Fiscal space and low interest: A Eurozone perspective
The European Commission has just needed a fiscal stance that’s more supportive of the recovery and of monetary policy in the Eurozone. This column argues that the case is strong for spending now on investment and other targeted programmes supporting growth and employment. However, fiscal space is heterogeneously distributed over the Eurozone, with some countries in a position to exploit a clear margin, and others having to pursue a far more prudent approach of gradual debt unwinding. A common stabilisation capacity would help for managing shocks that can’t be absorbed by national stabilisers alone.
Some observers have needed more aggressive fiscal policies, arguing that fiscal space is increased by historically low interest (Furman 2016). Additionally, there are demands ‘living with the debt’ (Ostry et al. 2015) provided that debt is ‘safe’. Debt ought to be stabilised, not reduced.
This column asks what lengths these arguments could be taken, specifically in the precise setting of the Eurozone. The European Commission has just needed a fiscal stance more supportive of the recovery and of monetary policy in the Eurozone (European Commission 2016a). However, the Commission in addition has signalled the tensions between your desirable fiscal stance when contemplating the Eurozone as an individual entity, as if there have been a Eurozone finance minister, and the limitations of the existing EU fiscal framework, including fiscal sustainability concerns that are particularly relevant for several member states. The implications of the reduced interest levels environment should thus be tailored to the peculiarities of the Eurozone.
The essential arithmetic of debt, growth and interest levels
In the last decades, interest levels have steadily fallen plus they have finally reached historic lows. Super-low nominal interest levels reflect the fall in (expected) inflation and a decline of the natural interest. Since there is great uncertainty on future evolutions and a moderate rebound from current lows is probable at some time, the mainstream view is that generally low interest are to stay for some time (e.g. Fisher 2016).
Low interest rebel the boundaries of government debt sustainability. Debt stabilisation requires generating a primary surplus for servicing your debt burden. When there is a maximum feasible primary surplus p max , there exists a corresponding debt limit b max = p max /(r*-g*) where r*-g* may be the interest growth rate differential (Blanchard 1984). In this stylised framework, a durably lower interest implies an increased debt limit.
Stronger growth can be conducive to additional fiscal space. However, when lower rates are accompanied by equally lower growth, the inter-temporal budget constraint is actually unchanged. Put differently, it’s the difference (r*-g*) that plays out in your debt limit equation. Therefore, one must examine the data on r*-g*, now and in the years ahead, when assessing fiscal space.
What’s the empirical evidence and prospects?
The common r-g on Eurozone government bonds fell to -0.3% in 2015 and is on course to fall further in 2016 (Figure 1a). This contrasts with the average r-g of just one 1.4% because the start of EMU. Negative values of r-g allowing Ponzi-type schemes might not last forever. However, even assuming a medium-term uptick, an r*-g* lowered to state 0.5% as well as moderate primary surpluses will be in keeping with relatively high debt limits, e.g. 200% of GDP for a 1% of GDP primary surplus.
The power of Eurozone countries to create primary surpluses is backed by past evidence (Figure 1b). Excited, ageing-related pressures and expanding needs in public areas services will constrain that ability. This helps it be all the more essential to pursue structural improvements in the grade of public finances for raising the efficiency of tax and spending.
At the global level, the critical question is how long the existing exceptional financing conditions will continue. The entire aftereffect of exceptionally low issuing rates still must materialise typically borrowing costs, and governments can ‘lock in’ the currently favourable terms by increasing the maturity of emissions, as several sovereigns are doing. Rates will rise at some time however. Besides, forces which have weighed down on the natural rate such as for example demography may start employed in reverse (Bean 2015).
The end result is that r-g happens to be low, will probably rise at an indeterminate horizon, but could nevertheless remain just a little less than past averages indicate. Policy-wise, the perfect response is to invest now on growth-boosting but non-permanent programmes. These suggestions should be followed. The task is to find initiatives that are efficient and soon add up to a substantial macroeconomic total (Blinder 2016). On the fast track lane can feature maintenance investment and shelling out for active labour market policies, along with targeted investment tax credits and cuts in labour costs. Big ticket infrastructures that carry long lags would support growth in a longer-term perspective. A sound institutional framework is however essential to ensure the standard of projects. Similarly, a credible fiscal framework helps raising the commitment to needed medium-term adjustments.
