Killing Public Debt, Not Keynes

The excellent Seamus Coffey has a useful post on the implications of the Fiscal Compact rules for the ability of governments to run counter-cyclical fiscal policy,

Seamus correctly points out that it is still possible to run counter-cyclical policy while maintaining a structural balance of 0.5 percent. Here’s Seamus’s example:

One could debate the specific figures in this example but the point is well made. The country in this example only breaks the 3 percent deficit limit when the output gap is 6 percent. That’s a fairly big output gap, as seen from the figure showing the CBO’s estimates of the US output gap. Interestingly, the IMF estimates 6 percent as the maximum output gap for Ireland (see page 26) because they view the pre-crash economy as having been well above its potential level.

So all is good with this fiscal rule, right? Well, let’s think about the debt-GDP ratio in this economy. In the long-run, the debt-GDP ratio for a country that has deficit ratio of d and a growth rate of nominal GDP of g will converge towards d/g. Here‘s a note providing this formally but it’s not so complicated: If we keep adding one unit of debt for every four units of GDP then our debt-GDP ratio is going to tend towards one-quarter.

The Fiscal Compact specifies that the maximum cyclically-adjusted budget deficit should be a maximum of one percent. In any economy that grows at a nominal rate of four percent (say two real, two nominal) this will imply a maximum debt-GDP ratio of 25 percent of GDP. A government that does not want to be constantly flirting with warnings from the Commission or its own national budgetary body set up to enforce the Compact, will probably shy away from going too close to the one percent, so in practice these rules would send the economy on a path towards the elimination of public debt.

So while the Treaty may not kill Keynes, you could argue that it does attempt to kill public debt.

It is in this context that I have argued that the rule place limits on the sensible usage of counter-cyclical fiscal policy. In my recent VoxEU article on this topic, I said that the “rules will also severely limit the ability to use fiscal policies for stabilisation purposes in a manner consistent with moderate long-run debt levels.” The qualifier about moderate debt levels is important.

Consider Seamus’s example. Suppose a country with a nominal GDP growth rate of four percent had a government that wanted to stabilise its debt-GDP ratio at 60 percent.  This country could run an average deficit of 2.4 percent. In Seamus’s example, such a country would pass the 3 percent deficit limit as soon as there was an output gap of 1.2 percent, which is smaller than is triggered in almost every recession.

An alternative and consistent set of rules that focused on keeping debt ratios stable at 60 percent would, using Seamus’s theoretical figures, allowed this country to run a deficit of 5.4 percent at the bottom of the cycle when the gap is 6 percent and then to run a surplus of 0.6 percent at the top of the cycle when the gap is a negative 6 percent.

The underlying premise of the figures used to implement the proposed “golden rule” seems to be that “public debt is bad”.  Now I don’t want to go all MMT here but it’s not a huge insight that one person’s debt is another person’s asset. One has to wonder have the designers of these rule thought about the future structure of the economy, what pensions funds and other savings vehicles are supposed to use instead of government bonds and what the world looks like when public sector and private sector are both attempting to reduce their debt levels over time.

One might quibble with objections to the Compact rules based on their very long-run implications, when we know from Keynes what happens in the long run. However, the implications are not just short-run.

For example, consider the Netherlands. This country looks very like my stylised “well behaved” country above. According to the EU Commission, the Netherlands had a cyclically adjusted budget deficit of 2.5 percent in 2011 and it tends to grow at an average real rate of 2 percent, consistent with 4 percent nominal growth. Its debt ratio in 2011 was 64 percent.

So this country is doing just fine: They are on a course consistent with a stable debt ratio of about 60 percent. Yet the Fiscal Compact rules will insist that they reduce their deficit by a further two percentage points over the next few years. This example can be repeated across other countries to varying degrees. The point is that the new rules are likely to mean tighter fiscal policy in Europe than is necessary in the coming years, something that will make it all the harder for those countries that need to undertake fiscal retrenchment to obtain the growth required to reduce their debt ratios.

And even if the implications were only long-run, a treaty isn’t just for Christmas. It’s something that, once signed, we will be stuck with for a long time.  While the self-interest of countries like Ireland may be best served by signing up for this flawed treaty, the wider European public should focus on getting us a better treaty before this one comes into force.