PUBLIC DEBT and the EU Objectives

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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
  its debt
• Be able to apply the above to monetary union in
  the EU
• REF Eufiscalteach nov09
• Incl formulae

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PUBLIC DEBT and the EU

• Section 1

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What is the government deficit?

• Assumptions
• 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 rD-1
• primary deficit debt service

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Intertemporal budget constraints

• Assume
• 2 time periods
• Yr1 G1 T1
• Yr2 G2 T2
• No initial debt
• If G1 gt T1
• Yr2 must cover G2 debt service
• T2 G2(G1 - T1) (1r)

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PUBLIC DEBT and the EU

• Section 2

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DEBT STABILISATION

• 1960s - expanding debt no concern
• 1970s - explosive increase in debt
• Debt stabilisation central to fiscal policy
• See handout for EU data

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GOVERNMENT SOLVENCY

• Real debt burden (ieratio of govt. debt to GDP)
  doesnt grow without limit
• Adjustment of primary budget balance required
• total deficit primary deficit debt service
• D G - T rD-1
• primary deficit debt service
• Even if GT for a year, debt rises (debt
  service)
• Debt can be EXPLOSIVE!
• Primary surplus may be required

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DEBT STABILISATION

• Explosive if r gt g debt accumulates faster
  than GDP grows (as 1970s )
• If r lt g ratio debt to GDP can be
  stabilised with budget deficit

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• 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 gt g

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p18

• 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 debt service
• Examples-see worksheet

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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

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• Now, smaller primary budget surplus required for
  stabilisation
• Explosive nature of debt transferred to
  INFLATION eg. Brazil, Russia

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PUBLIC DEBT and the EU

• Section 3

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HOW TO STABILISE PUBLIC DEBT

• DEFAULT Extreme
• SEIGNIORAGE INFLATION TAX Reduces value of
  M0 Reduces value of public debt
• REDUCE DEFICIT

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REDUCE DEFICIT

• Raise tax / cut Govt. expenditure
• Politically/economically difficult
  Coalitions German unification depende
  ncy ratio tax problems eg.
  Distortions, deadweight loss
• Success?

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UK NEW FISCAL FRAMEWORK

• Deficit reduction plan
• Transparency
• Account for economic cycle
• Two rules Golden Rule over cycle Public
  debt - stable prudent level
• Adopted by EU?

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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

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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
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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
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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)

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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)

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SGP problems

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

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SGP problems

• Greece 2009

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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?

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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