Reforms, public debt and economic growth: what dynamics?

The dynamics of public debt

Current economic conditions reflect these issues: should we stimulate production to reassure investors and thus lower the cost of financing on the financial markets? Or, on the contrary, should we wait for a drop in refinancing costs to trigger a recovery in economic activity? To begin with, the answer is clear: the interest rate paid on debt and the growth rate are determinants of the share of public debt in GDP, so we need to understand their dynamics.

A country’s public debt/GDP ratio is equal to the sum of two components[2]. The first is the ratio of accumulated debt to GDP over the previous year, discounted by the real interest rate (the difference between the nominal interest rate and inflation). This real interest rate is further adjusted by the growth rate of output. The second component is the budget deficit/GDP ratio for the year in question. Thus, the more GDP increases over a year, the slower the growth in the stock of accumulated debt. Conversely, the higher the real interest rate, the faster the ratio of accumulated debt to GDP. For a given debt stock/GDP ratio, GDP growth must therefore be higher than the real interest rate. If this critical gap is not respected, a budget surplus/GDP ratio (the second component) can offset the growth in the accumulated debt/GDP ratio to stabilize the share of public debt in GDP.

The question is whether to stimulate economic growth in order to reduce debt, or to reduce debt in order to stimulate economic growth. A complex subject, given that:

– the budget deficit depends on public spending (consumption and investment), which are sources of growth to a certain extent[3], and on public revenues, which increase with GDP growth for a given tax base.

– the real interest rate depends on the level of inflation, which in turn depends on economic conditions (unemployment, productive capacity utilization, productivity gains), and on the nominal interest rate, which results in particular from a risk premium on the bond markets.

– the structure of bond maturities evolves: the annual share of the debt stock to be repaid varies considerably from one year to the next, depending on the maturities associated with the loans contracted by each country. This structure can accelerate the « snowball effect »: a rise in interest rates increases the cost of borrowing, and therefore public debt; if this increase is greater than economic growth, then needs exceed resources, making public debt financing unsustainable.

Acting on the two determinants of the public debt/GDP ratio, the stock of debt and the primary deficit, requires either a restrictive fiscal policy, by increasing revenues or reducing expenditure, or a growth policy capable of fuelling the public budget by enriching the agents subject to the fiscal policy.

The public decision-maker’s dilemma: reducing the budget at the risk of affecting economic activity

The implementation of economic policies requires the public decision-maker to act using the levers available to him. Fiscal policy measures to reduce the public deficit would make it possible to limit the effect of an increase in the stock of debt or to compensate for the differential between the interest rate paid on the debt and the rate of growth in economic activity. However, there are two ways of reducing this deficit: increase public revenues by raising direct and indirect taxation, which risks penalizing private consumption and private investment, or reduce public spending, the second option likely to penalize public investment, which is also a source of economic growth.

A first trade-off solution is to penalize the factor with the lowest contribution to GDP, i.e. public consumption and investment, but this depends on the budgetary share that this item represents in public spending. In France, between January and August 2012, public investment accounted for just 7.8 billion euros, or 3.94% of public spending, and contributed 0.05% of GDP, compared with 0.3% for public consumption. This option is therefore effective provided that the reduction in public spending leads to a reduction in the deficit at least as great as an increase in tax revenues would allow.

We might also ask what impact public spending has on the budget balance in the case of France. The graph below shows the average correlation over the last five years between public spending and the public deficit. Public spending can therefore reduce the public balance during periods of strong economic growth. However, since 2008, we have observed that this coefficient has become positive again, but without GDP growth. The contribution of public spending to GDP has thus become more significant since the start of the crisis. According to this analysis, it would therefore be necessary to reduce other budget expenditure items.

A second solution would be to reduce the debt burden by lowering the interest rate. In France, debt servicing accounted for 29 billion euros in the first 8 months of the year, or 15% of total budget expenditure. The contribution of debt servicing to the budget balance is historically high, which means that if the primary balance (before payment of debt servicing by the State) is positive (+1 point of GDP) but the contribution of debt servicing is -5 points of GDP, then there will be a budget deficit of 4 points of GDP. Debt servicing has played a major role in increasing the deficit in France, and, by way of comparison, in Spain and Greece (see chart below).

