A mountain of reasons to reduce public debt
"What is clearly needed almost everywhere is a large tightening in fiscal policy with a simultaneous easing in monetary policy"
Monday 09 October 1995
Although the UK has been a notable exception to the general rule of rising debt, we have been unable to avoid the adverse consequences of excess borrowing by other countries. Global capital flows mean that each country is now vitally affected by the build-up of debt elsewhere in the world economy - and those countries which are able to control their debt have every right to demand that others do the same.
It has been common in the UK to hear complaints that the budget rules written into the Maastricht Treaty constitute an unwarranted interference in the rights of a sovereign state to set its own tax rates and public- spending policies. But this misses a key point, which will remain true whether or not the European Union ever adopts monetary union. The existence of adverse spill-over effects from one country's debt to another country's real interest rates creates a new right for low-debtor nations like the UK to complain about the bad behaviour of others - just as the damaging effects of passive smoking justify new demands that the freedom of the smoker should be curtailed.
For much of the post-war period, economists have found it difficult to prove to governments that excessive budget deficits are necessarily bad for domestic interest rates. One possible reason for this failure was the so-called "Ricardian Equivalence" argument. This essentially states that the private sector will recognise that a build-up in public debt will have to be redeemed sooner or later through an increase in taxation. Anticipating this, individuals will simply save more whenever budget deficits rise so that they ca afford to pay the higher taxes later. The consequent rise in private savings eliminates the adverse effects of higher government borrowing on real interest rates, which are unaffected therefore by budget deficits.
The problem with this argument is that it demands an almost incredible degree of rationality, foresight, and concern about future generations from the person on the Clapham omnibus. Not surprisingly, most studies have found that full Ricardian equivalence does not apply, though some have suggested that changes in private saving do offset about half of the effect of a rise in government borrowing. This should still leave a large adverse effect on real interest rates to be uncovered as governments borrow more.
Why then has this effect been so hard to establish? Most likely, it is because it does not operate within any individual economy, but operates powerfully on a global scale. When a single country increases its budget deficit, it can draw nowadays on a huge global pool of savings to finance its increased borrowing, so the adverse effects on interest rates are spread too thinly to be immediately noticeable.
The problem, though, is that this creates an incentive for any individual government to increase its borrowing, since there will be no obvious pain through higher domestic interest rates. As each country responds to this incentive, the build-up in global levels of debt does indeed raise interest rates - but it is in no country's interest to be the first to curtail borrowing, since acting alone will have no effect on global real rates. Hence there is a clear case for supranational policing of excessive deficits.
All this has been mere speculation until recently, but now there is solid evidence which confirms that global real interest rates are strongly related to government borrowing around the world. For example, a recent IMF study by Thomas Helbling and Robert Wescott finds that global real rates have averaged 1 to 2 per cent in the 1960s and early 1970s, roughly zero from 1973-80, and 3 to 4.5 per cent in the 1981-94 period.
Two factors explain the rise in real rates. First - and harmlessly - the real rate of return on productive private investment has increased, raising the expected return on equities. This has bid up the real yield on competing assets, including bonds. Second, however, the rise in gross government debt has had a massive adverse effect on real rates. According to the IMF study, each 1 percentage point rise in the global debt/GDP ratio increases the long-term real rate of interest by around 0.1 per cent. Since the late 1970s, the global debt ratio has risen from around 40 per cent to about 75 per cent, which would be enough to account for the vast majority of the rise in real interest rates over this period.
As the graph shows, much of this increase in debt has come in continental Europe. This has happened despite the fact that the underlying fiscal stance, measured by the change in the structural budget balance, has been tightening for much of the past decade - and has done so in each year since 1992. In other words, governments have been willing to raise taxes or cut public spending in an attempt to curtail debt, largely in order to comply with the Maastricht criteria. But only in Britain - ironically a country that does not appear to worry much about hitting the Maastricht criteria for their own sake - has the budget consolidation been large enough to hold out the promise of a declining debt ratio in the next few years.
Who is to blame for this rise in debt? The orthodox answer is that governments have sought short-term political gains by increasing public spending, but have been unwilling to finance this through tax rises. This is the line taken by most central bankers. But a less orthodox answer is to blame the central bankers themselves. On this argument, interest rates have been held far too high for too long, either because of a desire to hit inflation targets, or to fix the exchange rate inside the ERM. The result has been a prolonged recession, which has automatically raised budget deficits as unemployment has risen.
This debate is a bit chicken-and-eggish. But what is clearly needed almost everywhere is a large tightening in fiscal policy with a simultaneous easing in monetary policy - exactly the mix which the UK has had since 1993. Most countries are officially committed to this mix, but few are actually pursuing it with sufficient rigour, and instead are allowing the global debt ratio to creep inexorably upwards. If they continue to do this, which they probably will, the real interest rate will rise further, and this will crowd out an ever larger number of private investment projects in the developed economies. More unemployment will result.
Ideally, we need a world fiscal authority empowered to enforce a Maastricht Treaty writ large (albeit only in its fiscal manifestation). Only with such a supranational police force - a souped-up IMF - can the adverse consequences of one country's fiscal actions on the well-being of others be properly curtailed. But is that likely? About as likely, I would say, as the election of Eric Cantona as the honorary president of the Crystal Palace supporters' club.
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