There are a number of challenges we face in coming years which are likely to put enormous pressures on the public finances of governments virtually everywhere. Some of these challenges are of a demographic nature and have to do with the aging of populations. The share of the population accounted for by the elderly will rise rapidly in most of the developed countries in the next couple of decades. The dependency ratio, or the total number of persons requiring some form of support divided by the working-age population, will increase to levels not seen before in most of these countries. Indeed, this trend will not be limited to the developed countries—with a lag with respect to the rich countries of North America, Europe and Asia, emerging markets such as China, Russia, Poland, Indonesia, Turkey and Mexico will also see the graying of their populations as a result of increases in life expectancy. The rich countries of the OECD have extensive social safety nets in place and have guaranteed public pensions, health care and other social benefits. These programs are costly to run and the costs are projected to increase rapidly over the next several decades. Indeed, in the absence of corrective measures, virtually all of the industrial countries will face considerably higher expenditure ratios, putting pressures on budget deficits or necessitating increases in taxes and/or potentially large increases in the retirement age. The fiscal implications for some of these countries (e.g., Greece, Italy, Japan) are sufficiently dire as to suggest that extraordinary fiscal effort will be necessary to restore sustainability.
A particularly worrying feature of these demographic trends is that, with few exceptions, governments have typically found it extremely difficult to introduce the reforms that are needed to ensure longer-term financial sustainability. Social programs such as guaranteed pensions were introduced decades ago at a time when life expectancy was much lower and the working-age population was growing. In time, they have come to be accepted as permanent features of the social landscape, entitlements the value of which must be preserved at all costs or, preferably, increased. With a rise in average life expectancy between 1960 and 2007 from 43 to 66 years the long-term fiscal positions of many developed countries have been overwhelmed. Furthermore, the political economy of reforms works in a way that rewards governments that manifest a nearly exclusive concern with the short-term. As noted by Peter Heller (2004) “the temptation is strong to leave tomorrow’s problems for tomorrow’s policymakers to solve, since it is they who will have to answer to tomorrow’s voters.” Or, as was once put by a senior finance official from Sweden: “the future has no lobbyists.”
This, in turn, explains why only a handful of countries frame their budgets in a medium-term perspective, looking at the next 3-5 years, though future budgetary resources are precommitted to an extent likely to severely reduce in the future the room for maneuver for government fiscal policies. It requires a high degree of political maturity and no small amounts of administrative capacity to give adequate attention to problems the full impact of which will not be felt for another decade or two. Indeed, the more serious the short-term challenges faced by governments—let us think of the 2008-2009 global financial crisis and the intimidating series of onerous problems it created for governments virtually everywhere—the less attention given to longer-term issues, such as the fiscal implications of population aging. The increases in public debt which the response to the crisis precipitated have only worsened the nature of the longer-term fiscal challenges we face, because of the additional claims on public resources, many of them in the nature of contingent liabilities arising from various guarantees and central bank support operations. Governments provided guarantees for a broad spectrum of financial sector liabilities, from bank deposits, to interbank loans and bonds; for some countries these are huge: close to 200 percent of GDP in the case of Ireland, 50 percent of GDP in the case of the United Kingdom, to name two of the more serious cases. The aggregate amount comes to close to US$4 trillion.
Indeed, aging populations is not by any means the only challenge which is likely to place an onerous burden on countries’ public finances. Over the past decade there has been a noticeable convergence of views within the scientific community about the expected rise in global average temperatures associated with increases in the concentration of greenhouse gases—climate change will be a feature of the global environment in the decades ahead. In the summer of 2010 we witnessed simultaneously forest fires and the hottest summer on record in Russia, floods in Pakistan which upended the lives of some 20 million people (leaving some 5 million of them homeless) and fatal mudslides in China precipitated by torrential rains. Extreme weather conditions are expected to be more frequent and governments may increasingly find themselves having to deal with the financial consequences. In Russia, the losses of millions of hectares of wheat and thousands of lives and homes will require significant outlays, partly to lend assistance to those affected, but also to invest in infrastructure and equipment and to take other preventive measures to stem future damage. In Pakistan the floods submerged 7 million hectares of cropland, killing more than 200,000 head of livestock and, according to press reports, “washing away huge stores of commodities that would have fed millions.”
