1. Deficits and Debt Chapter 16
© Dünhaupt, Dullien, Goodwin, Harris, Nelson, Roach, Torras

2. Chapter 16
Deficits and Debt

3. Deficits and the National Debt Public Debt: A Historical Perspective
Chapter outline
Deficits and the National Debt
Public Debt: A Historical Perspective
Arithmetics of Debt Dynamics
Potential Problems of Excessive Debts
European Rules on Debt and Deficits
Chapter 16

4. Learning goals After today‘s lecture, you will be able to:
Understand the difference between a deficit and a debt, and how the two are related.
Explain how the national debt in the European Union has evolved over the years.
Understand the main problems with excessive borrowing.
Explain the different ways in which a country’s debt infiltrates its politics, both domestic and international.
Discuss in simple terms the Stability and Growth Pact.
Chapter 16

5. Deficits and the National Debt

6. Why is the government deficit smaller than government debt?
government deficit is a flow variable while its debt is a stock variable
in the euro-area as a whole, the national governments’ deficits added up to €215 billion in 2015, while total debt of national governments stood at around €9.5 trillion at the end of 2015.
government’s debt rises when the government runs a deficit and falls when it runs a surplus
Chapter 16

7. What is the impact on the economy of government debt?
popular statement: “government debt represents a burden on future generations of citizens”
But:
two thirds of euro-area government debt is, directly or indirectly, owed to euro-area citizens
government debt is an asset, a form of wealth
government debt does not have to be paid off
old debt can be replaced by new debt
many developed countries are indebted in their own currency
central bank can print money to service debt (not in the euro area, though)
Chapter 16

8. a larger share of future budgets must be devoted to paying interest
But: There are problems related to rising government debt and interest payments
a larger share of future budgets must be devoted to paying interest
it encourages growing income inequality
problem of generational equity—future taxpayers will have to pay more interest because of government borrowing today
Chapter 16

9. borrowing in foreign currencies:
But: There are problems related to rising government debt and interest payments (cont.)
borrowing in foreign currencies:
to pay the interest denominated in foreign currencies, countries must earn enough income from exports and other sources to pay not only for imports but also for interest payments to the rest of the world
the country could borrow more, but overall foreign debt problem increases
Chapter 16

10. “Is government debt worth it?”
depends on what that debt is used to finance:
it can be beneficial:
if investment leads to economic growth, the government’s ability to collect tax revenue is enhanced
if necessary to maintain or protect valuable aspects of life debt enhances current spending
Chapter 16

11. Public Debt: A Historical Perspective

12. Deficits and debt since medieval times
European kings routinely borrowed funds in order to pay for their war efforts
acquisition of territories
largest peaks over the past centuries can all be attributed to the most important wars
in many cases, debt-to-GDP ratios tended to fall quickly again after each of the major war-caused increases
Chapter 16

13. Figure 16.2 British government debt as a percentage of GDP
British government debt surpassed 100 percent for the first time in the 18th century. It peaked during the Napoleonic wars and after World War II.
Source: International Monetary Fund
Chapter 16

14. Figure 16.1a Government debt of selected countries as a percentage of GDP
Government debt generally shoots up during wars and comes down afterwards.
Source: International Monetary Fund
Chapter 16

15. Figure 16.1b Government debt of selected countries as a percentage of GDP
There has been a general upward trend after the 1970s and a strong increase after the global financial and economic crisis of 2008/9.
Chapter 16
Source: International Monetary Fund

16. Public borrowing in peace times: A new trend since World War II
policy makers might have misunderstood the oil shocks of the 1970s and early 1980s
countercyclical discretionary policy might end in increasing spending and cutting taxes in bad times but not in reducing the stimulus again once the economy has recovered
the global economic and financial crisis of 2008–2009  bail out of banks
important changes in the global macroeconomic environment, first in the late 1970s, then after the Great Recession of 2008–2009
Chapter 16

17. Arithmetics of Debt Dynamics

18. How does debt accumulate? How can the debt burden be reduced again ?
deficits lead to an increase in debt
surpluses to a reduction in debt
economic growth and inflation can reduce the debt burden
if GDP increases more quickly than the debt level, the debt-to-GDP ratio falls
if inflation is high, everything else being equal, nominal GDP increases more quickly, and the debt-to-GDP ratio falls
countries can default on their debt
Chapter 16

19. Separate the effects of increased government spending from that of increased interest rates
Primary balance: government net borrowing or net lending, excluding interest payments on government debt
a primary surplus: a situation in which the government runs a surplus before accounting for its interest payments
a primary deficit: a situation in which the government is borrowing to cover its noninterest expenditure
Chapter 16

20. Table 16.1: Debt dynamics in an economy with strong economic growth
Year
Nominal GDP (in national currency)
Debt (in national currency)
Interest Payments (in national currency)
Primary deficit (in national currency)
Debt-to-GDP ratio 1
100
5.0
2.0
100% 2
109
107
5.4
2.2
98% 3
119
115
5.7
2.4
96% 4
130
123
6.1
2.6
95% 5
141
131
6.6
2.8
93% 6
154
7.0
3.1
91% 7
168
151
7.5
3.4
90% 8
183
162
8.1
3.7
88% 9
199
174
8.7
4.0
87% 10
217
186
9.3
4.3
86%
Real GDP growth: 6 % per year
Primary deficit: 2 % of GDP
Inflation: 3 % per year
Real interest rate: 2 %
Chapter 16

