when risk is high the actual mean bottoms out in 2011, the fitted mean also moves up. 10 Recession. When A significant complication in implementing the fiscal space model is the choice of interest rate to use in Interest curve with fixed yield when Interest curve calculatingand endogenous interest rates Market a countrys future interest payments. Using forecasts of market interest rates will likely risk is low 11 overestimate a countrys fiscal space. That is because interest rates will rise modestly with a rising debt-to- under current market rate GDPA significant complication inratio is A ratio when the debt-to-GDP implementing the fiscal spaceclearer that a choice of interest rate to use is low. But as it becomes model is the countrys debt-to-GDP ratio in B C approaching itscountrys future interest payments. Using forecasts of market interest rates will likely to rates will more quickly as investors demand higher yields calculating a debt limit, interestdebt limit increaseDebt/GDP Actual A Debt limit 11 compensate foraincreased risk of space. If it becomes clear that the country will default, interest rates debt-tooverestimate countrys fiscal default. That is because interest rates will rise modestly with a rising spike. Debt/GDP GDP ratio when the debt-to-GDP ratio is low. But as it becomes clearer Source: Moodys Analytics that a countrys debt-to-GDP ratio is Source: Moodys Analytics Using market debt limit, forecasts to will increase more quickly as investors demand higher yields approaching itsinterest rateinterest rates calculate a relatively safe countrys fiscal space thus likely to overstates the countrys actual space. For instance in Chart 7, if thethe country will rate is used to determine compensate for increased risk of default. If it becomes clear that market interest default, interest rates spike. fiscal of default when default risk is thought to be low (the blueMoreover, calculating the rate limit is at endogenous rate.12 curve), then the calculated debtcould theoretically be well into the douthe riskspace based on both forecasts of market interest rates is rate forecasts fiscalendogenous rate depends ondistance between Able digits. C while the market limitandat point A. en- to calculate ais overstated bycountrys fiscal space thus likely In reality, investors would likely space relatively safe the assumptions and C. Using actual interest so-called The dogenouslythe countrys interest rates.For instance in Chart 7, if the market interest rate is used toif interest rates got that high. These panic determine overstates determined actual space. The regarding investors expectations regarding endogenous space model default riskfrom the be low (the estimates of fiscal space countries The fiscal interest rate is derived is thought to probability of default, recovery the calculated on bothwould the risk of default when deals with this problem by providingblue curve), then rate, andbased debt limit is atsuffer a liquidity crisis long thewhile the actual limit is at point so-called endogenously determinedthe distance un- endogenous risk-free is overstated by interest rates. The A and C. forecasts of market interest rates andA. The fiscal spacerate, all of which are inherentlybetweenbefore interest rates rose to the very high C standard arbitrage condition for riskneutral investors: knowable. If the debt limit derived from the calculated survival rate. Indeed, it is assumed interest rate is derived from the standard arbitrage condition for risk-neutral investors: endogenous rate is estimates of fiscal space in our analysis The fiscal space model deals with this problem by providing greater than the market based on both that this will happen once (5) (5) rate-based limit, determined interest rates. = ( , ) forecasts of market interest rates and so-called endogenously then either the model for The market rates rise above 10%. endogenous the endogenous rate is not fully investors: It is important to note that a government interest rate is derived from the standard arbitrage condition for risk-neutral capturing where is the riskless rate of return one can reality or global is the random return of a where is the riskless rate of return one can invest in, and investors are overreacting. riskywill not immediately devolve towards default asset. 10 In general, )is the random out-of-sample validation shouldis neededbe worse than that fromthe interest rate on its debt only temporarinvest in, andtest ,results from return of a Further analysis always before determinif an in-sample = ( (5) validation. risky risk-neutral investor considering a risky government bond, the more accurate. from the asset is ing which conclusion is expected return ily rises above the survival rate. Market rates For aasset. 11 The current and future market interest rates and sovereign debt structure affect the future effective For a risk-neutral investor considering a must remain persistently above the survival 10where is the riskless ratea countrys future interest payments. random return of interestgeneral, test results fromreturn one can invest in, and should always be worse a risky asset. an in-sample rates that determine of validation is the than that from for this to happen. risky = (1 ) + ( out-of-sample survival interest rate rate (Ingovernment bond, the expected return ) 1) , (6) validation. The so-called the expected return from the from the asset is investor considering a risky government bond, survival interest rate for a asset is survival interest rate also depends on The 11For a risk-neutral The current and future market interest rates and sovereign debt structure affect the future effective country can also be derived will the fiscal the outlook where is the government bond yield, is the probability the countryfrom default, and is the for long-term inflation: The higher interest rates that determine a countrys future interest payments. recovery ) =on(1 debt)after the 1) Given , analysis. The risk-freerate is , the interestthe long-term inflation, the higher the surrate that (rate the + ( default. , (6) space , and the survival rate the high(6) vival rate. determines the debt limit can be determined usingest nominalnumerical methods. This is the endogenous This does not mean the country can nonlinear long-term sovereign interest where the rate a country can survive without getting where rt is is government bond yield, PDt interest rate.thethe government bond yield, is the probability the country will default, and is inflate its debt away; unexpected inflation can recovery rate on the debt after will default. Given trapped, in a vicious cycle rate , the interest rate bite away some debt, but once a government , and the risk-free in which its rising that is the probability the country the default, determinesthe recovery country determined using nonlinear numerical methods. This isfrom that calculated on a long-term inflation path, bond and RRt is the debt limit can be calculated using interest payments outstrip itsdiffer the serembarks The fiscal space for a rate on the debt after the market interest rate can ability to endogenous interestendogenous interest rate. The endogenous rate results are not necessarily superior to the market build this expectation into the rate. Given PD , RR , and the risk-free the default. vice its debt, ultimately resulting in a default markets will using the t t interest raterate , isparticularly whenof return onethe invest in, and is the randompolicy action. results, the riskless rate country is can deemed to risky by investors. of risky asset. rate be where the interest rate thatadetermines alreadywithout extraordinary fiscal returnTheamarket rate results when the country is rolling over The fiscal space for a country calculated using the market interest rate can differ from that calculated debt limit accurate as the collective psyche The survival interest rate is