PUBLIC DEBT and the EUObjectives

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?

Assumptions Ms constant lump sum tax autonomous

Government debt (D)(1) D = D-1 + rD-1 + G - Twhere:

D-1 = Govt. debt at the end of the previous periodrD-1 = interest paid on this debtG = Govt. spendingT = Taxes

Thus, budget deficit (BD) =

(2) D – D-1 = G + rD-1 - T

change in debt = Budget deficit

Rearrange

D – D-1 = G - T + rD-1

primary deficit debt service

Intertemporal budget constraints

Assume 2 time periods

Yr1 = G1 T1 Yr2 = G2 T2

No initial debt If G1 > T1 Yr2 must cover G2 + debt service T2 = G2+(G1 - T1) (1+r)

PUBLIC DEBT and the EU

Section 2

DEBT STABILISATION

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 Real debt burden (ie;ratio of govt. debt to

GDP) doesn’t grow without limit Adjustment of primary budget balance

required total deficit = primary deficit + debt service

D = G - T + rD-1primary deficit debt service

Even if G=T for a year, debt rises (debt service)

Debt can be EXPLOSIVE! Primary surplus may be required

DEBT STABILISATION Explosive if r > g

debt accumulates faster than GDP grows (as 1970’s +)

If r < gratio debt to GDP can be

stabilised with budget deficit

Now consider in relation to GDP D = G - T + (r-g) D-

1

Y Y Y g= growth rate of econ r= r% on debt

Debt Explosive if r > g

p18

Primary surplus required to stabilise total debt to GDP ratioie: D = 0

YwhenT-G = (r-g) D-1

Y Yprimary budget surplus debt service

Examples-see worksheet

PUBLIC DEBT & INFLATION Central bank can now monetise

the debt Seigniorage No debt service - breaks link

making debt explosive Inflation tax Introduce seigniorage into formula

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

DEFAULTExtreme

SEIGNIORAGE & INFLATION TAXReduces value of M0

Reduces value of public debt

REDUCE DEFICIT

REDUCE DEFICIT Raise tax / cut Govt. expenditure Politically/economically difficult

CoalitionsGerman unification

dependency ratiotax problems

eg. Distortions, ‘deadweight’ loss

Success?

UK ‘NEW FISCAL FRAMEWORK’

Deficit reduction plan Transparency Account for economic cycle Two rules

Golden Rule over cyclePublic debt - ‘stable &

prudent’ level Adopted by EU?

EU EXPERIENCE 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

Euro area; Budget deficitdeficit (-)/surplus (+)Selected countries

(as a percentage of GDP)

Source: Adapted from ECB Monthly Bulletin Nov 2007 & ECB Statistics Pocket book Oct 2009

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

Euro area; Government debt(as a percentage of GDP)

Source: ECB Statistics Pocket book Oct 2009

2003

69.1

2004

69.4

2005

70.0

2006

68.2

2007

66.0

2008

67.5

2009

73.1

SGP problems

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 it is not under SGP State budgets not automatic stabilisers

in recession (national fiscal policy constrained)

SGP problems

Can rules be enforced? action against ‘offenders’ requires 2/3

maj in Council Evidence suggests more flexibility

would be ok 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

France & Germany 2003/04 SGP effectively suspended 2004-08? Future?

SGP problems

Greece 2009

CONCLUSION Debt stabilisation central to fiscal

policy Debt can be explosive Primary budget surplus important Stability & Growth Pact

does it constrain national fiscal policy in EU?

will it stop fiscal externalities in EU?

ADDITIONAL READING

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