Definition of sustainable debt
Countries have reached the largest peacetime debt levels in history during the last months due to the public stimulus and bank saving operations. “According to IMF study, by next year the gross public debt of the ten richest countries attending the summits of the G20 club of big economies will reach 106% of GDP, up from 78% in 2007.”1
This article will investigate the underlying theory and relevant factors for debt sustainability with focus on the advanced economies with aging demographics. Current deficits and the expected aging costs make the issue more challenging for developed countries compared to emerging ones.
A brief summary of few underlying concepts behind government debts and fiscal policies forms the base for discussion. The implications in the current crisis will be discussed in the next section.
i) A government can pay its interests as far debt/GDP ratio is constant. This statement results in the below formula:
(r-g)*D/Y = Primary Surplus /GDP2
The formula implies that the government needs to run a surplus if interest rate (r) is larger than the growth rate (g). Deficit would be possible only if growth rate is larger than the interest rate.
If interest rate increases with D/Y and higher r leads to lower g then countries can rapidly find their public finances deteriorating. Argentina is a good example to learn from where high r (with other factors) resulted into default of the country.
ii) Second important concept to remember is the intertemporal budget constraint. Government debt plus the interest rate equal the future discounted account surpluses of debt.
Using the debt on investments which do not provide future surpluses will potentially result in defaults. i.e. Saving firms without transforming them into efficient organizations as in the case of Japan’s Zombie Firms which is seen as one of the reasons for Japan’s lost decade.9
Another observation to remember is the Public Debt as % of GDP development in the past. Traditionally countries have maintained high ratios during war time and recovered their debts in the peace. However, as Figure 1 shows; Countries maintain different levels of debt. It is not necessarily good or bad to have small debt/GDP ratio as far as it is sustainable based on i and ii.
Factors impacting sustainable debt
Above concepts shed some light on how to approach today’s issue of sustainable debt. Governments need to foster growth at a larger rate than the interest rates or run surpluses. Running surpluses means either to raise taxes, or cut spending, or monetize the debt – or most likely do some combination of all three5. Nicely said but in practice all the factors mentioned impact each other.
Monetizing the debt as the governments are currently doing i.e. printing money is typically expected to increase inflation. However, the current output gap (See Figure 2) and low demand is unlikely to create inflation in the short run. Yet once markets perceive an inflation scenario, it will be too late to react due to “time inconsistency” to revert the inflation expectations. Issuing bonds will also not be a solution as the country risk ratings due to default risk will increase as in the recent example of Greece and Ireland within the Euro area. Given the two impacts and equation (i), monetization of debt alone is obviously not a solution.
Secondly, raising taxes has a positive impact on running surpluses but will impact the growth rate. Governments need to find the right timing to increase their tax revenues not to endanger the slightly starting upturn.
Thirdly cutting spending is a key factor that helps to improve fiscal deficits. On one hand, stopping the stimulus early to recover public finances is risky at a deflationary environment. The weak private demand might not be sufficient in many economies to foster growth.10 On the other hand, loose fiscal policy as explained above might create hard to correct expectations for the mid-term.
Lastly, equation (ii) suggests that debt should be spent in areas those will bring future cash flows like transformation of the banking system, infrastructure, etc. One of the largest issues waiting the governments is the health and pension system which is estimated to increase debt/GDP ratio of EU by another 6%7. The fiscal stimulus should also support innovative solutions for the pension and healthcare system. Transformations of the system, change of retirement age are some examples which will impact the debt sustainability more than the current crisis’ burden.
