Yves here. I have a small quibble in this post. The main reason for the sharp rise in government debt levels around the world was not bailouts of financial firms, but the impact of the crisis. Economies all suffered sharp downturns. That led to a big drop in tax receipts and an increase in spending, such as unemployment benefits. But this otherwise is a fine, high level but technically sound discussion of the dangers of debt scaremongering.
By Anis Chowdhury, former Professor of Economics, University of Western Sydney, who held various senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, former UN Assistant Secretary General for Economic Development. . Originally published at Inter Press Service
Debt anxieties are not new, often fanned by political competition. But so is a double dip recession due to premature deficit reduction. For example, to seek re-election, President Roosevelt backed down from his New Deal in 1937, promising that “a balanced budget [was] on the way”. In 1938, he slashed government spending, and unemployment shot up to 19 per cent.
Deficits and Debt
Many countries had huge public debts when World War II ended. Despite such anxieties and calls for drastic spending cuts, governments continued to spend. Had they caved in, Europe would not have been rebuilt so soon. As governments continued with massive expenditure to rebuild their countries, economies grew and the debt burden diminished rapidly with rapid economic growth. Clearly, debt is sustainable if government expenditure enhances both growth and productivity.
When the debate about deficits and public debt was raging during the Great Depression, Evsey Domar, growth theory pioneer, noted, “Opponents of deficit financing often disregard … completely, or imply, without any proof, that income will not rise as fast as the debt … There is something inherently odd about any economy with a continuous stream of investment expenditures and a stationary national income.”
After the 2008-2009 financial meltdown brought many OECD economies to a standstill, there was a brief revival of fiscal activism. Many OECD governments initially responded with large fiscal stimulus packages, while bailing out influential financial institutions. Major developing countries also put in place well designed fiscal stimulus packages including public infrastructure investment and better social protection.
Hence, there were sudden increases in debt/GDP ratios, mainly due to large financial bail-out packages and some fiscal activism. But with the first hints of “green shoots” of recovery from mid-2009, fiscal hawks stepped up their calls for winding back, sounding dire warnings about ballooning deficits. They argued that rapid fiscal consolidation would boost confidence, particularly in the finance sector, creating an expansionary impulse.
Thus, the affected countries undertook rapid fiscal consolidation measures with large cuts in public expenditure, especially in the areas of health, education, social security and infrastructure. Yet, their debt-GDP ratios continue to rise as they struggle to reignite growth. Meanwhile, the IMF has admitted that its initial fiscal consolidation advice was based on erroneous ad-hoc calculations.
Overwhelming recent research findings, including from the IMF, indicate that discretionary counter-cyclical fiscal policy in recessionary periods augments and catalyses aggregate demand, encourages private investment and enhances productivity growth, instead of raising interest rates and crowding-out private spending.
Optimal Debt-GDP Ratio?
The fixation with a particular debt-GDP ratio lacks any sound basis. The 60 per cent debt-to-GDP ratio, used by the European Commission and the IMF as the upper threshold for fiscal sustainability by 2030, was simply the median pre-crisis ratio for developed countries and the median debt-GDP ratio of EU countries at the time of the Maastricht Treaty. Similarly, the 3 per cent budget deficit rule of the EU happened to be the median budget deficit ratio at the time of the Treaty. None of these ostensible bench-marks imply optimality in any meaningful, economic sense.
Public debt in Japan soared to well over 200 per cent of GDP over two and a half decades of deflation. Yet, interest rates have remained low for many decades. In 1988, Belgium had the highest public debt, and Italy’s debt rose above 100 per cent of GDP during this period. Neither of them experienced spiraling inflation or very high interest rates as ‘austerity hawks’ claim will happen when government fiscal deficits rise. Meanwhile, studies of public finance in the United States do not find any significant relationship between debt-to-GDP ratios and inflation or interest rates during 1946-2008.
However, real interest rates may be adversely impacted by whether the debt is denominated in domestic or foreign currencies. In other words, a sovereign country should have the option to monetize debt. The problem arises when that option does not exist, as with countries in the Euro zone. This is clear from the contrasting experiences of Spain and the UK during the recent rapid public debt build-up.
The UK public debt-GDP ratio was 17 percentage points higher than the Spanish Government debt (89 versus 72 per cent) in 2011. Yet, the yield on Spanish government bonds rose strongly relative to the UK’s from early 2010, suggesting that international bond markets costed Spanish risk much more than UK government bonds.
As a member of a monetary union, Spain does not have control over the currency in which its debt is issued, while UK public debt is mostly in its own currency, as in the US and Japan. Therefore, much of the problem in the Euro zone is not really about high public debt or deficits. Rather, it is rooted in the currency union that limits its members’ policy space with regard to money creation and exchange rate policy. Hence, the only way they can improve what is seen as competitiveness is by cutting wages!
Then and Now
Since 2014, even the IMF has changed its stance. In its October 2014 World Economic Outlook, it advised that “debt-financed projects could have large output effects without increasing the debt-to-GDP ratio, if clearly identified infrastructure needs are met through efficient investment”.
There is, of course, one difference between now and the 1930s. The finance sector and rating agencies are much more influential and powerful now than then. Democratically elected governments have become hostage to money-market investors who shift money from one place to another in search of quick profits.
Governments should not be driven by superficial diagnoses of complex economic issues by rating agencies. The record of rating agencies before the 2008 global economic crisis was abysmal, and the US Congress has seriously debated whether they should be prosecuted. Trying to win their confidence is futile, and trying to anticipate them is hazardous, but they nevertheless hold finance ministries and central banks to ransom.