The impact of global warming is expected to be felt with particular intensity in the developing world, because these countries tend to be located in the tropics and equatorial regions, their economies are most heavily dependant on agriculture and many of their cities are to be found in coastal areas. Furthermore, being relatively poor, they will have fewer resources for precautionary interventions or be generally less able to respond to climate-related damage. Increases in sea levels could well require heavy investments in infrastructure (e.g. sea barriers) or, as many regions become drier, outlays for irrigation networks and other investments to deal with emerging water scarcity. In some cases it may be necessary to resettle populations no longer able to live in low lying areas; roughly 1.2 billion people live within 100 km of the shore. The impact—particularly the fiscal consequences—of climate change may be subject to a larger margin of uncertainty than the consequences of population aging, the main parameters of which have been fixed for decades and are subject to relatively small margins of error. Few scientists could claim with certainty that the floods in Pakistan or the fires in Russia were caused by global warming, but few would question that, with global average temperatures rising—the incidence of extreme weather conditions has indeed increased.
In addition to the likely pressures on public spending to deal with the consequences of climate change, one would also expect that to the extent that weather-related catastrophes put a dent on economic growth (the losses of the wheat harvest in Russia are thought to have taken at least one percentage point off economic growth in 2010), there will be adverse repercussions for government revenue as well, putting additional pressures on budget deficits. Finally, there may be other effects as well which are difficult to quantify but which could also have fiscal repercussions. One that comes to mind is rising food prices because of reductions in the area of arable land and the depletion of fish stocks, both of which put pressure on governments to sustain or increase food subsidies for vulnerable groups in the population.
In a sense the potential repercussions for the public finances of climate change are more worrying than those associated with population aging because the margins of uncertainty are that much larger. Governments are generally aware that pension and healthcare claims will rise as the baby-boom generation retires and fertility rates remain below replacement levels, and they also have a fairly good sense of what needs to be done to set the public finances on a more sustainable path. The choices may all be unpalatable and there may be little public support at the outset for such things as increasing the retirement age, as governments in Spain, France and Greece, for instance, found in 2010. But at least the contours of a possible solution are identifiable, the scope of the measures necessary has been quantified and some countries (e.g. the Nordics) have shown that a combination of responsible political leadership and a well-informed public which attaches tangible value to notions of sustainability, can make a solution possible.
The uncertainties associated with climate change, however, add a considerable degree of difficulty to public policy. Witness the debacle of the 2009 Copenhagen conference on climate change and the subsequent inability of the U.S. government to persuade Congress to support a comprehensive climate change bill. The risk, obviously, is that markets will not wait until a government is insolvent before significantly increasing the costs of borrowing. In 2010 we saw how systematically destabilizing the prospect of default by an even relatively small country such as Greece could be. Furthermore, we saw how losses of confidence in the debt-carrying capacity of the country can, through an increase in risk premia, dramatically reduce the government’s room for fiscal maneuver. Greece’s travails were eventually “solved” (many analysts still argue that a Greek default is eventually inevitable) through a combination of IMF and EU largesse but, along the way, the EU was forced to introduce a bailout facility to signal massive support to other countries in Europe as well. The point here is that the fiscal consequences of climate change and population aging could at some point interact with financial markets in highly destabilizing ways, which could significantly worsen an already difficult fiscal situation.
Of course, in addition to putting onerous pressures on public resources, climate change could also simultaneously interact with the world economy in other ways. Thomas Homer-Dixon (2010) argues that in some plausible scenarios “climate change would cause some kind of regional or continental disruption, like a major crop failure; this disruption would cascade through the world’s tightly connected economic and political systems to produce a global effect. Severe floods dislocating millions of people in key poor countries—as we’re are seeing right now in Pakistan—could allow radicals to seize power and tip a geopolitically vital region into war. Or drought could cause an economically critical region like the North China plain to exhaust its water reserves, forcing people to leave en masse and precipitating a crisis that reverberates through the world economy.”
