Chair: Charles Enoch, St Antony’s College
Following the global financial crisis, public debt spiked in many advanced countries. However, according to Carlo Cottarelli, the risks, which accompany living with high debt-to-GDP ratios, are not often discussed publicly. This has prompted him to write a book, What We Owe – Truths, Myths, and Lies about Public Debt, which forms the basis of his PEFM talk.
Cottarelli began with a striking chart demonstrating the level of public debt in advanced economies. As was clearly visible, after World War II there was an unprecedented build-up of debt in peacetime. Notably, these ratios do not include the hidden liabilities in terms of pension and healthcare entitlements, which are likely to rise, but are outside the focus of Cottarelli’s work.Why is high public debt potentially a problem? Cottarelli outlined two main reasons. First, high debt levels raise the risk of a rollover crisis. If investors perceive governments as running Ponzi schemes borrowing more to simply repay previous debt, they are likely to refrain from buying the paper that the government needs to sell to ‘roll over’ previous commitments. This is a particular risk if governments are running a negative primary balance (difference between revenues and primary spending without debt interests), which means debt is continuously growing.
Pinning down the point at which debt becomes unsustainable is notoriously hard, but Cottarelli estimates this to be at around 110% of GDP, with Italian debt currently standing at 130% of GDP for example. Currently, the costs of carrying such high debt load are not felt as the spread over German debt is just at around 100 basis points. However, this is due to the large-scale actions of central banks, notably the ECB, which is buying government bonds. At some point this will likely cause too much inflation. Then, central banks will need to sell government securities and Italy and others will feel the full weight of their debt load.
Following the global financial crisis, public debt spiked in many advanced countries. However, according to Carlo Cottarelli, the risks, which accompany living with high debt-to-GDP ratios, are not often discussed publicly. This has prompted him to write a book, What We Owe – Truths, Myths, and Lies about Public Debt, which forms the basis of his PEFM talk.
Cottarelli began with a striking chart demonstrating the level of public debt in advanced economies. As was clearly visible, after World War II there was an unprecedented build-up of debt in peacetime. Notably, these ratios do not include the hidden liabilities in terms of pension and healthcare entitlements, which are likely to rise, but are outside the focus of Cottarelli’s work.Why is high public debt potentially a problem? Cottarelli outlined two main reasons. First, high debt levels raise the risk of a rollover crisis. If investors perceive governments as running Ponzi schemes borrowing more to simply repay previous debt, they are likely to refrain from buying the paper that the government needs to sell to ‘roll over’ previous commitments. This is a particular risk if governments are running a negative primary balance (difference between revenues and primary spending without debt interests), which means debt is continuously growing.
Pinning down the point at which debt becomes unsustainable is notoriously hard, but Cottarelli estimates this to be at around 110% of GDP, with Italian debt currently standing at 130% of GDP for example. Currently, the costs of carrying such high debt load are not felt as the spread over German debt is just at around 100 basis points. However, this is due to the large-scale actions of central banks, notably the ECB, which is buying government bonds. At some point this will likely cause too much inflation. Then, central banks will need to sell government securities and Italy and others will feel the full weight of their debt load.
The second reason to be worried about high public debt is that it lowers long-term GDP growth. There are two economic explanations for this. First, government borrowing can lead to ‘crowding out’ and less money being available to the private sector, thus reducing investment. Second, higher debt also requires higher taxes to finance, which might in turn discourage entrepreneurs. While problems of reverse causality are important, it is notable that the three advanced countries with the lowest growth rate over the last 25 years are those with highest debt load (Japan, Greece, and Italy). Econometric evidence Cottarelli provided suggests that increasing debt by 60 percentage points of GDP leads to a reduction of 1% in economic growth per year, leading to a per capita level of GDP difference of over 10% in just 10 years.
If high debt is a problem, how can a country go about lowering it? The orthodox solution is of course to cut spending or raise taxes, but given how politically unpopular that is, governments have been looking for alternatives. However, such alternatives according to Cottarelli either do not work or are not sufficiently important. First, governments can rely on central banks printing money, but that replaces risk of repayment with risk of inflation. This can be effective in paying down debt given fixed interest rates, but the problem is that moderate inflation is insufficient as markets have time to adjust. What is needed for a sizable cut is an inflation outburst of around 25% over a two-year period, which however is extremely hard to control. It also presupposes the country can print its own money, which is not the case in the euro area.
There are other unorthodox approaches. A popular method in the past was financial repression in which interest rates are capped or money is not allowed to leave the country. Something akin is happening now due to combination of loose monetary policies and restrictive banking regulation, leading to banks ‘swimming’ in liquidity and providing financing without inflation. However, banks are likely to sooner or later attract enough equity to begin lending again, breaking out of the accidental financial repression we are currently observing. Another method is simply the refusal to pay back debt, but that comes with reputational cost and is ineffective if debt is held by domestic bondholders with spillover effects. Debt mutualization is a theoretically good idea, but requires a level of altruism that is not found even within political unions like the US. Finally, privatization might be good, but there is simply too little left to privatise, and even optimistic assessments are unlikely to bring down debt much.
This all leads Cottarelli to ultimate suggest an orthodox way to reduce public debt by combining structural reforms and a moderate level of austerity. Structural reforms are key to increasing growth, which then can reduce the debt-to GDP ratio, but such reforms take time and, to be most effective, require that the government save the revenues to pay down the debt rather than spend them. This leads him to his second component – a moderate level of fiscal austerity such as a freeze of primary public spending in real terms. However, countries with high debt such as Italy need to maintain primary surpluses of 4.5% of GDP for a considerable amount of time. While hard, it may be successful as putting debt on declining trajectory alone is likely to reduce the negative consequences of the debt load.
Overall, Cottarelli presented a bleak picture for advanced economies and argued that ultimately orthodox measures are the way forward for reducing interest rates. Such measures however should be adopted as soon as possible before interest rates begin rising again and advanced countries begin to feel the full weight of their public debt.
Ivaylo Iaydjiev (St Antony's College, Oxford)
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