The Many Ways to Reduce Debt-to-GDP Ratio
In the current debate we’ve become accustomed to the idea that public debt is the main reason of Italy’s problems. This statement, that at this point we hear like a dogma in every talk show, is clearly simplistic and ignores that the high public debt is only a symptom of the negative economic situation of Italy. For the benefit of readers, we remember that the crisis we have suffered was originated by private debt: only subsequently it turned into a public debt crisis.
Another wrong but recurrent statement is that in order to reduce debt to GDP ratio, austerity is necessary. Some commentators and economists present this solution as the only possible way. Some even go further and say that austerity, besides reducing the weight of debt, would encourage growth: another hypothesis denied by data. But is austerity really the only way to reduce the ratio between the public debt and the gross domestic product?
Some simple notions of political economy are sufficient to know that this is not the case.
Our aim is not to discuss if austerity is the correct way to realize reduction of public debt (neither the debt/GDP ratio), but to show that it is not the only instrument available to governments.
First, we have to make an essential remark. First thing first, let’s state the obvious: debt to GDP ratio is indeed a ratio. There is a numerator (the debt of the country) and a denominator (the gross domestic product) and in order to reduce this ratio, therefore facilitating debt sustainability, you can work on the numerator, reducing it, or on the denominator, increasing it.
Throughout history, various instruments have been used to reduce debt to GDP ratio. We can group them into five classes:
1. Fiscal consolidation(i.e. austerity). You act on the numerator, trying to reduce nominal value of debt through bigger primary balances. However, these measures could diminish also the denominator, i.e. the GDP, especially when there is a recession.
The economist Mariana Mazzucato, teacher at the UCL, wrote about this issue: “The austerity politics that are predominant in the world are proving to be counterproductive in their efforts to reduce debt to GDP ratio, because they penalize consumption and, at the same time, they erode firms’ confidence, discouraging them from investing”.
2. Default or debt restructuring. Here too, you work on the numerator. Possible inconvenience: if the State declares default, it would lose almost certainly the trust of the investors for a prolonged period, whose duration depends on the efficacy of after-default economic policy. The operations of restructuring are often painful and could include hard structural reforms (take Greece as an example).
3. Growth-enhancing policies. In this case you work on the denominator: State intervenes in order to sustain production. An example is bigger public spending for investments that stimulate GDP growth to such an extent that counterbalances the increase of debt.
4. Monetary policy. In this case you work both on the numerator and the denominator. Practically, you inject a bigger quantity of money into the economy, trying to pursue the following effects:
a) bigger GDP growth in the short
b) termsurprise inflation that reduces real interest rates on debt
c) bigger revenues from seigniorage (i.e. you finance debt not with primary balances, but with money creation, reducing debt’s nominal value)
5. Financial repression. Let’s analyze more in depth this instrument. The expression could be scary, but the concept is not as terrible as it could appear.
Basically, it consists of pushing interest rates to artificially low levels, in order to reduce borrowing costs: the aim is to reduce the interest-growth differential and so provoke a reduction of debt to GDP ratio.
This policy involves various instruments. The main ones are:
explicit or implicit caps on interest rates, for example through the purchase of government bonds by the central bank (any reference to quantitative easing is purely wanted)
creation of a captive audience at national level: a constrained public of investors that ensures a stable demand for public debt, making the borrowing conditions easier.
This aim can be pursued also through capital account restrictions and exchange controls.
Financial repression was used to reduce debt in a lot of countries from the II World War until the beginning of the ‘80s, when capital movements were liberalized. But it is not a simple historical curiosity. Even today something similar is happening with quantitative easing and with the incentives provided by ECB to domestic banks in order to hold government bonds.
In 2016 Olivier Blanchard, ex chief economist at IMF, argued: “Restrictions on capital flows were and are a more natural instrument for advancing the objectives of both macro and financial stability”.
Let’s look at the following graph, drawn from a paper of IMF whose title is “Reducing debt short of default” and which was published in 2018. The graph shows the episodes of debt reduction not due to default and the factors which contributed to them.
You can see that during the decades the interest-growth differential (in blue) contributed to debt reduction in a much bigger way than primary surpluses (i.e., grossly, austerity, indicated in red). Between 1945 and 1970 in advanced economies (AEs) this result was pursued largely thanks to financial repression, high growth and persistent inflation. From the ‘70s, instead, in advanced countries there were few episodes of substantial debt reduction. They were mainly based upon austerity measures. On these occasions, inflation was low and interest-growth differential was near to zero.
The other two sections of the graph refer to emerging markets (EMs) and low-income countries (LICs). Here we don’t want to analyze them in detail, even if you can see that here too a decisive role was played by the interest-growth differential, more than fiscal consolidation. Therefore, there’s not only austerity. The true alternative is to widen and exploit interest-growth differential: there are various ways to do it, as we have just seen.
There’s a large range of instruments that policy-makers can use in order to reduce debt to GDP ratio. Which are chosen depends on the balance of power and on the objectives that the ruling class want to pursue. Undoubtedly, austerity is compatible with a reduction of State intervention into economy. But today we need something different.
WRITTEN BY ALESSANDRO BONATTI FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT