Reprinted with permission By Charles Wyplosz, Professor of International Economics at the Graduate Institute, Geneva; Director of the International Centre for Money and Banking Studies. CEPR Research Fellow
Europe’s debt crisis is unfolding while Japanese and US debt problems are on hold. The problem of public debt in advanced economies will be with us for decades. This column introduces a new Geneva Report on the World Economy that addresses the nuts, bolts, and worries surrounding the issue.
- Long ignored, the issue of public debt sustainability among developed countries has been brought to the forefront as a result of the crisis.
- The need to recapitalise banks and to provide fiscal stimuli to avoid another Great Depression has resulted in public debt increases of 20% to 30% of GDP.
The problem is that this increase comes on top of previously sizeable debts. For many countries, the challenge is to firmly establish fiscal discipline, an undertaking that has eluded them for decades. The 13th Geneva Report on the World Economy examines the case of the Eurozone, Japan, and the US.
It’s all about institutions
To varying degrees, Japan, the US, and many Eurozone countries have let their public debts grow in good and bad times alike. The Geneva Report proposes a common interpretation of this widespread phenomenon and draws policy implications. The interpretation is the well-known common-pool effect, an externality between recipients of public expenditures and taxpayers. Since those who benefit from a given public policy do not bear the full burden of funding it, they tend to ask for more spending (or tax benefits) than they would if they did. The externality also concerns the revenue side. Voters would prefer to receive the benefits of public spending, but let others either in the current generation or future generations pay for those benefits. The result is excessive deficits.
The phenomenon is a general feature of democracies, but its severity depends on national characteristics. Empirical work (eg Kontopoulos and Perotti 1999) shows that it is stronger the larger is the number of decision makers with access to the general tax fund. Ideological and ethnic divisions or ethno-linguistic and religious fractionalisation also aggravate the common-pool problem.
Mitigating the deficit bias faces the same problem in reverse. Instead of benefits, pain must be distributed, but, again, citizens prefer that others bear the burden of the adjustment, even though they favour fiscal adjustment in principle. The general solution involves good governance and good fiscal institutions, designed to reign in the common-pool effect by enforcing the budget constraint on political actors. However, because political conditions differ from country to country, there is no one-size-fits-all magic bullet. Fiscal institutions that work in one country may well fail in another.
Two broad classes of solutions exist. Results-oriented approaches focus on outcomes, such as constitutional or legal deficit, debt, or spending limits and fiscal rules. Procedural approaches focus on decision-making processes and take two main forms: delegation and contracts. Delegation is based on hierarchical structures among the decision makers; contracts are based on horizontal relationships. Delegation is appropriate in parliamentary systems with single-party governments, while contracts is the proper approach for multiparty coalition governments. Similarly, there is no magic formula for successful fiscal consolidation. Where the proximate source of the problem is excessive government spending – as has historically been the case across much of Europe – successful fiscal consolidation will have to rely principally on spending cuts. Where the proximate source of the problem is inadequate revenue – as is partly (but only partly) the case in the US today – successful fiscal consolidation will have to involve revenue increases.
Growth is crucial too
The debt-to-GDP ratio has not just a numerator but also a denominator. The best way to reduce that ratio is by growing the denominator. In the US, the controversy over the recent debt ceiling agreement revolved around whether the debt deal would help or hinder growth. In Europe, sharp cutbacks in public spending in the UK and Southern Europe have depressed growth, and a long-lasting series of increases in tax rates caused a decade and a half of depressed growth in Germany without solving the underlying fiscal problems. In Japan, the exceptionally high debt ratio reflects the economy’s inability to escape from its low-growth trap.
As a country with a presidential system with frequently divided government, the US and its system of checks and balances has a bias toward inertia that in theory makes it difficult to address fiscal imbalances. Yet, the US political system has historically performed quite well in correcting fiscal imbalances. Whenever fiscal imbalances are perceived to threaten the health of the economy, voters reward elected officials who correct those imbalances. Since the 1980s, the favoured approach to overcoming inertia has been to negotiate deficit reduction packages in multiple stages. First, legislation is passed establishing multiyear targets for the amount of deficit reduction to be achieved and the consequences, typically across the board cuts in spending, if subsequent legislation is not passed to achieve the targets. Then decisions are made about the specific policies needed to reach the targets.
The US political system’s bias toward inaction raises particular challenges for mandatory spending programmes, such as social insurance programmes that are increasing as a share of GDP. One way to overcome this inertia would be to subject these programmes to annual appropriations. Another way would be to make the programmes completely self-financing and to institute trigger mechanism to ensure that spending and revenues remain equal, or to fund them via a dedicated revenue source like a VAT.
Given that any legislated deficit-reduction procedure can be negated by subsequent legislation, it is worth considering whether a constitutional amendment would help overcome inertia. In theory this would be possible – including provisions to allow for countercyclical fiscal policies, designing effective enforcement and allowing for overrides by a Congressional supermajority. Whether it is in fact possible to design an amendment of this sort is an open question.
It likely that the US political system will be able to make the fiscal adjustments necessary to stabilise the debt-to-GDP level during the upcoming decade, but demography ensures that there will then be further deterioration in the fiscal outlook between 2021 and 2035. The challenging fiscal environment, in other words, is not going away.
Europe’s public debt outlook has deteriorated because of its ageing population and the global economic and financial crisis. Absent corrective action, public debts are projected to rise from 59% to 128% GDP by 2035 – and much more for some countries. In addition to the usual national common-pool problem, the Eurozone suffers from an international common-pool problem whereby individual countries may be led to expect support from others, including through bailouts as is currently the case.
Europe offers a rich variety of situations that illustrate both successful and unsuccessful fiscal consolidations. It also provides a rich body of evidence on the role of budgetary institutions.
One unsuccessful arrangement is the Stability and Growth Pact, a contract between each country and the EU