calculated by its debt. Consequently, its real debt burden may be more can be determined using nonlinear of investors incorporates the impact of a wider range of issues using the endogenous interest rate. The endogenous rate results are not necessarily superior to the market numerical particularly when a country is already deemedsovereign rates, and thusThe growth- asset rate raising to bond, the investors. the the endogenous than accounted for by a model-determinedrisky government be Moreover, calculatingmarket rate resultsis become any easier to manage. For a results,methods. This is the endogenous risk-neutral investor considering a endogenous rate. 12 risky byexpected return from the will not rate interest assumptions regarding investors of investors interest rate curve, until the interadjusted regarding the impact of a of default, of issues depends onrate.accurate as the collective psycheexpectationsincorporatesthe probability wider rangerecovery rate, may be more est curve is the debt limit (6) primary from the and )The (1 of+ model-determined endogenous rate. 12 Moreover, calculating the endogenousValidating fiscal space risk-free rate, all ) which are inherently ( accounted for by a a country1) , unknowable. If tangent to the derived balance endogenous rate = fiscal space for ( calculated than rate using thanassumptions rate-baseddiffer then either theregarding this occurs at of default, not fullyrate, curve. Chart for the endogenous A. is greaterthe market interest rate caninvestors expectationsInmodel 8, the probabilitypointrate is recovery To validate the results, the fiscal space the market regarding limit, depends on from is the or all using the endogenous capturing realitygovernment bond yield,overreacting.For countries that havewill default, and model was simulated to determine how well Further the limit needed low debt whererisk-free rate, global investors are unknowable. If the analysis isderived from the determiningrate is the and that calculatedof which are inherently is the probability debtcountry a verybefore endogenous which is greater rate. The market rate-based results interest than the endogenous rate limit, then either the , and for the endogenous , the interest rate that load and have shown a high degree of not recovery rate is more accurate.the default. Given , modelthe risk-free rate rate isfiscalfully it would have predicted the current Euroconclusion on the debt after capturing debt or global investors market which are not necessarily superior determined using nonlinear numerical methods. This is the prudence in the past, needed before determining pean sovereign debt crisis. The model was determines therealitylimit can be to the are overreacting. Further analysis is the survival interest endogenous conclusion is particularly when a country is more accurate. simulated as if we were in the middle part rate results, interest rate.interest rate Survival of the last decade, before the financial crisis already deemed to be risky by investors. The 12 In Chart 5, if we use the orange curve corresponding to market interest rate The fiscal rate results may be more accurate as the higherBdefault risk in calculation, the debit limit will would be and Great Recession. Simulations were done market interest ratefrom the actual limit A be at calculated can differ from that Survivalspace for a country calculated using The so-called survival interest rate for a country point alsothe upward bias from the fiscal space analysis. The can and be derived using the collective psyche of investors incorpoendogenous interest rate. The endogenous rate difference between A and B. This bias is superior to the using actual historical data, to isolate errors market the results are not necessarily smaller than the survival rate is the highest nominal long-term sovereign interest rate a country can survive without getting bias represented by the difference between The so-called of a wider country for a country can also bederived from the fiscal space analysis. results to the model, and forecasted ecodue solely rates particularly when a range of issues rate results,the impactsurvival interest rate is already deemed to be interest curve corresponding A and Cmarket rate The risky by investors. to a lower The from the blue trapped in a vicious cycle innominal its rising interestusinginterest rate country can survive without debt, which long-term payments outstrip its ability to service its getting survival rate is the as the collective psyche of investors risk. default nomic data. than accounted highestmodel-determined sovereign incorporates the may be moreresultingfor bydefault without extraordinary fiscal policyaaction.impact of a wider range of issues accurate in a a ultimately in vicious trapped than accountedafor by a cycle in which its rising interest paymentsMoreover, calculating the endogenous rate model-determined endogenous rate. 12 outstrip its ability to service its debt, ultimately resulting in a default extraordinary fiscal policy depends on assumptions/regarding without Zandi, Xu Cheng and Tu Packard action. investors expectations regarding the probability of default, recovery rate, MOODYS ANALYTICS / Copyright the 7 The survival interest Special Report: Mark by raising sovereign rates, and thus2011 growth-adjusted primary rate is calculated and risk-free rate, all of which are inherently unknowable. If the debt limit derived from the endogenous rate curve,The survival interest rate is calculated by raising sovereign rates, and In Chartgrowth-adjustedat point A. until the interest curve is tangent to the primary balance curve. thus the 8, this occurs primary is greater than the market rate-based limit,to the either the model for the endogenous occurs at point A. then primary balance curve. In Chart 8, this rate is not fully curve, until the interest curve is tangent
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changes or bailouts (see Table 3).13 200 To account for Greece 175 errors in economic Portugal forecasting, the 150 fiscal space model 125 was simulated unNo fiscal space 100 der the assumption 75 that the forecasts 50 were wrong to a 25 degree consistent 0 with Moodys Ana00 01 02 03 04 05 06 07 08 09 10 11 lytics current foreSource: Moodys Analytics cast errors.14 When the forecast error The results are satisfying. Greece and was one standard deviation, the fiscal space Portugal provide good examples. Under the model began signaling fiscal problems in the simulation using actual economic data, both euro zone as early as 2004. When the forebegan to run out of fiscal space in the middle cast error is a large 1.96 standard deviation, of the last decade; by 2006, they had no the model no longer signals problems in space left (see Chart 9). In other words, the 13 An important caveat to this validation test is that the prifiscal space model projected that these counmary balance response functions of many governments may tries would default unless policymakers unhave changed since the middle part of the last decade. dertook unprecedented fiscal austerity steps 14 While it would be desirable to use actual country economic forecasts made during the mid-2000s to test the fiscal space or were bailed out. Moreover, the fiscal space model, this is not possible given that the forecasts were not model strongly signaled by year-end 2007 archived. Besides, the econometric models currently being used by Moodys Analytics to produce country forecasts that Iceland, Ireland, Italy and Spain were all were developed very recently. They differ substantially from those used in the middle part of the last decade. at serious risk of default without big policy
Fiscal space with actual economic data, debt-GDP percentage
9
Chart 9: Fiscal Spaces for Greece and Portugal
Spain and Iceland, but it warns of problems in other euro zone nations as early as 2006.
Fiscal space results

