PUBLIC DEBT and the EU Objectives 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

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 - 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

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 = G1T1 Yr2 = G2T2 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 1960s - expanding debt no concern 1970s - 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) 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 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 1970s +) If r < g ratio 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 ratio ie: D = 0 Y when T-G = (r-g) D -1 Y Y primary 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 DEFAULT Extreme SEIGNIORAGE & INFLATION TAX Reduces value of M0 Reduces value of public debt REDUCE DEFICIT

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

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?

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 deficit deficit (-)/surplus (+) Selected countries (as a percentage of GDP) Source: Adapted from ECB Monthly Bulletin Nov 2007 & ECB Statistics Pocket book Oct 2009 BLDEFRITFIEuro area Q1 -7.0

Euro area; Government debt (as a percentage of GDP) Source: ECB Statistics Pocket book Oct

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 ? 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