Public debt

9 Rules and institutions for public debt management

Maintaining sustainable debt levels can be challenging for political as well as economic reasons. Governments have taken two approaches to this problem: budgetary rules on the one hand, and institutions and procedures on the other. Rules may be embodied in a legal statute or a country’s constitution. Germany’s ‘debt brake’, for example, was written into the Federal Republic’s constitution in 2009. This limits annual federal government borrowing to no more than 0.35% of GDP. Articles 121 and 126 of the ‘Treaty on the Functioning of the European Union’ (originally the Treaty of Rome) and associated protocols commit EU member states to limiting their debt and deficits to 60% and 3% of GDP, respectively. In other jurisdictions, rules set separate targets or limits for the growth of government spending and/or revenues.

For further details on the Greek debt crisis in 2009, you can read ‘Greece’s Debt’ by the Council on Foreign Relations; or ‘Breaking the Greek debt impasse’ by Barry Eichengreen, Peter Allen, and Gary Evans; or ‘Putting the Greek debt problem to rest’ by Barry Eichengreen, Emilios Avgouleas, Miguel Poiares Maduro, Ugo Panizza, Richard Portes, Beatrice Weder di Mauro, Charles Wyplosz, and Jeromin Zettelmeyer.

The strength of fiscal rules is their simplicity. Everyone knows what is meant by 60% of GDP, and monitoring compliance is relatively straightforward. Or is it? The Greek debt crisis in 2009 was triggered when a new government announced that its predecessor had cooked the books and that the public-sector debt and deficit were significantly higher than acknowledged previously. And as we saw earlier, there are many different ways of calculating the debt.

The weakness of rules is their arbitrariness. No single limit on the deficit or debt is right for all countries at all times. There is no single threshold where debt is too much—where it suddenly becomes a drag on growth. (See ‘Find Out More: Public debt and economic growth’ for further discussion.) The EU’s 60% ceiling on the debt ratio just happened to be the average in Europe when the Maastricht Treaty was negotiated, and a 3% deficit just happened to be the level needed to keep that debt ratio constant, given then prevailing interest rates and growth rates. Interest rates, growth rates and debt ratios are all very different today, of course. An arbitrary rule not tailored to circumstances is unlikely to garner respect and compliance. Thus, both Germany and France violated the Maastricht Treaty’s 3% ceiling on deficits within five years of the euro’s creation.

Find out more Public debt and economic growth

Does too much public debt hamper economic growth? High levels of debt could put upward pressure on interest rates and crowd out private investment. They could increase uncertainty about future taxation and inflation. If heavy debts make it difficult for the government to issue additional debt, they could limit the pursuit of countercyclical fiscal policies.

For surveys of the literature on these questions, see ‘Public Debt and Economic Growth in Advanced Economies: A Survey’ by Ugo Panizza and Andrea Presbitero; ‘The 90% Public Debt Threshold: The Rise and Fall of a Stylized Fact’ by Balázs Égert; or ‘Do Higher Public Debt Levels Reduce Economic Growth?’ by Philipp Heimberger.

In an influential 2010 article, the economists Carmen Reinhart and Kenneth Rogoff concluded that high levels of public debt are negatively correlated with economic growth once debt exceeds 90% of GDP. Subsequent research reanalyzed their data and criticized their findings. Those subsequent studies did not find consistent evidence of threshold effects at 90% or other levels. It still makes sense, of course, that at some point, public debts become so heavy that they constitute a burden for society and for growth. But the debt-to-GDP ratio at which any negative effects begin to become evident will vary with country conditions. Equation 5 in Section 5 shows that the level of debt is less likely to be a concern when the growth rate of the economy is high and when the interest rate is low. The level of debt at which negative effects begin to become evident will be higher when a country has the economic, financial, and political wherewithal to mobilize a higher share of GDP in the form of taxes and run primary surpluses. But analyzing the growth-debt nexus requires careful study of specific country cases, not a search for magic numbers.

causality

A direction from cause to effect, establishing that a change in one variable produces a change in another. While a correlation is simply an assessment that two things have moved together, causation implies a mechanism accounting for the association, and is therefore a more restrictive concept.

An important issue is causality. Even if there is evidence that public debt is, on average, negatively correlated with economic growth, correlation does not necessarily imply causation. Low economic growth could simply be leading to high levels of debt. Alternatively, the observed correlation between debt and growth could be due to a third factor that affects both debt and growth. Again, this points to the need for caution before making general statements about the effect of public debt levels on economic growth.

Another weakness of fiscal rules is that if rules are too rigid, they will not accommodate the special circumstances of a recession, financial crisis, or pandemic. But if they are too flexible and easily relaxed, they will lack credibility. Observers expecting exceptions to be invoked will doubt that the rules will be enforced. The EU has tried to strike a balance between credibility and flexibility, enhancing the first by adding to its own agreement a version of the German debt brake, while enhancing the second by making provision for the business cycle when gauging countries’ compliance with its rules. This balancing act remains a work in progress.

autonomous fiscal council

A nonpartisan, fiscal watchdog providing the government with independent estimates of the public finances and their sustainability.

The alternative is strengthening institutions and procedures in order to increase transparency and avoid the kind of problems experienced by Greece in 2009. Countries can create a non-partisan fiscal watchdog such as the U.S. Congressional Budget Office, the Netherlands Bureau for Economic Policy Analysis, or the UK Office for Budget Responsibility to provide independent estimates of the public finances and their sustainability. They can create an autonomous fiscal council with its own budget, and staffed by experts serving long terms in office, to provide realistic forecasts of tax revenues and economic growth. They can require budgeting to incorporate those forecasts, thereby preventing governments from basing spending plans on unrealistic assumptions. Chile, for example, has an Autonomous Fiscal Council that calculates cyclical adjustments to observed budgetary outcomes, comments on possible deviations from announced structural balance targets, and proposes mitigation measures. A growing number of countries are moving in this direction.

Exercise 5 The role of fiscal councils

Look for the website of the autonomous fiscal councils in two countries of your choice. You can use the IMF Fiscal Council Dataset, for example, if you want to find out which countries have one.

1. Briefly summarize the purposes of your chosen councils. How do they provide incentives for the government to manage its debt appropriately?
2. The economist Beetsma and his colleagues suggest that countries with an autonomous fiscal council tend to do better at fiscal forecasts and compliance with fiscal rules. Why might a government not want to establish such a council? (Hint: You may find the article ‘What are fiscal councils, and what do they do?’ helpful.)
3. Find a country that does not have an autonomous fiscal council. Might this have impacted the management of public finances?