Public debt and deficits have surged to alarming levels. Global growth is flagging, and the path of interest rates is highly uncertain. In many respects, the world economy echoes the early 1980s, when fiscal challenges took center stage after a period of focus on inflation and monetary policy.
But the situation now is different in several ways. More and bigger global challenges such as climate change, population aging, and the fight against poverty and inequality are adding even more pressure to government budgets. At the same time, along with the return of populism, public demand for fiscal restraint has weakened substantially over the last two decades.
This unique set of conditions has produced a fiscal policy trilemma. As they manage their finances, countries face three key policy pressures. To begin with, governments are under intense pressure to increase spending on defense, climate change, and much more. At the same time, they face strong public resistance to higher taxes. Finally, higher levels of public debt and higher deficits are threatening to put the public finances and financial stability of many countries at risk. Thus, they are under pressure to cut deficits and debt.
Why is this a trilemma? Because it is virtually impossible for policymakers to pursue all three choices at the same time. For example, a country could rein in debt while holding the line on taxes. But that would leave the government with little choice but to cut spending. Alternatively, the country could cave to spending pressures without raising taxes. Yet that would lead to further rises in debt and deficits and risk fiscal sustainability and financial stability. Policymakers around the world, in advanced and developing economies alike, face this trilemma.
Back in the early 1980s, similar pressures on vulnerable emerging-market countries became too much to bear and led to a systemic debt crisis. Policymakers globally have no choice but to face up to the policy trilemma now—but how to avoid a similar outcome?
Over the 80 years since the International Monetary Fund (IMF) was founded, and the 60 years since its Fiscal Affairs Department came into existence, not much has stayed constant in macroeconomics. The foundations of the IMF articles of agreement were decidedly Keynesian—arising from the publication of John Maynard Keynes’s General Theory in 1936—in the sense that they assumed that national economic systems were not self-balancing. Active macroeconomic management was thought necessary to correct macroeconomic imbalances.
But the Great Inflation of the 1970s broke the spell of Keynesian macroeconomics, as rising prices became the biggest macroeconomic problem in the eyes of the U.S. public, and consumer inflation climbed to 13.5 percent by 1980.
Then as now, politics took a central role in macroeconomic policy. The U.S. Federal Reserve’s determination to tame inflation through a series of interest rate hikes prompted criticism that the central bank was ignoring the costs of disinflation in the form of slower growth and higher unemployment.
The tension came to a head in 1977, when Congress strengthened the political accountability of the Fed board with the Federal Reserve Reform Act. It required the central bank to report to Congress “concerning the ranges of monetary and credit aggregates for the upcoming 12 months.” The reform act also included what was to become known as the Fed’s dual mandate to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
Moreover, a year later, the Humphrey-Hawkins Full Employment and Balanced Growth Act was passed, with a quantified goal for the unemployment rate at 4 percent. Such a goal was one of the emblematic elements of the New Economics approach advocated by the Council of Economic Advisers back in 1962.
Eventually, inflation and macroeconomic instability opened the way to a new paradigm. Inflation became a salient problem for the American public, opening the way for Fed Chairman Paul Volcker’s effort to stamp out inflation. But a new paradigm gradually spread and gained political acceptance in many countries. The clearest institutional response came from New Zealand in 1989, when its central bank committed to inflation targeting. The shift also influenced the negotiations on a monetary union in Europe around the same time. In a nutshell, the paradigm enshrined central bank independence in the conduct of monetary policy to achieve price stability. In doing so, central banks aim to stabilize the business cycle by keeping output close to potential. In this setting, the role of fiscal policy in smoothing the business cycle is limited to automatic stabilizers (for example, by increasing unemployment insurance transfers during recessions). Nevertheless, fiscal policy plays a much more expansive role, as fiscal structural policies affect growth, competitiveness, and the distribution of income and wealth.
Yet the new paradigm ran into trouble during the 2008 global financial crisis and its aftermath. Many advanced economies experienced disappointing growth and persistently below-target inflation, while their central banks were believed to be unable to lower nominal interest rates below zero in the face of the “effective lower bound.” Eventually, of course, some central banks did cross the line into negative interest rates, as well as pursuing other unconventional methods such as quantitative easing.