21. Table 16.2: Debt dynamics in an economy with stagnating economic growth
Year
Nominal GDP (in national currency)
Debt (in national currency)
Interest Payments (in national currency)
Primary deficit (in national currency)
Debt-to-GDP ratio 1
100
5.0
2.0
100% 2
103
107
5.4
2.1
104% 3
106
114
5.7
108% 4
109
122
6.1
2.2
112% 5
113
131
6.5
2.3
116% 6
116
139
7.0
120% 7
119
149
7.4
2.4
124% 8
123
158
7.9
2.5
129% 9
127
169
8.4
133% 10
130
180
9.0
2.6
138%
Real GDP growth: 0 % per year
Primary deficit: 2 % of GDP
Inflation: 3 % per year
Real interest rate: 2 %
Chapter 16

22. Table 16.3: Debt dynamics in an economy with deflation
Year
Nominal GDP (in national currency)
Debt (in national currency)
Interest Payments (in national currency)
Primary deficit (in national currency)
Debt-to-GDP ratio 1
100
0.0
2.0
100% 2
102
102% 3
104
104% 4
106
106% 5
108
108% 6
110
110% 7
112
112% 8
114
114% 9
116
116% 10
118
118%
Real GDP growth: 2 % per year
Primary deficit: 2 % of GDP
Inflation: -2 % per year
Real interest rate: 2 %
Chapter 16

23. Different scenarios for debt dynamics
Chapter 16

24. Debt increase since the onset of the Great Recession
a combination of
stagnation scenario
increased deficits
some elements of the deflation scenario
increase in debt-to-GDP ratios
Chapter 16

25. Potential Problems of Excessive Debts

26. Potential problems of excessive debts
fear: increased debt level might lead to increasing share of government expenditure going to debt service
For most developed countries, this has not been the case (yet?)
potentially, countries might be cut off financial markets
This might force countries to default, turn to the IMF or run the printing press
This happened in the euro-crisis to some countries (see chapter 17)
Chapter 16

27. Figure 16.3 Interest payments as percentage of total government expenditure
Despite increasing debt levels, interest payments on the debt have fallen as a percentage of total government expenditure due to unusually low interest rates.
Chapter 16
Source: AMECO

28. Figure 16.4 The interest rate on 10-year German bonds
Interest rates on 10-year German bonds have fallen steadily, and were briefly even negative in Yields on other euro-area government bonds have by and large followed this trend.
Chapter 16
Source: Macrobond.

29. Pros and cons of government debt
“low-multiplier” activities are counterproductive
mounting debt
interest rate becomes so high that governments are cut off from financial markets
monetizing the debt: risk of inflation
high level of government debt reduces private investment
programs that produce a high multiplier effect
programs that increase the long-term ability of an economy to grow, such as education
Chapter 16

30. European Rules on Debt and Deficits

31. European rules for deficits and debts
convergence criteria
rules for countries which want to join the euro area
Stability and Growth Pact
rules for countries after they have joined the euro area
Chapter 16

32. Maastricht Treaty 1992: Five convergence criteria
Inflation: No higher than in the three EU countries with the lowest rates of inflation plus 1.5 percentage points
Public deficits: Below 3 percent of GDP
Government debt-to-GDP-ratio: Below 60 percent or “sufficiently diminished and must be approaching the reference value at a satisfactory pace”
Exchange rates: Must have been in a stable corridor with other EU currencies for two years
Yields on 10-year-government bonds: No more than 2 percentage points above the yields in the three EU countries with the lowest rate of inflation
Chapter 16

33. Stability and Growth Pact (1997)
rules for euro-area countries about government deficit and government debt which can be enforced by imposing fines on member states with excessive deficits
keep budget deficit below 3 percent of GDP
gross government debt level 60 percent of GDP
aim at a national budget “close to balance or in surplus” over the medium term
Chapter 16

34. Should the Stability and Growth Pact be relaxed?
The Stability and Growth Pact induces procyclical fiscal policies
fines are necessary to prevent countries running irresponsible fiscal policies
introduce automatic fines for countries reporting a deficit of more than 3 percent of GDP
Chapter 16

35. The Stability and Growth Pact changed several times
SGP became more flexible
threshold of 3 percent: accepted if deemed to be “exceptional and temporary”
commitments to balance the budget over the medium term: reduce deficits by 0.5 percentage points per year
significant tightening of SGP in the euro crisis
Chapter 16

36. The Treaty on Stability, Coordination and Governance in the Economic and Monetary Union
Fiscal Compact: agreement among euro-area member states to put rules for balanced budget into national law and preferably their constitution
Chapter 16

37. What to take home (I)
government deficit is a flow variable while its debt is a stock variable
government debt generally shoots up during wars and comes down afterwards
the usefulness of government debt depends on what is financed
deficits lead to an increase in debt and surpluses to a reduction in debt
Chapter 16

38. What to take home (II)
economic growth and inflation helps the debt-to-GDP ratio to come down while deflation increases the debt-to-GDP ratio
countries wishing to join the euro need to fulfill convergence criteria
countries having introduced have to fulfill the rules of the Stability and Growth Pact, but compliance has been weak
Chapter 16