Some remarks on debt

Maybe I’ve blogged some of this before (in the comments?) but I couldn’t find the stuff in the archives, so I decided to write this post either way. The post contains a few graphs, click on them to view them in full size.

First, some stuff from Martin Paldam’s Development and foreign debt: The stylized facts 1970-2006 (link). This is about the debt of developing countries. From the abstract:

“The paper uses the data from the incomplete debt cycle for the LDC world from 1970 onwards to tell the typical story of debt. Two debt stories are contrasted: A good debt story: Here countries borrow and invest wisely, so that they grow more. A bad debt story: Here countries borrow when they are in crisis, and the debt grows and generates low growth in the next couple of decades. The analysis concentrates on two relations: (R1) the relation between borrowing and growth, and (R2) the relation between initial debt and growth. Both relations are negative, so essentially the stylized story of debt is a story of bad debt.”

Here’s a figure, each group consists of 15 countries:

The debt of Group 1 didn’t get paid off, in case you were in doubt. They got debt relief and debt ‘restructuring’ (/’managed default’). Over time debt service went down, not up. Here’s a bit on the political economy of the debt accumulation:

“One may also ask the simple question: Why does a country borrow when it has a crisis? Is it to adjust quicker to the crisis or to be able to finance non-adjustment? Our results certainly suggest that the latter possibility dominates the picture.

The analysis has showed that debt accumulation is normally associated with some underlying problem leading to economic crises. Somehow things are going badly, and the political system is unable to handle the crisis. A foreign loan provides some wiggle room, and this is surely used to solve the most pressing problem. The reader may then ask what decision makers are most likely to take this problem to be. Think of the choice between a political stabilization and a balance-of-payments stabilization.

A political stabilization means that the popularity/support of the government is increased. This can be done either by satisfying the demands of the voters or by paying off some pressure group, such as the military, the unions etc. In both cases it costs money. Here the foreign loan comes in handy. It appears that such solutions are of a short-run character.

A balance-of-payments stabilization inevitably means that domestic absorption has to be reduced. It is obvious that this is painful and likely to cost the government some support, thus it is almost the reverse of a political stabilization. Hence, it is likely that the government may fully or partly shy away from solving the balance-of-payments crisis.”

Next, some stuff from The future of public debt: prospects and implications, by Cecchetti, Mohanty and Zampolli (link). I’ll quote from it below, but really you should read it all:

“Since the start of the financial crisis, industrial country public debt levels have increased dramatically. And they are set to continue rising for the foreseeable future. A number of countries face the prospect of large and rising future costs related to the ageing of their populations. In this paper, we examine what current fiscal policy and expected future age-related spending imply for the path of debt/GDP ratios over the next several decades. Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability. […]

The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalise banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programmes to revive demand. According to the OECD, total industrialised country public sector debt is now expected to exceed 100% of GDP in 2011 – something that has never happened before in peacetime.2 As bad as these fiscal problems may appear, relying solely on these official figures is almost certainly very misleading. Rapidly ageing populations present a number of countries with the prospect of enormous future costs that are not wholly recognised in current budget projections. The size of these future obligations is anybody’s guess. As far as we know, there is no definite and comprehensive account of the unfunded, contingent liabilities that governments currently have accumulated.”

“existing studies report that the magnitude of the long-term fiscal imbalance – the present value of unfunded liabilities arising from ageing – is very large. Hauner et al (2007) estimate the change in the primary balance required to equate the net present discounted value of all future revenues and non-interest expenditures to the debt levels prevailing at the end of 2005 for seven major industrial countries (Canada, France, Germany, Italy, Japan, the United Kingdom and the United States). The authors report that in order for these countries to pay off all their financial liabilities, they would require an average improvement in their budget balance excluding interest payments of 4.5% of GDP. For the United States and Japan, the estimate is 6.9% and 6.2%, respectively.

Other estimates are similar in magnitude. For example, Gokhale (2009) presents a measure of the long-term fiscal imbalance faced by 23 industrial countries. His estimates suggest that, for financing future benefits without future tax increases, the United States and major European countries would be required to generate an annual present value surplus of the order of 8–10% of 2005 GDP over the period to 2050.”

You can quibble over the details in the following, and I’m not a big fan of the ‘government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 level’-assumption, because that’s just not going to work out. But then again, that’s part of the whole point of the exercise, realizing that fact. An important point I forgot to include/remark upon in the first version of the post is that a big chunk of the projected deficits below are structural.

“We now turn to a set of 30-year projections for the path of the debt/GDP ratio in a dozen major industrial economies (Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the United Kingdom and the United States). We choose a 30-year horizon with a view to capturing the large unfunded liabilities stemming from future age-related expenditure without making overly strong assumptions about the future path of fiscal policy (which is unlikely to be constant). In our baseline case, we assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 level as projected by the OECD. Using the CBO and European Commission projections for age-related spending, we then proceed to generate a path for total primary government spending and the primary balance over the next 30 years.12 Throughout the projection period, the real interest rate that determines the cost of funding is assumed to remain constant at its 1998–2007 average, and potential real GDP growth is set to the OECD-estimated post-crisis rate.13

From this exercise, we are able to come to a number of conclusions. First, in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio will rise to 13% in Ireland; 8–10% in Japan, Spain, the United Kingdom and the United States; and 3–7% in Austria, Germany, Greece, the Netherlands and Portugal. [remarks about Italy that are actually quite fun to read now…] in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear from the slope of the line, without a change in policy, the path is unstable. This is confirmed by the projected interest rate paths, again in our baseline scenario. Graph 5 shows the fraction absorbed by interest payments in each of these countries. From around 5% today, these numbers rise to over 10% in all cases, and as high as 27% in the United Kingdom.”

This is also part of why I posted a link to Paldam’s paper in this post. Look at the first graph again. Many of these modern, developed countries will end up in the group of basket case countries if the people in charge don’t change their ways.


November 20, 2011 - Posted by | Data, Economics, Studies

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