Figure 1a Distribution of growth-adjusted implicit rate
Figure 1b Distribution of primary surplus
Source: AMECO, authors’ calculations. Data for EMU countries, 1999-2015, with countries included because they enter EMU. Final number of observations is 242. The left chart plots the distribution of the difference between your average interest on government bonds and nominal GDP growth. The proper chart plots the distribution of the principal balance in percent of GDP.
The empirical evidence also points to a big heterogeneity of country situations including within the EU. Debt levels, growth prospects and borrowing rates all differ. At the national level, there is a thing that appears like a vicious circle and a virtuous cycle. Generally speaking, one band of countries have a tendency to combine high debt, low growth and higher borrowing rates. These factors are mutually reinforcing. Another group gets the opposite characteristics. That is a loose categorisation. Nonetheless it is suggestive – a simple Blanchard criterion uses the same r-g for all. The truth is, there is multi-dimensional endogeneity.
One implication is that there is absolutely no one size fits all. Policy prescriptions should be differentiated. Interestingly, while r and g could be strongly connected worldwide, there is room for national differences in r-g. Free moving capital implies common trends in r (Gros 2016), but national factors affect national r, including on liquidity and perceived sustainability. 1 Differentiation of g is a lot more evident. Specifically investments and reforms sustaining growth remain largely national.
In advanced economies, sovereign debt is normally regarded as without risk in nominal terms. The reason being the central bank can always ensure the money payment of debt burden, while keeping the choice to raise interest levels to preserve a minimal inflation regime.
The Eurozone includes a more difficult setting with an individual central bank, 19 national budget authorities and legally enshrined clauses of no bail out no monetary financing. This helps it be impossible for the central bank to backstop governments unconditionally. The instruments which have been introduced by the ECB within its price stability mandate recognise this reality. For instance, the Outright Monetary Transactions programme is depending on a sustainability-restoring programme with the European Stability Mechanism. Similarly, quantitative easing by the ECB incorporates only limited cross-border risk sharing.
The existing institutional setting in the Eurozone means that government debts can’t be consolidated within a ‘federal’ balance sheet (Coeuré 2016). Fiscal space should be evaluated on a national basis. Moreover, such as US states, you will find a case for a far more conservative debt strategy at the united states level than within an environment where direct monetary control would fully get rid of the rollover risk on sovereign debt (Fall et al. 2015). As well, if the Eurozone were to deepen its fiscal integration later on, it may be in a position to sustain a higher degree of public borrowing overall than is presently the case as the sum of individual Eurozone countries.
Which ‘debt anchors’ in the EU?
One method to devise a credible debt strategy is to keep a long-run debt objective serving as an anchor to the fiscal framework. Stabilising debt around its current level is a practicable strategy when a long way away from debt limits. When nearer to those limits, some gradual reduction could be necessary. That implies a long-run debt anchor that’s below the existing level.
One rationale for aiming at reducing debt when beginning with high levels is uncertainty. Medium to long-run projections of debt are sensitive to numerous risks. One is uncertainty on the near future values of r-g. Other risks have a tendency to be positively (debt enhancing) biased. Specifically, debt shocks are largely asymmetric, including due to contingent liabilities (Escolano and Gaspar, 2016). Furthermore, implemented fiscal policy is commonly looser than planned.
In a risk-based approach, aiming at debt stabilisation ex ante will not be enough to be reasonably confident that debt won’t increase ex post. That is why, highly indebted countries might need to shoot ex ante for a few pace of debt reduction, just to be able to have sufficient assurances that debt will at least stabilise ex post. As an illustration, you can calculate the targeted debt decrease in a median scenario in order that you have a 90% chance that your debt ratio at least will not increase ex post, given the historical variance of shocks on r and g. 2
To give a far more operational characterisation of fiscal space, one must consider the info on both ‘stock’ (debt) and ‘flow’ (balance). In a stylised ‘Blanchard framework’ (Figure 2), your debt limit curve (red curve) depicts the frontier between initial combinations of debt and primary balances that are sustainable and the ones that aren’t. In real life, nearing your debt limit is probably not prudent enough for the above reasons. Thus, for debt to be thought to be safe, one must add a security margin (green curve) vis à vis your debt limit.