Of the 30 countries included in the fiscal space analysis, five have completely run out of space based on the Moodys Analytics economic forecast and market interest rates (see Table 4). Given current events, it is no surprise that these include Greece, Ireland, Italy, Japan and Portugal. Greece has already effectively defaulted, as private investors in Greek sovereign debt are being asked to cut the value of their holdings in half. Ireland and Portugal have been bailed out, borrowing money from the European stability fund. Italy has not defaulted or been bailed out, but Italian policymakers are now working feverishly to impose fiscal austerity. It is unclear whether these efforts will be sufficient, and Italy may yet be forced to seek help from the stability fund or the International Monetary Fund. Japan has not taken any significant steps to address its long-term fiscal problems, and at the moment faces little financial pressure to do so, but the fiscal space analysis suggests it will ultimately need to take unprecedented action. Survival interest rates for these countries are very low, or in the case of Japan, negative. Somewhat surprising is Italys survival rate of just over 4%. Yields on 10-year Italian sovereign debt have briefly risen to over 7% in recent weeks and are still near 6%. According to this analysis, Italian policymakers will need to work very hard and exhibit unprecedented fiscal discipline to avoid some form of bailout or default. Belgium and Spain have some fiscal space left but have no margin for error. Much depends on these nations economic growth prospects. Fiscal space is sensitive to economic fundamentals; even a modest deterioration can quickly reduce the amount of fiscal space available. Based on historical experience, it is wise for sovereigns to maintain at least 125 percentage points of fiscal space. Both Belgium and Spain are below this threshold assuming they suffer only mild recessions, ending by the second half of next year. If the downturn is more severe
8
Table 3: earliest Warning Time for european Sovereign debt Crisis