Under such conditions, the need to account more explicitly for monetary-fiscal interactions becomes central for the conduct of macroeconomic policies. This implies a recognition that fiscal policy has an important role to play in achieving economic goals. The power of monetary and fiscal policy acting in concert was on full display at the time of the COVID-19 pandemic. Quick and decisive policy action literally saved lives and livelihoods. Expectations and demands on policymakers were never higher. In the aftermath of the pandemic, public debt and deficits increased, inflation surged, and political demands for public intervention only grew. Keynesian stimulus was in vogue again. Things had turned full circle.
As Keynesian economics revived, other branches of public economics expanded: political economy and behavioral and empirical public finances. From the viewpoint of the IMF, which was tasked at its founding with overseeing a new international monetary system to stabilize the global economy, the most consequential new area is international and global public economics. The world has witnessed phenomena that demand collective action, such as pandemics and global warming. But there are many other important areas demanding global collective action. Think of the need for countries to cooperate in eliminating poverty and hunger, ensuring education for all, setting international fair and effective taxation rules, and resolving debt impasses.
In recent years, the IMF has stepped up its efforts in areas such as international taxation, climate, and financing for development. Take cross-border spillovers in the taxation of multinationals and wealthy individuals as an example. Simply put, the rules set by one country can affect many others. While international tax coordination efforts led by the OECD and the United Nations have played an important role in addressing these spillovers, the IMF has been enhancing its support by leveraging its deep economic expertise, near-universal membership and long-standing experience in developing countries.
When it comes to climate change, the world needs to do more to limit global warming to the temperature ceilings set by the Paris Agreement. The IMF has been advocating for complementing the Paris Agreement with an internationally coordinated carbon price floor. In conjunction with other policy instruments, this can provide an effective, efficient, equitable, and flexible path toward the world’s climate goals.
Meanwhile, financing gaps are large and growing, especially for low-income developing countries. Sound macroeconomic management is key. But, for low-income countries, a decisive factor is their ability to mobilize their own domestic resources to finance development. It requires tax capacity as a strong pillar bolstering solid public finances and domestic financial development, which the IMF has been supporting.
This is the challenge we face in this unique historical moment: elevated debt and deficit levels and lingering inflation, reminiscent in some ways of the aftermath of the Great Inflation of the 1970s but now coupled with new fiscal pressures from global structural issues from climate change to aging populations. As they grapple with the fiscal policy trilemma in this context, countries would do well to keep four important principles in mind.
First, it is important that they identify spending priorities and improve the quality of public spending. In a world where they are facing ever-growing pressures, including from global threats such as climate change whose costs may only grow, governments simply cannot afford to spend on wasteful projects that don’t deliver clear value for their entire population.
Second, whatever spending envelope chosen should be backed by sound public financing, which is crucial to keeping debt sustainable. That requires a broad-based, elastic, and fair tax system. For developing countries, a considerable upgrade in tax capacity is usually necessary. In many countries, tax bases can be broadened by reducing tax evasion and avoidance, as well as through simpler and more robust tax design.
Third, it is important to consider the political dimension of fiscal policies. This requires building fiscal institutions—beliefs, perceptions, rules, procedures, and organizations—that reinstill and foster public support for fiscal sustainability and stable finances. And yes, in certain cases, this may require pushing back against one of the legs of the policy trilemma: namely, the public’s resistance to higher taxes. In such cases, it’s important that decision-makers honestly explain what the money is for. In addition, clear fiscal rules can also help manage political pressure. When governments operate in a transparent, credible manner, they dramatically improve their chances of maintaining public support.
Fourth, periods of debt reduction are often associated with deep cutbacks and painful sacrifices. But, as our upcoming Fiscal Monitor report on fiscal policies around the world will show, a gradual but sustained fiscal adjustment can balance the need to put debt on a more sustainable track without undermining growth or causing a surge in inequality—by carefully calibrating the adjustment design with different fiscal tools. Even more importantly, fiscal policy is structural policy and can affect long run growth. In considering the long-run implications from policy choices, policymakers may be able to improve growth prospects, thereby contributing to ease the fiscal policy trilemma.
The solution to the policy trilemma must be political and pragmatic. Countries will have to find their own way forward. But if they follow sound fiscal principles and stay the course, the great fiscal challenges of our time are far from insurmountable. The trilemma is a test, but it need not be a trap.
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