Thursday, September 3, 2009

Government Debt. Going up (and then down?).

There is a growing debate about the increasing burden of government debt in advanced economies. As a result of the recession and the large stimulus packages, government debt is likely to increase over the coming years to levels that we have not seen in many decades. In the case of the US, the Congressional Budget Office expects government debt to go from 40.8% in 2008 to 68% of GDP in 2019 (more details here, this figure corresponds to the debt held by the public which is lower than the overall level of debt, as some of it is held by public institutions).

Is 68% too high? The debate is open and some think that while high debt in itself is not desirable, this is a number that we have seen before (Krugman has made this argument here). Others disagree and believe that this level of debt will impose a large burden on the economy (Hamilton makes the argument here).

Many countries (including the US after the second World War) have dealt with levels of debt as high or even higher than what we are likely to see over the coming years. In the US debate, there is a reference to the case of European countries that in the 90s saw levels of debt above 100% of GDP and "survive". What was their experience? Here is the picture from two of the "worst offenders": Belgium and Italy.

In both cases, the debt to GDP ratio increased above 110% of GDP. What did we learn from that experience? The good news is that countries can "survive" with such levels of debt. In fact, we need to realize that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today (more so the US government). Even with those high rates, levels of debt above 100% did not lead to insolvency and what we saw over the years that followed was a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth.

The first piece of bad news is that the economic performance of these two countries was not great but it is hard to argue that government debt was the main reason for such a low performance. The second piece of bad news is that while the levels have been coming down, they have done so at a very low rate. The slope going up seems to be much faster than when it goes down.

Here are two other European countries that might provide a more optimistic perspective: Ireland and Sweden.

In both cases we see a much faster decline in the debt-to-GDP ratio. In Ireland, the ratio went from 105% to 25% over two decades. In the case of Sweden, the ratio decreased from 75% to 35% in about ten years. We know that high growth played a role, much more so in Ireland than in Sweden, but the trend is also a reflection of the efforts to bring discipline to the budget. The bad news is that these figures are likely to explode in the years ahead because of the current recession, a reminder once again, that the effect of the discipline of the last year might vanish quite soon.

Here is my reading of these experiences:

1. Advanced economies can live with high levels of debt-to-GDP ratios. The levels that European countries or the US are likely to see over the coming decades are manageable.

2. How easy will it be to manage the burden of the debt depends on interest rates and growth. An environment of low interest rates (the one we have seen so far) and healthy growth (to be seen) will make the lives of governments much easier.

3. There is no need to pay back the debt within the next "x" years. What matters is to keep the level of debt-to-GDP ratio under control. [Of course, there is an issue of fairness that I am ignoring, about which generation should pay for the current expenditure]

4. Having said that, we need to plan for the next crisis, even if we are still trying the get out of the current one. The real fiscal discipline shows up during good times when government manage to save the necessary resources to pay for the extra spending and the reduced taxes that the next recession will bring. In many countries, including the US, the high projected levels of debt are a result of the consequences of the current recession but also the inability of previous administrations to bring the level of debt down when growth was high.

Antonio Fatás.