Scenario 1 Actual economic data Scenario 2 Wrong-side 1 standard deviation Probability of equal or greater same-side mistakes = 16% greece iceland ireland italy Portugal Spain
note: The standard deviation of forecast error is estimated from available archived forecast errors for all countries forecasted by Moodys analytics. na means that the countrys sovereign risk problem is not captured in the scenario. Source: Moodys analytics
Scenario 3 Wrong-side 1.96 standard deviation Probability of equal or greater same-side mistakes = 2.5% dec-06 na dec-06 dec-06 dec-07 na
dec-05 dec-07 dec-05 dec-04 dec-06 dec-07
dec-05 dec-08 dec-05 dec-04 dec-07 dec-08
Table 4: Fiscal Space results

endogenously determined interest rate iMF Fiscal Space Moodys analytics 3.2 1.7 1.5 2.3 1.8 2.1 1.6 1.9 -0.7 4.3 2.8 1.3 3.9 0.8 1.1 2.4 1.3 3.1 1.9 0.2 232 261 88 165 196 205 175 140 211 142 185 115 104 156 201 194 224 196 175 4.6 4.3 1.5 2.8 1.6 4.5 1.8 3.1 4.7 2.8 2.0 3.9 0.7 1.5 3.0 1.6 2.8 2.1 0.4 4.4 4.1 1.5 3.4 1.8 5.0 2.1 2.5 0.0 1.7 1.8 2.4 2.2 1.9 1.3 1.9 2.4 3.0 1.3 2.6 2.2 -0.2 2.0 1.8 2.9 2.6 2.1 0.9 2.8 1.7 1.7 1.3 0.3 2.9 2.0 1.7 1.6 2.3 2.4 1.9 2.2 2.5 2.3 2.3 2.5 1.6 0.9 0.5 3.3 3.0 1.2 2.6 1.8 -0.5 1.8 1.5 2.9 2.6 1.4 2.2 3.1 1.7 2.3 1.0 1.0 3.1 1.2 2.2 1.5 2.0 3.0 3.1 2.8 iMF Moodys analytics iMF 179 90 92 136 152 147 74 104 217 84 43 155 226 152 185 251 187 161 197 197 220 187 162 202 debt Limit 5-Yr annualized growth 5-Yr annualized growth real gdP growth gdP deflator growth
Market interest rate iMF Fiscal Space 227 154 132 153 201 187 128 142 no space no space no space no space 202 84 44 155 no space no space no space no space no space no space no space no space 174 88 178 177 173 227 90 121 143 166 94 157 158 259 216 189 229 232 179 214 178 213 234 153 87 152 194 185 205 226 153 185 236 232 117 189 260 218 266 225 116 199 214 75 162 238 121 171 246 136 180 237 139 223 227 59 153 226 92 164 250 186 209 debt Limit
Long-Term Bond Yield 5-Yr Forward Ma* Moodys analytics 5.0 3.9 5.1 4.3 3.8 4.4 3.8 3.1 13.6 4.6 8.9 8.2 5.3 6.2 1.9 3.3 3.6 5.5 4.8 9.9 2.1 6.5 6.1 2.6 2.2 1.0 4.8 4.3
Moodys analytics Fiscal debt Space Limit
Moodys analytics Fiscal debt Space Limit
australia
232
254
austria
139
211
Belgium
120
215
Canada
155
239
denmark
194
239
Finland
178
228
France
127
214
germany
149
232
greece
no space no space no space no space
hong kong
219
253
iceland
117
218
ireland
israel
189
260
italy 232 164 220 209 227 245 110 227 189 238 150 153 223 231 277 241 263 177 277 270 264 256 229 252
Japan
Luxembourg
226
246
netherlands
163
228
new Zealand
221
256
norway
207
262
Portugal
Singapore
217
260
South korea
243
275
Spain
98
166
Sweden
213
249
Switzerland
189
242
Taiwan
228
267
u.k.
142
223
u.S.
171
242
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note: The results shown in this table are based on forecasts from Moodys analytics and the iMF. * Ma is moving average Sources: iMF, Moodys analytics
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table 5: Probabilities for maintaining Fiscal space over Given level

