The n-th discussion of why austerity makes matter worse for Europe
4 June, 2012, 1:24. Posted by Zarathustra
Tags: Euro Crisis
I am sure that you have by now heard a lot about why austerity is not working for Europe, both from me and many others. My general point, allowing for oversimplification, is that within a monetary union, assuming that it is a closed economy by itself, the trade surplus of one part of the union must necessarily equal to the private sector net saving (i.e. saving less investment) and public sector net saving (i.e. government tax revenue less government consumption expenditure) by definition. Unless the monetary union as a whole is within an open economy and runs trade surplus with the rest of the world, it is impossible to have all member states within a monetary union to run a government budget surplus or a more or less balanced budget. And of course, this is not what’s happening for the Euro area as a whole.
Another rather intuitive explanation is that as the private sector is not growing, government cut back must necessarily make negative contribution to the GDP, which has additional multiplier effect on private sector spending, which depresses the economy further. With GDP more likely than not shrinking at the time of government cutback, the debt-to-GDP ratio must necessarily go up because the denominator is shrinking, and that because GDP represents the tax base of the economy, shrinking GDP will mean less tax revenues, thus more debt.
Rainer Willi Maurer’s paper published earlier this year has some more interesting finds on why austerity for Euro area is making matters worse, not better, and why growth is so important for the success of debt reduction. He points out that to make debt-to-GDP ratio constant over time, the primary surplus (i.e. the difference between government revenues and spending excluding interest expenses on government debt) as a percentage of GDP has to be equal to existing debt-to-GDP ratio times the difference between nominal interest rate and nominal GDP growth (Buiter and Keltzer, 1992):
As it turns out, the average nominal interest rates that various countries are currently paying for all outstanding debts are not that different among themselves. In particular, the differentials between periphery and Germany are not that large at all.
And the equation clearly suggests that with higher GDP growth, it is easier for a given country to maintain or reduce outstanding debt. Maurer’s analysis shows that at the level of interest rates above, a 1% annual real growth with 3% inflation is more or less all it takes to stabilise debt-to-GDP ratios, and indeed some of the peripheral countries can even afford to run small primary deficits without raising the debt levels:
It is obvious that the interest differentials on outstanding debt compared to Germany are not yet extremely large. If the nominal GDP growth rate of these countries were 4% (say 1% real growth and 3% inflation), Ireland and Spain could stabilize their debt-to-GDP ratios even with a small primary budget deficit (-0,3% respectively -0,2%), while Greece, Portugal and Italy needed only relatively small surpluses (0,9% and 0,5% respectively 0,3%) – despite the relatively large debt-to-GDP ratios of these countries. However, given their actual much lower growth performance, significantly higher primary budget surpluses are necessary to stabilize their debt-to-GDP ratios (Ireland 4,0%, Spain 1,0%, Greece 14,2%, Portugal 5,1%, Italy 2,8%).
Next, he found that if one computes the debt-to-GDP ratio stabilising primary surplus (i.e. that level of primary surplus/deficits which keeps debt-to-GDP ratio constant throughout), and then computes the differences between each eurozone country and German, the spreads can pretty much explain most variance of interest rate spreads of 10-year government bonds for Eurozone countries, with the correlation at 0.95.
If one calculates the debt-to-GDP ratio stabilizing primary surpluses for the Eurozone member states according to the above formula and subtracts from these values the corresponding value for Germany (“debt stabilizing primary surplus gaps” in the following) the resulting differences are quite large. As figure 4 shows, the resulting primary surplus gaps display also a very strong correlation with the current interest rate spreads for ten-years government bonds. The correlation is even stronger than for the debt-to-GDP ratio spreads (figure 1) and for GDP growth gaps (figure 2). As table 1 shows, this correlation too has been growing since the year 2008 and is now considerably stronger than for the other variables.
As it seems, current interest rate spreads are not only influenced by debt-to-GDP ratios; economic growth too has a very strong impact. The strongest correlation results for debt-to-GDP stabilizing primary surplus gaps – a value that combines debt-to-GDP ratios and GDP growth rates in a meaningful way. Consequently, economic policy strategies to fight the European debt crisis must consider their consequences for economic growth too.
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About Zarathustra
Zarathustra: Founder and Managing Editor of Also sprach Analyst. Once an analyst, now an investor and entrepreneur. Based in Hong Kong, but Londoner at heart.