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PUBLIC DEBT and the EU Objectives

PUBLIC DEBT and the EU Objectives. 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 it’s debt Be able to apply the above to monetary union in the EU REF: Eufiscalteach nov09

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PUBLIC DEBT and the EU Objectives

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  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 it’s 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 > T1 • Yr2 must cover G2 + debt service • T2 = G2+(G1 - T1) (1+r)

  6. PUBLIC DEBT and the EU Section 2

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

  8. GOVERNMENT SOLVENCY • Real debt burden (ie;ratio of govt. debt to GDP) doesn’t 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 G=T for a year, debt rises (debt service) • Debt can be EXPLOSIVE! • Primary surplus may be required

  9. DEBT STABILISATION • Explosive if r > g debt accumulates faster than GDP grows (as 1970’s +) • If r < 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 > 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 surplusdebt 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 dependency 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) Source: Adapted from ECB Monthly Bulletin Nov 2007 & ECB Statistics Pocket book Oct 2009

  20. Euro area; Government debt (as a percentage of GDP) 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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