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High public debts in the wake of COVID-19 pandemic will present
a vulnerability for European governments with strong incentives to
stabilize and lower their debt-to-GDP ratios.
Changes in public debt as a share of GDP are determined by the
primary balance (balance without interest payments), the difference
between nominal growth and interest payments (snowball effect), and
deficit-debt-adjustment (also called stock-flow adjustment), which
consists of financial transactions not included in the general
fiscal balance.
Since the 1990s, European governments have sought to lower
debt-to-GDP ratios primarily through improvements in the primary
balance (austerity), although this weighs down on growth and has
had mixed results across economies over the last decade.
Given weak potential growth rates across much of Europe, due to
adverse demographics and other structural impediments, and the
potential political fall-out from renewed austerity, more
unconventional measures may be explored to help with the high
public debt.
As a result of the fallout from COVID-19 and the extensive
fiscal support measures, public debt to GDP in several European
countries is set to match or surpass historical highs.
As long as interest expenditure remains sufficiently low, in
line with the global trend over the last few decades, governments
can live with debt stocks that are elevated by historical
standards. However, elevated public debt does present some key
risks, including:
Vulnerability to a sudden tightening of financial conditions
and unexpected shocks, which can disrupt market access or
exacerbate rollover risks.
High deficits and debt levels limit a government's ability to
pursue counter-cyclical fiscal policy stimulus during economic
downturns.
Private sector under-investment due to uncertainty about future
taxes.
Changes in public debt: a framework
Even in a low-interest-rate environment, governments will have
incentives to lower their public debt in relation to GDP. The
evolution of public debt-to-GDP ratios depends on these underlying
drivers:
Nominal interest rate paid on the existing debt.
Nominal GDP growth.
Primary budget balance.
Deficit-debt-adjustment, which includes financial transactions
not captured in the overall budget balance.
This can be expressed using a simple equation:
dt - dt-1 = dt-1((rt
- gt)/(1+gt)) - pt +
ddat
The key terms in the equation are defined as follows:
dt is the debt-to-GDP ratio at t
r is the nominal interest rate on the debt (the average rate of
interest on debt outstanding, weighted by maturity)
g is the growth rate in nominal GDP
p is the primary budget balance
dda is the debt-deficit adjustment
Put simply, nominal GDP growth running below the nominal
interest rate on the outstanding debt would imply, other things
being equal, a "snowball effect", whereby nominal debt increases
more quickly than the size of the economy, and vice versa.
Lowering public debt to GDP ratios
The basic formula to lower public debt to GDP ratios is for real
growth and inflation to be higher than the combined primary budget
balance, interest expenditure, and the deficit-debt adjustment.
There are several ways to achieve this, including:
Grow out of debt with real growth outpacing real interest
payments.
Inflate debt away, historically often accompanied by financial
repression.
Fiscal policy adjustment to significantly improve the primary
budget balance (austerity).
Table 1 shows recent episodes of public debt deleveraging across
European economies. These include 10 instances between 1995 and
2007 in which the public debt-to-GDP ratio declined by more than 10
percentage points (pp.) in Western Europe.
On average, across the 10 Western European economies, public
debt-to-GDP ratio declined by 25 pp., with the full adjustment
coming via the primary balance component. Both the snowball effect
(that is, the difference between nominal interest payments and
nominal growth) and DDA added to the public debt-to-GDP ratio.
Of the 10 economies, only in Ireland, Spain, and Cyprus the
snowball effect contributed to a reduction in their public
debt-to-GDP ratios. However, in all three, the pre-global financial
crisis period of high growth was accompanied by the build-up of
significant macroeconomic imbalances, later resulting in a need for
external financial assistance and painful macroeconomic adjustment
programmes.
Two lessons can be drawn based on the experience of the public
debt reductions in Western Europe in the decade or so prior to the
global financial crisis:
Changes in the primary balance (austerity) proved the only
viable way to lower public debt-to-GDP ratios. Despite the secular
decline in interest rates, nominal growth was not sufficiently
strong to contribute towards debt reduction, without a build-up of
significant macroeconomic imbalances in the process.
The positive impact of substantial, effective austerity
programmes can outweigh the adverse effects on debt ratios from the
other components.
Italy and Germany after 2010
Perhaps driven by this experience, the response to the
eurozone's escalating public debt vulnerabilities after the onset
of the global financial crisis was centred on fiscal austerity.
However, the outcomes were very different across economies.
From 2010 to 2019, both Germany and Italy ran significant
primary budget surpluses, but Germany's public-sector debt-to-GDP
ratio declined by almost 23pp. (from 82.3% to 59.6%), while Italy's
ratio increased by more than 15pp. (from 119.3% to 134.7%).
Whereas in Germany, nominal growth outpaced interest payments
over the period in question, with the snowball effect subtracting
8.1pp. from the public debt-to-GDP ratio, in Italy it added
23.2pp., far outweighing the contribution of the primary budget
component, which lowered debt by 14.5pp. After 2010, the adverse
snowball effect dominated as Italy's economy never recovered its
pre-financial-crisis peak with real growth and inflation remaining
anaemic.
Outlook
Given the unprecedented adverse shock from the COVID-19 virus
pandemic, governments across Europe have rightly responded with
large-scale fiscal support to try to mitigate the short- and
longer-term negative effects on their economies. Although
necessary, ballooning fiscal deficits have led to substantial
increases in public-sector debt-to-GDP ratios, in many cases from
already high levels.
As long as interest costs remain low, aided by central bank
asset purchases, high debt-to-GDP ratios can be sustained for some
time. However, they do entail various risks and once the
post-COVID-19 recovery is well established, high debt burdens will
need to be tackled.
Structural impediments to future economic growth across many
European countries will make this very challenging, while prolonged
fiscal consolidation risks suffocating growth still further and
escalating social tensions. Therefore, alternative solutions
including mutualisation and extensive ECB involvement are also
likely to come under consideration further down the line, although
both will face significant political hurdles.