Download Public Debt and the EU Objectives

PUBLIC DEBT and the EU
Objectives
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By the end of this lecture students should:
Be aware of the significance of the
intertemporal budget constraint
Understand why and how a country can
stabilise it’s debt
Be able to apply the above to monetary union
in the EU
REF: Eufiscalteach nov09
Incl formulae
PUBLIC DEBT and the EU
Section 1
What is the government
deficit?
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Assumptions
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Ms constant
lump sum tax autonomous
Government debt (D)
(1)
D = D-1 + rD-1 + G - T
where:
D-1 = Govt. debt at the end of the previous period
rD-1 = interest paid on this debt
G = Govt. spending
T = Taxes
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Thus, budget deficit (BD) =
(2) D – D-1 = G + rD-1 - T
change in debt = Budget deficit
Rearrange
D – D-1 = G - T
primary deficit
+
rD-1
debt service
Intertemporal budget
constraints
Assume
 2 time periods
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Yr1 = G1
Yr2 = G2
T1
T2
No initial debt
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If G1 > T1
Yr2 must cover G2 + debt service
T2 = G2+(G1 - T1) (1+r)
PUBLIC DEBT and the EU
Section 2
DEBT STABILISATION
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1960’s - expanding debt no concern
1970’s - explosive increase in debt
Debt stabilisation central to fiscal policy
See handout for EU data
GOVERNMENT SOLVENCY
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Real debt burden (ie;ratio of govt. debt to GDP)
doesn’t grow without limit
Adjustment of primary budget balance required
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total deficit = primary deficit + debt service
D = G-T
+
primary deficit
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rD-1
debt service
Even if G=T for a year, debt rises (debt service)
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Debt can be EXPLOSIVE!
Primary surplus may be required
DEBT STABILISATION
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Explosive if r > g
debt accumulates faster than GDP
grows (as 1970’s +)
If r < g
ratio debt to GDP can be stabilised
with budget deficit
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Now consider in relation to GDP
D = G-T
Y
Y
(r-g) D-1
Y
g= growth rate of econ
 r= r% on debt
Debt Explosive if r > g
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+
p18
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Primary surplus required to stabilise total
debt to GDP ratio
ie:
D =0
Y
when
T-G
= (r-g) D-1
Y
Y
primary budget surplus
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debt service
Examples-see worksheet
PUBLIC DEBT & INFLATION
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Central bank can now monetise the
debt
Seigniorage
No debt service - breaks link making
debt explosive
Inflation tax
Introduce seigniorage into formula
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Now, smaller primary budget surplus
required for stabilisation
Explosive nature of debt transferred to
INFLATION
eg. Brazil, Russia
PUBLIC DEBT and the EU
Section 3
HOW TO STABILISE PUBLIC
DEBT
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DEFAULT
Extreme
SEIGNIORAGE & INFLATION TAX
Reduces value of M0
Reduces value of public debt
REDUCE DEFICIT
REDUCE DEFICIT
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Raise tax / cut Govt. expenditure
Politically/economically difficult
Coalitions
German unification
dependency ratio
tax problems
eg. Distortions, ‘deadweight’ loss
Success?
UK ‘NEW FISCAL
FRAMEWORK’
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Deficit reduction plan
Transparency
Account for economic cycle
Two rules
Golden Rule over cycle
Public debt - ‘stable & prudent’ level
Adopted by EU?
EU EXPERIENCE
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Maastricht criteria
Stability & growth pact
Rationale
fiscal discipline - debt is ‘explosive’
 risk of ‘fiscal externalities’
 danger ECB monetising debt
See handout that links these arguments
to earlier theory
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Euro area; Budget deficit
deficit (-)/surplus (+)
Selected countries
(as a percentage of GDP)
BL
DE
FR
IT
FI
Euro
area
2003 0
-4
-4.1
-3.5
2.5
-3.1
2004 0
-3.8
-3.6
-3.5
2.3
-2.8
2005 -2.3
-3.4
-2.9
-4.2
2.7
-2.6
2006 0.4
-1.6
-2.6
-4.4
3.8
-1.6
2009
Q1
-7.0
Source: Adapted from ECB Monthly Bulletin Nov 2007 & ECB Statistics Pocket book Oct 2009
Euro area; Government debt
(as a percentage of GDP)
2003 69.1
2004 69.4
2005 70.0
2006 68.2
2007 66.0
2008 67.5
2009 73.1
Source: ECB Statistics Pocket book Oct 2009
SGP problems
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Loss of ER & monetary policy - fiscal
policy is only policy left to States
OCA analysis suggests centralised
budget - not possible
Thus, fiscal policy must be flexible to
deal with negative shocks
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it is not under SGP
State budgets not automatic stabilisers in
recession (national fiscal policy constrained)
SGP problems
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Can rules be enforced?
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action against ‘offenders’ requires 2/3 maj
in Council
Evidence suggests more flexibility would
be ok
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evidence (DE Grauwe) that States in
monetary unions have lower budget
deficits that individual States
risk of default in EU low (10yr bond yields
have converged on German rates)
SGP problems
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France & Germany 2003/04
SGP effectively suspended
2004-08?
Future?
SGP problems
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Greece 2009
CONCLUSION
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Debt stabilisation central to fiscal policy
Debt can be explosive
Primary budget surplus important
Stability & Growth Pact
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does it constrain national fiscal policy in
EU?
will it stop fiscal externalities in EU?
ADDITIONAL READING
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Reading list, plus
Gros & Thygesen, ch8
De Grauwe ch9
Bohn H, ‘The Behaviour of US Public Debt and Deficits’,
Quarterly Jnl of Economics, Aug 1998
Weale M, ‘Monetary and Fiscal Policy in Euroland’, Jnl of
Common Market Studies, March 1999
Balsssone & Franco,’Public Investment, the Stability Pact
and the ‘Golden rule’, Fiscal Studies (2000), vol. 21
Buti, Franco & Ongena,’Fiscal Discipline and Flexibility in
EMU: The Implementation of the Stability and Growth Pact,
Oxford Economic Review, vol.14, no.3