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PUBLIC DEBT and the EU Objectives

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Title: PUBLIC DEBT and the EU Objectives


1
PUBLIC DEBT and the EUObjectives
  • By the end of this lecture students should
  • Be aware of the significance of the intertemporal
    budget constraint
  • Understand why and how a country can stabilise
    its debt
  • Be able to apply the above to monetary union in
    the EU
  • REF Eufiscalteach nov09
  • Incl formulae

2
PUBLIC DEBT and the EU
  • Section 1

3
What is the government deficit?
  • Assumptions
  • Ms constant
  • lump sum tax autonomous
  • Government debt (D)
  • (1) D D-1 rD-1 G - T
  • where
  • D-1 Govt. debt at the end of the previous
    period
  • rD-1 interest paid on this debt
  • G Govt. spending
  • T Taxes

4
  • Thus, budget deficit (BD)
  • (2) D D-1 G rD-1 - T
  • change in debt Budget deficit
  • Rearrange
  • D D-1 G - T rD-1
  • primary deficit debt service

5
Intertemporal budget constraints
  • Assume
  • 2 time periods
  • Yr1 G1 T1
  • Yr2 G2 T2
  • No initial debt
  • If G1 gt T1
  • Yr2 must cover G2 debt service
  • T2 G2(G1 - T1) (1r)

6
PUBLIC DEBT and the EU
  • Section 2

7
DEBT STABILISATION
  • 1960s - expanding debt no concern
  • 1970s - explosive increase in debt
  • Debt stabilisation central to fiscal policy
  • See handout for EU data

8
GOVERNMENT SOLVENCY
  • Real debt burden (ieratio of govt. debt to GDP)
    doesnt grow without limit
  • Adjustment of primary budget balance required
  • total deficit primary deficit debt service
  • D G - T rD-1
  • primary deficit debt service
  • Even if GT for a year, debt rises (debt
    service)
  • Debt can be EXPLOSIVE!
  • Primary surplus may be required

9
DEBT STABILISATION
  • Explosive if r gt g debt accumulates faster
    than GDP grows (as 1970s )
  • If r lt g ratio debt to GDP can be
    stabilised with budget deficit

10
  • Now consider in relation to GDP
  • D G - T (r-g) D-1
  • Y Y Y
  • g growth rate of econ
  • r r on debt
  • Debt Explosive if r gt g

11
p18
  • Primary surplus required to stabilise total debt
    to GDP ratio
  • ie D 0
  • Y
  • when
  • T-G (r-g) D-1
  • Y Y
  • primary budget surplus debt service
  • Examples-see worksheet


12
PUBLIC DEBT INFLATION
  • Central bank can now monetise the debt
  • Seigniorage
  • No debt service - breaks link making debt
    explosive
  • Inflation tax
  • Introduce seigniorage into formula

13
  • Now, smaller primary budget surplus required for
    stabilisation
  • Explosive nature of debt transferred to
    INFLATION eg. Brazil, Russia

14
PUBLIC DEBT and the EU
  • Section 3

15
HOW TO STABILISE PUBLIC DEBT
  • DEFAULT Extreme
  • SEIGNIORAGE INFLATION TAX Reduces value of
    M0 Reduces value of public debt
  • REDUCE DEFICIT

16
REDUCE DEFICIT
  • Raise tax / cut Govt. expenditure
  • Politically/economically difficult
    Coalitions German unification depende
    ncy ratio tax problems eg.
    Distortions, deadweight loss
  • Success?

17
UK NEW FISCAL FRAMEWORK
  • Deficit reduction plan
  • Transparency
  • Account for economic cycle
  • Two rules Golden Rule over cycle Public
    debt - stable prudent level
  • Adopted by EU?

18
EU EXPERIENCE
  • Maastricht criteria
  • Stability growth pact
  • Rationale
  • fiscal discipline - debt is explosive
  • risk of fiscal externalities
  • danger ECB monetising debt
  • See handout that links these arguments to earlier
    theory

19
Euro area Budget deficit deficit (-)/surplus
() Selected countries (as a percentage of GDP)

BL DE FR IT FI Euro area
2003 0 -4 -4.1 -3.5 2.5 -3.1
2004 0 -3.8 -3.6 -3.5 2.3 -2.8
2005 -2.3 -3.4 -2.9 -4.2 2.7 -2.6
2006 0.4 -1.6 -2.6 -4.4 3.8 -1.6
2009 Q1 -7.0
Source Adapted from ECB Monthly Bulletin Nov
2007 ECB Statistics Pocket book Oct 2009
20
Euro area Government debt (as a percentage of
GDP)
2003 69.1
2004 69.4
2005 70.0
2006 68.2
2007 66.0
2008 67.5
2009 73.1
Source ECB Statistics Pocket book Oct 2009
21
SGP problems
  • Loss of ER monetary policy - fiscal policy is
    only policy left to States
  • OCA analysis suggests centralised budget - not
    possible
  • Thus, fiscal policy must be flexible to deal with
    negative shocks
  • it is not under SGP
  • State budgets not automatic stabilisers in
    recession (national fiscal policy constrained)

22
SGP problems
  • Can rules be enforced?
  • action against offenders requires 2/3 maj in
    Council
  • Evidence suggests more flexibility would be ok
  • evidence (DE Grauwe) that States in monetary
    unions have lower budget deficits that individual
    States
  • risk of default in EU low (10yr bond yields have
    converged on German rates)

23
SGP problems
  • France Germany 2003/04
  • SGP effectively suspended
  • 2004-08?
  • Future?

24
SGP problems
  • Greece 2009

25
CONCLUSION
  • Debt stabilisation central to fiscal policy
  • Debt can be explosive
  • Primary budget surplus important
  • Stability Growth Pact
  • does it constrain national fiscal policy in EU?
  • will it stop fiscal externalities in EU?

26
ADDITIONAL READING
  • Reading list, plus
  • Gros Thygesen, ch8
  • De Grauwe ch9
  • Bohn H, The Behaviour of US Public Debt and
    Deficits, Quarterly Jnl of Economics, Aug 1998
  • Weale M, Monetary and Fiscal Policy in
    Euroland, Jnl of Common Market Studies, March
    1999
  • Balsssone Franco,Public Investment, the
    Stability Pact and the Golden rule, Fiscal
    Studies (2000), vol. 21
  • Buti, Franco Ongena,Fiscal Discipline and
    Flexibility in EMU The Implementation of the
    Stability and Growth Pact, Oxford Economic
    Review, vol.14, no.3
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