The point of these scenarios is less to highlight the likelihood and consequences of mega-catastrophes associated with climate change but rather to make the more fundamental point that we need to be thinking about how we would respond to emerging crises. What would be the options open to us and at what cost? Mega-catastrophes associated to climate change (e.g., large rises in the global sea level, disruptions to ocean circulation, other large-scale ecosystem disruptions) are, by definition, small probability events but it would be infinitely better to face them—should they materialize—from a position of fiscal strength, not one where governments are thinly stretched because of competing claims on dwindling resources. A sharp global economic downturn associated with some climate shock would, of course, through its adverse impact on government revenues, only heighten the fiscal impact of the long-term forces which, by themselves, are already putting heavy pressures on public resources.
The above discussion does not pretend to present a comprehensive listing of the many ways in which various factors are likely to put pressures on public resources over the next 10-20 years and beyond. (No effort is made, for instance, to explore the ramifications of a war in the Middle East, through its impact on oil prices, investor and consumer confidence and what, thus far anyway, remains a fragile economic recovery from the global financial crisis). Indeed, it is not inconceivable that well before the impact of population aging and climate change kick in with all their force, there is some other factor that precipitates a fiscal crisis—even at existing debt levels which are considerably higher than in 2007, before the onset of the global financial crisis. All that would be required is some event which depresses market confidence in the ability of highly indebted governments to sustain current debt levels, leading to a sharp increase in risk premia and, therefore, imposing literally overnight, a much tighter fiscal outlook, with sharply higher long-term interest rates and diminished growth prospects.
Greece stumbled into such a crisis in late 2009; a sudden rise in the cost of new debt precipitated a fiscal crisis, riots in the streets and, within a few weeks, a crisis in Portugal and Spain, though the latter had debt levels that were less than half those of Greece and below that of France, Germany and the United Kingdom. It stretches the powers of one’s imagination to think about what might happen to the global economy if the object of negative market sentiment was not some small, fiscally irresponsible, habitually dishonest (with the budget figures) Southern European country, but the U.S. Treasury and the federal government’s fiscal outlook. A sudden rise in the debt servicing costs of Greece is, in the first instance, highly problematic for the country itself, imposing painful adjustments, usually involving tax increases and expenditure retrenchment and restructuring, to make room for the higher interest bill. Greece’s own brush with default had broader and deeper adverse repercussions for the euro area as well and led to fiscal pressures in other countries, as well as on the exchange rate of the euro. A sudden reassessment by the markets of potential U.S. solvency would be potentially far more destabilizing, given the preeminent position of the U.S. economy globally, the central role of the dollar in international finance and trade and the vast holdings of U.S. dollar denominated assets in the hands of its creditors.
Furthermore, a sudden rise in the cost of debt-service would have unforeseen geopolitical ramifications as well. One cannot help agreeing with Ferguson (2010) when he suggests that if interest payments take up a growing share of tax revenues, what is likely to give is military spending, which, unlike mandatory entitlements, is discretionary spending. For the United States’ enemies—Ferguson adds—“it must be consoling to know that U.S. fiscal policy today is programmed to reduce the resources available for all overseas military operations in the years ahead.” The issue here is not that it would be inconvenient for the United States to be increasingly constrained militarily, but rather that resource constraints more generally might underpin the weakening of the United States globally and, de facto, imply a rise in the relative influence of other countries with questionable commitments to democracy, human rights, and the rule of law or, worse, empower the lunatic fringe, whether in the Islamic Republic of Iran or in the Democratic People’s Republic of Korea.
Thomas Friedman (2010) makes this point convincingly when he says that “the most unique and important feature of U.S. foreign policy over the last century has been the degree to which America’s diplomats and naval, air and ground forces provided global public goods—from open seas to open trade and from containment to counterterrorism—that benefited many others besides us. U.S. power has been the key force maintaining global stability, and providing global governance, for the last 70 years. That role will not disappear, but it will almost certainly shrink.” Mandelbaum (2010), commenting on the nature of U.S. leadership in “a cash-strapped era” observes: “When Britain could no longer provide global governance, the United States stepped in to replace it. No country now stands ready to replace the United States, so the loss of international peace and prosperity has the potential to be greater as America pulls back than when Britain did. Therefore, the world will be a more disorderly and dangerous place.”
 “Flooding in Pakistan Threatens Stability,” International Herald Tribune, August 17, 2010.