december 2011
Fiscal space Fiscal space Fiscal space Fiscal space Fiscal space Fiscal space Fiscal space Fiscal space Fiscal space >0 >25 >50 >75 >100 >125 >150 >175 >200 (Probability) (Probability) (Probability) (Probability) (Probability) (Probability) (Probability) (Probability) (Probability) australia austria Belgium Canada denmark Finland France germany greece hong kong, China iceland ireland israel italy Japan korea Luxembourg netherlands new Zealand norway Portugal Singapore Spain Sweden Switzerland Taiwan, China united kingdom united States 100 99 100 100 100 100 99 100 0 100 100 1 100 0 0 100 100 100 100 100 0 100 53 100 100 100 100 100 100 99 100 100 100 100 99 100 0 100 100 1 100 0 0 100 100 100 100 100 0 100 53 100 100 100 100 100 100 99 100 100 100 100 99 100 0 100 100 0 100 0 0 100 100 100 100 100 0 100 53 100 100 100 100 100 100 99 100 100 100 100 99 100 0 100 100 0 100 0 0 100 100 100 100 100 0 100 53 100 100 100 100 100 100 98 98 100 100 100 98 100 0 100 98 0 100 0 0 100 100 100 100 100 0 100 49 100 100 100 100 100 100 88 27 100 100 100 61 100 0 100 10 0 100 0 0 100 100 100 100 100 0 100 12 100 100 100 97 100 100 7 0 84 100 100 0 44 0 100 0 0 100 0 0 100 100 96 100 100 0 100 0 100 100 100 10 100 100 0 0 0 100 67 0 0 0 100 0 0 100 0 0 100 100 1 100 100 0 100 0 100 99 100 0 21 100 0 0 0 11 0 0 0 0 100 0 0 0 0 0 100 100 0 100 97 0 100 0 100 1 100 0 0
note: Background color blue is safe [97.5,100], yellow is cautionary [84,97.5], orange is at significant risk [16,84], red is at grave risk [0,16]. Source: Moodys analytics
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and prolonged, then what space they have will quickly evaporate. Moreover, assuming the European economy cooperates, policymakers will not have to take unprecedented fiscal policy steps, but the austerity needed will be very painful. That Spain is on very thin fiscal ice is also evident from its close to 6% survival 10-year sovereign yield. It was only a couple of weeks ago that yields were well over 6%. They are still uncomfortably high at close to 5.5%. France and the U.K. have an adequate amount of fiscal space, but policymakers in these countries must act judiciously. With more than 125 percentage points of space, these countries should be able to manage through the current crisis, but only if the European economic downturn is modest and short-lived as expected. France in particular appears vulnerable to the economic outlook. Clearly, if the euro zone were to crack even a bit, these countries would have to take unprecedented fiscal steps to avoid defaulting on their debt. The U.S. and Germany have a substantial amount of remaining fiscal space. While the U.S. has a larger budget deficit and somewhat higher debt load than Germany, its growth prospects are meaningfully stronger. U.S. real GDP growth over the next five years is forecast to be near 3% per year, while Germany is expected to grow closer to 2% per year. The U.S. survival interest rate of almost 9% is meaningfully higher than Germanys survival rate of 6.5%. This reflects both the higher growth potential in the U.S., but also higher underlying long-term inflation prospects. Despite their better fiscal positions than most other big countries, U.S. and German policymakers have no room for complacency; deficits and debt loads are still rising, and the risk that growth will fall short of expectations is uncomfortably high. Nations with the most fiscal space are for the most part smaller Scandinavian and Asian economies. Some of these nations such as Sweden and South Korea have experienced fiscal problems in the past but have learned from their experience. These nations generally also have solid economic growth prospects due in part to disciplined government finances. Survival interest rates in
these countries are generally at least in the high single digits. Countries whose fiscal space is above 125 percentage points when calculated using market interest rates have less space when the calculation is based on endogenously determined interest rates. This is consistent with our earlier reasoning. The relative calculations of fiscal space for high-risk countries are somewhat different. Some countries with no fiscal space using market interest rates have some positive fiscal space using endogenously determined rates. These results are not in the direction expected, either because the fiscal space model is not capturing all the factors being considered by global investors or because investors are overly pessimistic.
dealing with uncertainty

Since the fiscal space model is a simplified representation of reality, estimates of a countrys debt limit and fiscal space are subject to significant uncertainty. This uncertainty can be measured and accounted for in part by deriving probabilities that a country has a given amount of fiscal space.15 For example, the probability that the U.S. has more than 125 percentage points of fiscal space is close to 100% (see Table 5). That is, using Moodys Analytics economic projections for the U.S. economy and market interest rates, it is highly likely that the U.S. will solve its fiscal problems without policymakers having to take fiscal steps they have not taken historically. The U.S. has shown the political will in the past to address its fiscal problems. However, the probability that the U.S. has more than 175 percentage points of fiscal space is closer to 20%, and it is very unlikely that the U.S. has more than 200 percentage points of fiscal space. More broadly, if the probability that a country has fiscal space of the given level is greater than 97.5%, then it is deemed to be highly likely to have at least that much fiscal space. This is consistent with the 95% confidence interval commonly used in statistical analysis. Probabilities between 84% and 97.5% are considered very likely. The 84%
15 These probabilities are calculated from the distribution of the modeling error of the primary balance reaction function.
cutoff is consistent with the calculation used by banks to cover their unexpected losses under capital regulations. Banks generally keep enough capital to cover losses that are at least one standard deviation greater than expected; the losses that occur with an 84% probability assuming a normal distribution. Probabilities between 16% and 84% are considered somewhat likely, and those below 16% are termed unlikely. The probability of fiscal space is helpful in gauging how resistant a sovereign is to an unexpected shock such as a war or a financial crisis. For instance, there is a more than 97.5% probability that both Belgium and Norway have more than 100 percentage points of fiscal space. However, there is a nearly 97% probability that Norway has fiscal space of more than 200 percentage points while, the probability that Belgium has that much space is close to 0%. Norwegian sovereign debt is much safer against the fiscal fallout from adverse events. The Belgians have much less room to tolerate anything that may go wrong. Attaching probabilities to different levels of fiscal space should also be helpful to users of this analysis with different levels of risk aversion. Risk-averse regulators for instance will take solace in a country that has a higher probability of having a substantial amount of fiscal space, while an aggressive risk-taking investor may not care as much.
Fiscal space, ratings and cds-edFs