A third item is public administration operating expenses. These accounted for 56% of the French budget in 2011 (113 billion euros). Aid plans are raising awareness of the importance of reducing these costs, for example by cutting the civil service wage bill. However, some countries, such as France, guarantee the sustainability of their public debt and their solvency through the efficiency of their tax administration, which is capable of levying taxes quickly if necessary. In addition, a reduction in public spending, likely to have a negative impact on administrative organization, can have an impact on investors’ perception of risk, and therefore increase the likelihood of an interest rate rise. Thus, while a reduction in the interest rate would certainly be justified, the effect on the public budget would remain less significant than an increase in the taxable base or an increase in tax revenues through higher taxes. This underlines the importance of taking into account the specific features of each country before embarking on restrictive fiscal policies.

There are two possible levers for acting on public spending:

– a falling interest rate, which reduces the interest burden. A lower interest rate is likely to distort the primary balance and therefore the long-term debt maturity schedule. A low interest rate is necessary in countries with high bond maturities, which could stifle economic recovery by requiring ever more of the national budget.

– A reduction in operating and personnel costs: Greece and Spain have begun these reforms.

In addition to the factors increasing public debt, some studies have shown that the ratio of public debt to GDP should alert public decision-makers to the need to implement structural reforms.

A necessary solution to the 90% threshold dilemma

Reinhart and Rogoff (2010) analyzed the evolution of the link between real GDP growth and the debt/GDP ratio, given a given debt/GDP ratio:

– below a ratio of 90%, the relationship between the two variables is weak, while it becomes strong above that level: non-linearity. Above 90%, median real GDP growth falls by at least 1%.

– Above 90%, economies are highly vulnerable.

This threshold effect makes it possible to assess the urgency of the structural reforms that may be required of public decision-makers. However, all this research is not sufficient to contest the dual causality between public debt and GDP growth. A contraction in activity reduces tax revenues. A rise in public debt can also have a crowding-out effect on the growth of the capital stock, by using up more of the economy’s resources (Kumar and Woo, 2010). There is therefore a double causality and different measures need to be taken if the debt/GDP ratio approaches 90%. This condition takes on its full meaning if public debt is significantly financed externally. Japan, for example, has a debt-to-GDP ratio of 225%, which is sustainable thanks to internal financing in which agents accept to be remunerated at a low rate. So, beyond the threshold effect, we need to distinguish other explanatory variables, such as the origin of creditors holding public debt, to better consider the risk of unsustainability of a country’s public finances.

Three major initiatives in Europe

Faced with these issues, reforms are not just economic, but also legal and political. The European example shows the need for structural reforms and initiatives over different time horizons, actions which have been underway for several months and which can be grouped under three types of commitment.

The first short-term initiative is to reassure investors by ensuring financial and banking stability. The bond repurchase program for sovereign debt announced by the ECB in September 2012 (OMT program) should affect risk premiums, while the Banking Union will limit the risk of financial contagion. These policies will improve the financial environment in the short term, and enable countries committed to austerity policies to stabilize their indebtedness and start recovering.

A second initiative is to improve fiscal and budgetary transparency, a prerequisite for better supervision of the evolution of public finances between countries in the euro zone. In particular, this may involve reorganizing the public administration to enhance the credibility of economic policies undertaken at national level.

Finally, a third initiative to combat indebtedness in the eurozone is to offset the current macroeconomic imbalances in Europe. The South must no longer be the borrower of the North. The South must offer a political framework and an economic and financial potential capable of attracting investors from Northern Europe. Private consumption is affected by austerity, while investment in real estate is suffering from the depreciation of its assets. Productive private investment must therefore take over to stimulate activity and develop new comparative advantages that will enable countries in difficulty to develop a genuine growth strategy.

Conclusion

Our analysis leads us to distinguish two stages. The first is to reassure investment in order to stabilize debt: the sustainability constraint will become less severe. The second is to structurally modify the competitiveness of economies and the economic environment to prepare for the investments of tomorrow, those that will contribute to a recovery in activity.

Stabilizing the debt-to-GDP ratio is a target variable, not an objective, and as such must act as a stimulus to investment. This requires a structural overhaul of economies’ growth strategies, which will translate into a sufficiently strong rise in economic activity to reduce the weight of public debt in gross domestic product.

Notes

References

C.Reinhart, K.Rogoff, « This time is different: eight centuries of financial folly », Princeton
University Press, 2011.
M. Kumar and J.Woo, « Public Debt and Growth », IMF Working Paper 10/174, 2010.
http://www.performancepublique.budget.gouv.fr/le-budget-et-lescomptes-de-letat/le-budget-deletat/approfondir/le-tableau-de-bord-desfinances-publiques/focus-budget-de-letat.html