There can be no meaningful reductions in government debt without stronger economic growth and better primary balances says Fitch Ratings in their Global Perspectives Series.
The dramatic increase in advanced economies’ government debt due to the financial crisis was quick, but its reduction in most countries will be very slow. Conditions that would facilitate rapid debt reduction appear unlikely to take hold.
In the absence of one-off factors such as privatisation receipts directed at paying down debt or – in extreme cases – agreements with creditors to reduce the debt stock, changes in government debt/GDP ratios depend on the primary balance, the effective interest rate on the debt and economic growth. These three variables form the classic government debt dynamics equation, and encompass all policy “solutions” to high debt, such as fiscal austerity (running a stronger primary position), inflating debt away (high nominal GDP growth relative to interest rates) or growing out of a debt problem (high real and nominal GDP growth relative to interest rates).
Much of the contemporary policy debate surrounding high government debt in Europe centres on the desirability and effectiveness of fiscal austerity. One argument is that it is self-defeating, especially when an economy is weak and growth is fragile – as is typical after a crisis – because the contractionary measures necessary to improve the primary balance will pull growth even lower. The absence of inflation, as we are seeing now, may supplement the view that demand is simply too weak to sustain another negative knock.
A counterargument contends that a tighter fiscal position ultimately fosters growth, first by boosting confidence that post-crisis policymakers are following a more prudent path, supporting private investment, and second by allowing for an increase in the flow of financial resources to the private sector, where they can be more efficiently and effectively deployed.
The austerity debate has largely overlooked how well this approach has worked in the past, and under what conditions. The dataset accompanying Mauro, Romeu, Binder and Zaman’s A Modern History of Fiscal Prudence and Profligacy, IMF Working Paper No. 13/5, provides a useful historical overview, as it contains data on government debt, GDP growth, primary balances and real long-term interest rates for more than 50 countries since 1800, where data availability permits. The episodes of meaningful debt reduction (debt falling 10 percentage points of GDP or more over a five-year period) in advanced economies since 1970 highlight the modern debt dynamics conditions that facilitated such declines, allowing an assessment of whether they might be replicable today.
In 1970-2011 there were 22 instances in 16 countries of government debt falling by 10 percentage points of GDP or more over a five-year period. On average during these episodes, governments ran primary surpluses of 4% of GDP, real economic growth was 3.6% and real interest rates were 3%. We may consider these figures debt dynamics benchmarks.
A comparison of the current and forecast debt dynamics of highly indebted (greater than 60% of GDP) advanced economies with these benchmarks, combining Fitch estimates of effective interest rates and IMF World Economic Outlook forecasts to 2020 for growth and primary balances, reveals that interest rates align favourably with the benchmark, but economic growth and primary balances are typically too low.
The only countries in this exercise forecast to have meaningful reductions in government debt are Iceland and Ireland, both of which are projected to run primary surpluses consistently of 2%-3% of GDP. Japan and Slovenia fare the worst, with debt expected to be higher in 2020 than in 2015. Most other countries are somewhere in between, with reductions in government debt of 5-10 percentage points of GDP, predicated on stronger growth and better primary outturns.
Need for Stronger Growth and Primary Balances
The policy implications of this review are clear, if difficult to address. For better debt dynamics, the current low level of interest rates must be accompanied by larger fiscal adjustments to improve primary balances, or stronger growth, or both. Enhancing growth prospects may prove difficult. Private debt is still at historically high levels in many countries, reducing the impact of accommodative monetary policies. Advanced economies with “productivity puzzles” abound, and export-led growth, while alluring, cannot be pursued universally, particularly in the context of the profound weakness in global trade flows.
This brings us back to the austerity debate, which is unresolved as yet, but with plenty of supporters on both sides. The situation will become more urgent if neither growth nor primary balances were stronger by the time long-term interest rates eventually begin to rise, at which point all three debt dynamics variables could be working against lower government debt ratios.
If high public debt is here to stay, as seems probable, so too are the consequences. Governments will be less able to enact specific countercyclical fiscal measures, possibly amplifying the next downward shift in the economic cycle and resulting in even higher debt. Policymakers will also find themselves in unfavourable starting positions should the need arise to respond to other potential strains on public finances, such as systemic financial sector stress or a catastrophic event. For the advanced economies as a whole, the probability of debt continuing to climb over the next several years may be at least as high as that of meaningful debt reduction.