Fiscal space provides an alternative approach to evaluating prospects that a sovereign will default on its debt. Other useful approaches include ratings and implied default probabilities derived from credit default swaps, essentially insurance contracts that pay off if a debtor defaults. Fiscal space is highly correlated with ratings from Moodys Investors Service (see Table 6). All sovereigns rated Aaa have more than 125 percentage points of fiscal space; sovereigns rated Baa or less have less than 125 percentage points of space, and in most cases have already run out of space. There are also some interesting discrepancies between the fiscal space analysis and the ratings. Several Asian economies and Israel are considered very safe according to
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Table 6: Comparing Fiscal Space and Moodys investors Service ratings

december 2011
Fiscal Space Moody's eCCa korea australia Taiwan, China Luxembourg new Zealand hong kong, China Singapore Sweden norway denmark israel Switzerland Finland united States of america netherlands Canada germany united kingdom austria France Belgium iceland Spain Japan italy ireland Portugal greece 243 232 228 226 221 219 217 213 207 194 189 189 178 171 163 155 149 142 139 127 120 117 98 no space no space no space no space no space Foreign Currency rating Moody's MiS a1 aaa aa3 aaa aaa aa1 aaa aaa aaa aaa a1 aaa aaa aaa aaa aaa aaa aaa aaa aaa aa1 Baa3 a1 aa3 a2 Ba1 Ba2 Ca Outlook domestic Currency rating Moody's MiS STa STa STa STa STa POS STa STa STa STa STa STa STa neg STa STa STa STa STa STa rurneg neg STa neg neg neg dVLPg Moody's MiS a1 aaa aa3 aaa aaa aa1 aaa aaa aaa aaa a1 aaa aaa aaa aaa aaa aaa aaa aaa aaa aa1 Baa3 a1 aa3 a2 Ba1 Ba2 Ca Outlook Moody's MiS STa STa STa STa STa POS STa STa STa STa STa STa STa neg STa STa STa STa STa STa rurneg neg STa neg neg neg dVLPg
note: Background color blue is safe, yellow is cautionary, orange is at significant risk, red is at grave risk. Sources: Moodys analytics, Moodys MiS
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fiscal space, yet their ratings are meaningfully lower and imply a higher degree of risk. Conversely, the fiscal space analysis shows Italy and Japan having more serious problems than their ratings would suggest. These differences could be explained by future political developments anticipated by the rating analysts but not considered in the fiscal space analysis. An advantage of fiscal space is that it provides more granularity with respect to judging future risks. The fiscal space values are neither bounded from above nor from below. In contrast, ratings are bounded by the top grade of Aaa. Consider Norway and Austria, for example. Both are rated Aaa, but the fiscal space analysis suggests that the risks involved in investing in the debt of these two sovereigns are very different. Fiscal space and CDS-implied expected default frequencies (CDS-EDF) are also highly correlated (see Table 7). As CDS-EDF values increase, the probability of various amounts of fiscal space decline. Except for Korea and Israel, countries with close to a 100% probability of having at least 125 percentage points of fiscal space have less than a 0.1% probability of defaulting in the next year, according to the CDS-EDF. Moreover, save for Japan, those countries that have no fiscal space left have almost a 2% or greater probability of defaulting in the next several years. It is important to note that an EDF typically has a relatively short time horizon (often one year or just a few years). In contrast, the horizon considered by fiscal space analysis is much longer. For instance, if a country has a 99% probability of having no fiscal space, it does not mean that its chance of default next year is 99%. Rather, it only means that its probability of default sometime in the future assuming no extraordinary changes in fiscal policy is 99%. For this reason, despite the observed strong comovement between fiscal space and CDSEDFs, they are in general very different in terms of magnitude of values. The no-space probability should generally be greater than the short-term default probabilities implied by CDS, especially for those currently safe countries with long-term structural problems such as Japan.
There are some notable differences between fiscal space and CDS-EDFs. According to the CDS market, U.S. Treasury debt has the lowest default risk. In contrast, according to fiscal space, there are a number of other sovereigns with lower default risk than the U.S. The CDS markets evaluation of the risk of U.S. debt has actually improved since the spring, perhaps due to flight-to-quality movements stemming from the European crisis. Perhaps also, the agreement reached between Democrats and Republicans in the wake of this summers showdown over the debt ceiling is viewed as substantive. The fiscal space analysis of U.S. debt has not changed appreciably during this period. This highlights the difference between the two measures: The CDS-EDF is driven by changes in investor sentiment, while fiscal space is largely driven by changes in economic fundamentals. This was particularly helpful in identifying the troubles brewing in Greece. In late 2007, for example, the fiscal space analysis identified Greece as a significant and increasing default risk. By November, the probability that its fiscal space was more than 125 percentage points had fallen to less than 85%. The CDS-EDF for Greece at the time was still 0.01%, the lowest default frequency a country can get in the CDS-EDF universe. Because the CDS-EDF and fiscal space are derived from two completely different approaches, it is encouraging when they are both signaling the same thing. When they diverge, it is very important to ascertain why.
development plans
The fiscal space analysis presented here will be updated each month after the completion of the Moodys Analytics country economic forecasts. The results will be archived to allow for a more thorough validation of the model in the future. Any significant changes in the fiscal space results will be identified and reported to clients. The fiscal space model will also be enhanced in three key ways. First, the risk to sovereigns posed by too-big-to-fail financial institutions will be incorporated into the model. A potentially significant limitation of the current model is that the primary balance response function is not directly
impacted by the potential failure of major financial institutions. The collapse of the Irish and Icelandic banking systems is clearly a reason why the Irish government required a bailout and why Iceland defaulted. The near collapse of the U.S., U.K., and euro zone banking systems has put significant pressure on the fiscal space of these nations. CDSEDFs of systemically important financial institutions for each nation are a good proxy for this risk and will be tested in the model. The fiscal space results will also be stresstested under the range of Moodys Analytics alternative economic scenarios. Results presented in this paper assume a generally benign economic outlook, save for a modest near-term European recession. It is not difficult to construct darker economic scenarios, however, and regulators are asking their banks to formally consider such scenarios in the stress-testing process. Given how sensitive fiscal space is to changing economic fundamentals, this could be a very informative exercise. A third enhancement will be to consider the impact of the share of a sovereigns debt that is owned by foreign investors. This varies substantially across countries and could have a significant bearing on the threat of default posed by a given debt-to-GDP ratio. Japan has no fiscal space in the current fiscal analysis, but the risk may be overstated given that so much of its debt is held by Japanese citizens and institutions. This may be a reason why ratings and CDS-EDFs show much less concern about Japans fiscal situation than that implied by a fiscal space analysis.
conclusions
The global economic upheaval that began four years ago has undermined the finances of the wealthiest nations. Most developed economies continue to run large budget deficits; debt loads have increased rapidly and grown very heavy. Global investors are demanding higher interest rates to compensate for the risk of owning the debt of many of these nations. In some notable cases, investors have stopped buying altogether. While most nations have the financial wherewithal to make good on their debt obligations, they may lack the political will. History provides numerous examples of na13
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Table 7: Comparing Fiscal Space and CdS-implied edF