Figure 2 . Operationalising fiscal space: A Blanchard (1984)-inspired framework
Note: Points A, B, C describe stylised positions of hypothetic countries. Point A corresponds to moderate debt and moderate primary surplus: there is ample fiscal space. Point B: debt remains moderate however the current primary position is low. In a prudent approach considering a safety margin there is little fiscal space. Point C: debt is relatively high. The united states has adjusted somewhat with regards to ‘flows’, i.e. a moderate primary surplus. Hence, it is still in the safety space (note it could not be if had the same primary balance as country B). However, in a prudent approach considering a safety margin there is little fiscal space.
In practice, a simple way of measuring available space could be derived by comparing the existing level of the principal balance with a primary balance norm in keeping with a long-run debt anchor. The difference between your two is suggestive of fiscal space, or remaining adjustment needs. Figure 3 illustrates based on a conservative selection of debt criterion consistent with EU fiscal rules. The email address details are cross-checked with another criterion directly drawn from the Stability and Growth Pact, i.e. the length between current positions of the structural balance and medium-term objectives.
Using this simple criterion, one sees that there surely is fiscal space in a few EU countries, but there remains an adjustment gap in others. Some member states now have significant fiscal space (e.g. Germany). Other countries including France, Italy and Spain still show a dependence on further adjustment from the perspective of debt stabilisation cum gradual reduction.
Figure 3 . Fiscal space and adjustment needs at country level
Source: Commission autumn forecast 2016, authors’ calculations. The length to the medium-term objective may be the difference between the degree of the structural balance in 2016 and the medium-term objectives of the united states within the Stability and Growth Pact. The structural primary gap may be the difference between the degree of the structural primary balance in 2016 and a primary balance norm. The latter may be the primary balance that generates an annual reduced amount of 5% of the surplus of debt over 60% of GDP. For countries with debt levels below 60%, the principal balance norm stabilises debt at its current level. The calculations of the principal balance norms assume a positive but low growth adjusted interest of 0.5%.
Current conditions are extraordinary and require a supportive fiscal policy. However, the results for the inter-temporal budget constraint could be less than meets the attention. They depend on uncertain future evolutions (specifically of r*-g*) aswell as on policies. The point is, the case is strong for spending now on investment and other targeted programmes supporting growth and employment.
However, fiscal space is heterogeneously distributed. In the Eurozone some countries have a clear margin and really should use it. Others which may be pushed closer to your debt limits should pursue a far more prudent approach of gradual debt unwinding. The sustainability risks mounted on Eurozone individual countries may actually avoid the Eurozone from pursuing an adequately supportive fiscal policy in unusual circumstances. A common stabilisation capacity would help for managing shocks that can’t be absorbed by national stabilisers alone, as advocated in the Five Presidents’ Report (Juncker et al. 2015).
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Blinder, A (2016), "Fiscal policy reconsidered", The Hamilton Project, Policy Proposal 2016-05, May.
Coeuré, B (2016), "Sovereign debt in the euro area: too safe or too risky?", Keynote address at Harvard University’s Minda de Gunzburg Center for European Studies in Cambridge, MA, 3 November.
Escolano, J and V Gaspar (2016), "Optimal debt policy under asymmetric risk", IMF Working Paper, WP/16/178.
European Commission (2016a), "Towards a positive fiscal stance for the euro area", Communication from the Commission, COM(2016) 727, 16 November.
European Commission (2016b), "Fiscal sustainability report", European Economy, Institutional Paper 018, January.
Fall, F, D Bloch, J M Fournier and P Hoeller (2015), "Prudent debt targets and fiscal frameworks", OECD Economic Policy Papers, N°15, OECD Publishing, Paris.
Fisher, S (2016), "Low interest rate rates", Remarks at the 40th Annual Central Banking Seminar sponsored by the Federal Reserve Bank of NY, 5 October.
Gros, D (2016), "Ultra-low or negative yields on euro area long-term bonds: Causes and implications for monetary policy", CEPS Working Documents, N°426, September.
Juncker, J C, D Tusk, J Dijsselbloem, M Draghi and M Schulz (2015), Completing Europe’s Economic and Monetary Union, European Commission, Brussels, June.
Ostry J, A Ghosh and R Espinoza (2015), "When should public debt be reduced?", IMF Staff Discussion Notes, N 15/10, June.
 Used liquidity and risk premia are also strongly influenced by overall market conditions.
 The Fiscal Sustainability Report explores this approach over a five-year horizon by introducing the idea of ‘non increasing debt caps’ (European Commission, 2016b, see section 2.3).