december 2011
Fiscal space >75 (Probability) norway u.S. Canada Finland Sweden Switzerland germany australia netherlands Singapore u.k. hong kong, China new Zealand denmark Taiwan, China Japan korea austria israel France Belgium iceland Spain italy ireland Portugal greece 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 0 100 99 100 99 100 100 53 0 0 0 0 Fiscal space >100 (Probability) 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 0 100 98 100 98 98 98 49 0 0 0 0 Fiscal space >125 (Probability) 100 100 100 100 100 100 100 100 100 100 97 100 100 100 100 0 100 88 100 61 27 10 12 0 0 0 0
CDS-I EDF 1-yr 0.03 0.03 0.04 0.05 0.05 0.05 0.06 0.07 0.08 0.08 0.08 0.08 0.08 0.09 0.08 0.13 0.16 0.21 0.23 0.23 0.45 0.52 0.75 1.08 2.19 4.43 32.07
CDS-I EDF 5-yr 0.06 0.07 0.08 0.11 0.11 0.12 0.14 0.15 0.17 0.17 0.17 0.18 0.18 0.19 0.19 0.29 0.34 0.44 0.47 0.48 0.82 0.91 1.20 1.57 2.63 4.41 23.64
note: Background color blue is safe, yellow is cautionary, orange is at significant risk, red is at grave risk. note: economies are ranked according to CdS-implied edF. Source: Moodys analytics
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tions that calculated it more desirable to short creditors than to engage in the fiscal austerity required to repay in a timely way. While these examples generally involve emerging economies, Greeces recent default signals that when under pressure, even more advanced economies can show the same political dynamics. Given the turmoil in European bond markets, investors are clearly wary. There are a number of different approaches to evaluating just how close a sovereign is to reneging on its financial obligations. Credit rating agencies have provided opinions for decades. More recently, techniques have been developed to discern what investors think the risks are as implied by the cost of buying insurance against default in the CDS market. Bond yield spreads provide similar information. Fiscal space is a different approach. Using econometric techniques, it relates fiscal poli-
cymakers historical behavior to changes in their nations debt load and to economic and demographic fundamentals. Based on forecasts of these economic fundamentals and borrowing costs, the debt limit of sovereigns can be determined. This limit does not identify at what point a sovereign will default, but it identifies at what point policymakers must act more responsibly than they have historically to avoid default. There are many limitations to the fiscal space approach, but it provides an alternative perspective that should be carefully considered. If that perspective implies something very different than a credit rating or a CDS-implied probability of default, it is important to determine why. The fiscal space analysis signals that policymakers in a number of European nations will need to take unprecedented steps, seek
bailouts, or risk default. Greece, Ireland and Portugal are already at that point, Italy and Spain are not far behind, and even Belgium and France appear at some significant risk. Global investors are not wrong to be concerned about policymakers ability to preserve the euro zone as currently structured. The U.S. has more fiscal space, but not nearly as much as it had before the financial panic and Great Recession. Moreover, just how much space it has critically depends on whether the U.S. economy is able to avoid sliding back into recession. Even another modest downturn would likely wipe out what fiscal breathing room is left. Policymakers also need to act quickly to rein in future long-term budget deficits. Unlike their European counterparts, U.S. lawmakers can still reform spending and tax policies on their own terms. That will not last much longer.
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About the Authors

Mark Zandi
Mark Zandi is chief economist of Moodys Analytics, where he directs research and consulting. Moodys Analytics, a subsidiary of Moodys Corporation, is a leading provider of economic research, data and analytical tools. Mark is the author of Financial Shock, an expos of the financial crisis. His forthcoming book, Paying the Price, provides a roadmap for meeting the nations daunting fiscal challenges. He is on the board of directors of The Reinvestment Fund, a Philadelphia nonprofit that marries public with private capital to make investments in inner cities, and MGIC, a publicly traded firm that is the nations largest private mortgage insurer. Dr. Zandi received his PhD at the University of Pennsylvania, where he did his research with Gerard Adams and Nobel laureate Lawrence Klein, and received his B.S. from the Wharton School at the University of Pennsylvania.
Xu Cheng
Xu Cheng is a senior economist at the Moodys Analytics. Xu leads the team in developing sovereign risk-related instruments and fiscal space products. He also develops and stress-tests corporate credit risk models for all North American and Western European public companies. In addition, Xu has covered the analysis of the U.S., China, Canada, and Western European and emerging Asian economies since joining Moodys in early 2008. He has led the team in developing a producer price index forecast system for all U.S. industries and played an important role in many consulting projects. Xu got his PhD from the Department of Economics at Columbia University in 1999 and was an assistant professor at University of California at Riverside. He has published in various journals and in books of Oxford University Press.
Tu Packard
Tu Packard is a senior economist at Moodys Analytics and chief editor of the World Workstation. Ms. Packard holds an M. Phil. and an M.A. in economics from Columbia University and a B.A. from Bryn Mawr College. She has published peer-reviewed papers on the international business cycle, prototype models for economies in transition, monetary policy for developing countries, external liberalization, global financial crises, country risk analysis, and early-warning indicators. She has more than 20 years of experience in international economic consulting for clients that include the United Nations, the World Bank, the Ford Foundation, business enterprises, and academic institutions.
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About Moodys Analytics

Economic & Consumer Credit Analytics
Moodys Analytics helps capital markets and credit risk management professionals worldwide respond to an evolving marketplace with condence. Through its team of economists, Moodys Analytics is a leading independent provider of data, analysis, modeling and forecasts on national and regional economies, nancial markets, and credit risk.
Moodys Analytics tracks and analyzes trends in consumer credit and spending, output and income, mortgage activity, population, central bank behavior, and prices. Our customized models, concise and timely reports, and one of the largest assembled nancial, economic and demographic databases support rms and policymakers in strategic planning, product and sales forecasting, credit risk and sensitivity management, and investment research. Our customers include multinational corporations, governments at all levels, central banks and nancial regulators, retailers, mutual funds, nancial institutions, utilities, residential and commercial real estate rms, insurance companies, and professional investors. Our web and print periodicals and special publications cover every U.S. state and metropolitan area; countries throughout Europe, Asia and the Americas; and the worlds major cities, plus the U.S. housing market and other industries. From our ofces in the U.S., the United Kingdom, and Australia, we provide up-to-the-minute reporting and analysis on the worlds major economies. Moodys Analytics added Economy.com to its portfolio in 2005. Its economics and consumer credit analytics arm is based in West Chester PA, a suburb of Philadelphia, with ofces in London and Sydney. More information is available at www.economy.com.
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economic & consumer credit AnAly tics

December 13, 2011

ANALYSIS Fiscal Space

ANALYSIS Fiscal Space

Table 1: Who Has Fiscal Space and Who Does Not

243 232 228 226 221 219 217 213

ANALYSIS Fiscal Space

Chart 2: Market Revealed Debt Limit

Chart 3: Sovereign Debt Dynamics

ANALYSIS Fiscal Space

estimating fiscal space

table 2: Fixed effect regression of Primary Balance on economic Fundamentals

ANALYSIS Fiscal Space

Chart 5: Propensity for Fiscal Prudence

Chart 6: In-Sample and Out-of-Sample Validation

Source: Moodys Analytics

market and endogenous interest rates

ANALYSIS Fiscal Space

Chart 9: Fiscal Spaces for Greece and Portugal

Fiscal space results

Table 3: earliest Warning Time for european Sovereign debt Crisis

dec-05 dec-07 dec-05 dec-04 dec-06 dec-07

dec-05 dec-08 dec-05 dec-04 dec-07 dec-08

Table 4: Fiscal Space results

Moodys analytics Fiscal debt Space Limit

Moodys analytics Fiscal debt Space Limit

ANALYSIS Fiscal Space

no space no space no space no space

no space no space no space no space

no space no space no space no space

no space no space no space no space

no space no space no space no space

no space no space no space no space

ANALYSIS Fiscal Space

table 5: Probabilities for maintaining Fiscal space over Given level

ANALYSIS Fiscal Space

dealing with uncertainty

Fiscal space, ratings and cds-edFs

ANALYSIS Fiscal Space

Table 6: Comparing Fiscal Space and Moodys investors Service ratings

ANALYSIS Fiscal Space

ANALYSIS Fiscal Space

Table 7: Comparing Fiscal Space and CdS-implied edF

ANALYSIS Fiscal Space

ANALYSIS Fiscal Space

About the Authors

About Moodys Analytics

ANALYSIS Fiscal Space

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